Stephen King: Events in Libya and the Middle East will shape prospects, not those in Japan

What if a no-fly zone is needed in other parts of the region?

When tragedy and upheaval strike, financial markets sell off. It's not so much that the world has changed in any fundamental way: rather, investors hate uncertainty.

Japan's terrible problems may ultimately have no wider international economic effect but, with a nuclear power station suffering a slow-motion death and with Tokyo just down the road, it's no great surprise that markets have been jittery, to say the least.

While the region of Japan most heavily affected by the tsunami accounts for not much more than 4 per cent of GDP, downtown Tokyo and its port, Yokohama, account for almost 18 per cent. Any human tragedy is a terrible event, but the economic and financial consequences of a disaster unfolding in a densely populated urban area the size of Tokyo would be huge: only with urban economic density has the human race managed to deliver the living standards we now take for granted in the developed world.

Still, even if the nuclear situation is brought under control, Tokyo is already suffering economic problems. Rolling power cuts have put the brakes on economic activity. In the shops, the shelves are empty. Workers are staying at home to avoid the hazards of radiation.

The earthquake and the tsunami which led to such devastating destruction only serve to demonstrate how our complex industrial societies are stitched together using the finest of gossamer threads.

With the grim search for bodies now coming to an end, Japan has to prepare for the rebuilding programme. Some argue that the kind of stimulus that comes from large-scale public works could be an unexpected blessing, leading to a Keynesian fiscal stimulus that will drag Japan out of its 20-year period of stagnation. This conclusion is both optimistic and wrong. Japan's stagnation reflects its rapidly ageing population: lots of retirees to be supported by a dwindling number of workers. Japan's economy has also suffered from persistent outsourcing and offshoring, a consequence of the arrival of a billion Chinese on the global economic scene over the past three decades. Neither of these constraints on growth will be lifted as a consequence of the terrible events over recent days.

Ultimately, someone will have to pay for the rebuilding. One possibility is for the Japanese government to issue more bonds, thereby placing the burden of payment on future taxpayers. Borrowing more, however, tends to drive interest rates higher, an experience Germany went through during its reunification at the beginning of the 1990s, and higher interest rates, in turn, push the currency higher, choking off exports.

Another possibility is for Japanese companies to invest at home rather than abroad. Japan, after all, is a nation of savers, investing a lot of its money overseas. Perhaps outflows will now dry up. Alternatively, perhaps assets held abroad will now be repatriated. Either way, the yen is likely to rise as Japan's demand for foreign currency begins to wane. And countries elsewhere in the world may discover there are limits to Japan's ambitions regarding overseas investment.

Many investors reached this conclusion in the middle of last week and, as they did so, the yen rose dramatically. The Ministry of Finance and Japan's industrial partners then stepped in, selling yen on the foreign exchanges to prevent an appreciation that might have choked off Japan's export-led economy. To the extent that the yen's gains were becoming a little unruly, the intervention has been enough to calm some distinctly frazzled nerves.

Yet the question of precisely who pays for Japan's rebuilding is still out there. Either resources are diverted away from exports – hence why the yen was under upward pressure – or they are shifted away from other forms of domestic demand. If the Bank of Japan is unwilling to sanction higher interest rates – and, given Japan's continuous deflation, it will be in no mood to do so – perhaps the Japanese government will tax its citizens more. Given this risk, Japanese consumers are unlikely to be spending freely any time soon.

While Japan's own economic problems have worsened as a result of the terrible events in recent days, for the rest of the world there's a much bigger threat to economic progress. Events in the Middle East and North Africa are in danger of running out of control, not so much because of the monstrous developments in Libya but, rather, because of the challenges to regimes elsewhere in the region.

Imposing a no-fly zone over Libya is all very well, but what if a similar no-fly zone is needed in other parts of the region? Might the result be a huge spike in oil prices – far bigger than we've seen already – and, if so, what then becomes of the global economic recovery?

For the developed world, higher oil prices initially place upward pressure on inflation and downward pressure on economic activity. Because most developed nations are net oil consumers, higher oil prices leave their people genuinely worse off. How much worse off depends, of course, on how far oil prices rise. But that's not the only factor.

The European Central Bank, for example, is now planning to raise interest rates in response to higher oil prices in a bid to keep inflation under control. By doing so, European consumers and companies will hit both by the higher cost of fuel and also the higher cost of borrowing. Of course, if countries have relatively healthy fiscal positions, they might be able to counteract the effects of higher oil prices through a well-targeted tax cut or, perhaps, an increase in fuel subsidies. But for much of the Western world, still licking its financial wounds following the sub-prime crisis, looser fiscal policy really isn't an option. Put simply, we're in the worst possible position to cope with a rise in oil prices: the scars from the previous crisis have yet to heal. So while we shudder at the thought of the terrible traumas affecting the Japanese people, our own economic prospects will ultimately be shaped a lot more by events in the Middle East and North Africa.

The oil price provides the barometer for these events, telling us whether fuel supplies are at risk and, as a result, whether our own economies are in danger. We're not seeing a return to the 1970s – back then, both prices and wages rose rapidly whereas today, only prices are really going up – but we can't afford to forget one of the key lessons from the 1970s: the economic consequences of events in the Middle East can spread far and wide.

We're not yet staring into the second part of a double-dip recession, but it's not so difficult to imagine that the recovery we've seen so far – meagre though it has been – could easily come to a sticky end.