Invited by Bahrain in 2003 to advise the small Gulf country on how to reform its labor markets, Wharton management professor Peter Cappelli remembers addressing a gathering of local business leaders in the capital, Manama, on his findings. One was clear: Bahrain had to stop relying on cheap, imported labor from South Asia and provide job opportunities instead to its underemployed Shiite community.

“It was very clear the business community did not have the least bit of empathy toward them,” Cappelli recalls. “I said, ‘Look, you’ve got this high rate of unemployment among the Shiites, and their population is growing, and the opportunities aren’t there.’ At that point the big concern was about radicalization, and the threat of al-Qaeda spreading. And I said, ‘You have these young men; they’re sitting on street corners. You have to do something about that, or what do you think these guys are going to do? They’re going rise up at some point.'”

Protests by Bahrain’s Shiite majority against the country’s ruling Sunni royal family began in early February, and have since taken a violent turn. The Gulf country and Libya are the latest Arab countries to experience popular unrest following the successful ouster of Tunisian President Zine el-Abidine Ben Ali and Egypt’s Hosni Mubarak. Protestors in Yemen have sustained calls for the removal of President Ali Abdullah Saleh and demonstrators are on the march in Morocco. Even Saudi Arabia is not untouched — some activists organized a small group there, and were promptly arrested. But Bahrain and Libya now stand apart, because the use of armed state security forces against protestors has led to numerous civilian casualties.

Before the protests, Libya and Bahrain were seen as two very different Arab countries. Bahrain, regarded as one of the more reform-minded countries in the region, is a close U.S. ally and host to the U.S. Navy’s Fifth Fleet in the Gulf. Libya, long considered a pariah state, only rejoined the world community after denouncing terrorism and accepting responsibility for the 1988 Lockerbie bombing. But because of the brutal repression inflicted on protestors in both countries, the two now share a negative perception, say Wharton professors and other academics. This will undo any past progress in global politics and markets. Both governments will likely fall as a result, they add. The lesson governments need to learn is that violence can no longer be the response to calls for reform.

“You have to bring together different parties, build a national consensus, and manage that process so things move to a transition and people find a solution themselves,” says Wharton finance professor N. Bulent Gultekin, former governor of Turkey’s central bank. “Once people are on the streets and feel treated unfairly and that they can push harder to bring down the state structure, it’s the point of no return. It’s just not possible for an army now to go and shoot their own people. These days you can’t do what Saddam Hussein did or what Hafez al-Assad did in Syria. World opinion will not support you. You could have done these things during the Cold War, because everyone had their own sphere of interest. If Tiananmen Square happened today, I’m not so sure the Chinese would act as they acted then. Force will not solve the problem. That is the drastic change as a result of the end of the Cold War. You cannot rely on security forces.”

Enormous Damage

The violence waged by security forces against protestors in Bahrain is out of step with the reform path along which the country’s King Shaikh Hamad bin Isa Al Khalifa, and the Crown Prince Shaikh Salman bin Hamad bin Isa Al-Khalifa had been guiding the country, according to Cappelli. He suggests a power struggle could be taking place between Bahrain’s royals and members of its extended family. “Even though it’s a monarchy, there are lots of different power bases, and each has quite different views,” he says. “What happened with the police is an overreaction that wasn’t necessarily authorized from the top.”

The country — roughly one third the size of Rhode Island — struggled with an unstable political situation related to both sectarian and democratic tensions until 1999, when King al Khalifa came to power. One of his first reforms removed the notorious State Security Law, which allowed for unlimited detention of dissidents without trial. He allowed for the creation of a small, though tightly controlled, parliament. He also instituted economic reforms, including the creation of the Economic Development Board.

For its efforts, Bahrain basked in acclaim: According to the Heritage Foundation and the Wall Street Journal, it ranked as 13th among the world’s most free economies, largely because it had no personal or corporate tax and no withholding or VAT. Most uniquely for the Middle East, Bahrain allowed for 100% foreign ownership of companies and the formation of labor unions. Its stable financial system made it an early home for Islamic finance and Islamic law firms, which now comprise 25% of the economy.

In the wake of the violence, though, Bahrain’s economy has been hit with a downturn. Its credit ratings from Standard & Poors have been reduced to A- for long-term debt, and A-2 for short-term debt, while the cost of insuring its sovereign debt nearly doubled to US$300,000 to insure US$10 million of five-year government debt, from US$175,000. It also cancelled the Bahrain Grand Prix, an event that generated more than US$500 million for the economy.

“The damage is enormous,” Cappelli notes. “That’s a large part of the reason I don’t think the violence was an intended reaction, because it’s just so out of sync with what the leadership has been trying to do. They’re not stupid; they understand the importance of branding. It does damage the Bahrain brand a lot. It’s going to cost them a lot in terms of the business community and international investment.”

Libya too had begun to make efforts to invigorate its economy, shedding its pariah state status in 2004 by ending its support of terrorism and the pursuit of weapons of mass destruction. It planned to attract up to US$8 billion of foreign investment by 2015, with real estate, transportation and construction being offered up for privatization, according to African Economic Outlook, a think tank and research center network. Counting on revenues from the largest proven oil reserves in Africa, Libyan officials said the country would be investing US$500 billion to develop infrastructure over the coming decade.

It was expected that Colonel Muammar Gaddafi’s son, Saif Al-Islam, would soon take over the country’s leadership and bring a modernizing approach. Saif Al-Islam was a proponent for political and economic reform, pushing his father to abandon Libya’s nuclear and chemical weapons programs, and creating the National Economic Development Board, a body that worked to update Libya’s regulatory system.

The violence against unarmed protestors and Saif Al-Islam’s televised speech days into the protests, which parroted his father’s rhetoric, have erased whatever potential Libya had built up since the lifting of embargos against it, experts say. “Libya spent several years coming in from the cold, and all that has been lost,” says Charles Gurdon, managing director of Menas Associates, a London-based political risk consultancy. “All the people who said you couldn’t trust Gaddafi have been proven right.”

Political Contagion

The tumult wracking the region is the result of a thaw finally occurring in politics, says Gultekin. “There is pent-up dissent in the region and the Muslim world. Leadership hasn’t delivered prosperity, and people are dissatisfied. Media and new technology have been catalysts. The monopoly of print media in the region has been broken, and people are connecting in a way they never could have done so in the past.

“These are the aftershocks of the collapse of the Berlin Wall,” he adds. “The region’s dynamics have changed. During the Cold War, everything was artificially frozen, everyone knew where they stood — either with NATO or the Soviet Union. All of a sudden, we’re back to the 19th Century. It’s not that it was the end of history, it’s that history has resumed. Now we can see the wave coming. It happened in Eastern Europe, and it’s happening in the Middle East now. I don’t want to say it’s the power of the people, though, because people may be dissatisfied, but there aren’t enough structures, institutions, and democratic traditions to [duplicate] what happened in Eastern Europe. Because of the European Union, it was a relatively easy transition there, and they had a role model.”

Gultekin also likens what is happening in the Middle East now to the events of the ‘Asian flu’ financial crisis of 1997. “During the financial crisis in East Asia, we talked about a financial contagion. This is a political contagion. The reason we had financial markets being affected during the financial crisis was because they were so connected, and things were moving so fast. I think we have an analogous situation in politics these days. You can’t have a crisis because there’s bad news, you have to have fundamentals for that. Political unhappiness has been brewing in these countries because the leadership cannot deliver, and that is becoming obvious.”

The antidote, Gultekin points out, is not the common assumption that Tunisia, Egypt and other Arab countries can follow a political and economic model based on Turkey. That idea, he says, neglects to realize that Turkey forced itself on a path to modernization beginning in 1923 and that remains a work in progress. “It is a very different country, it has a longer history of statehood than any other country in the region,” he notes. “It transformed itself over time. Turkey came to this stage through a very long, sometimes painful process. It didn’t happen overnight. It’s not like we picked the model and adopted it.”

The solution lies in ensuring that political consensus can be broadly reached, and that a country’s economic and social problems are addressed in an equitable manner. Uneven policies now can become potential issues, which is why Bahrain, despite its efforts to liberalize, was not protected from the unrest, says Kristian Coates-Ulrichsen, deputy director of the Kuwait Research Program on Development, Governance and Globalization in the Gulf States, based at the London School of Economics and Political Science.

“Domestic Bahraini problems facilitated the interlinking of political grievances with socio-economic hardship,” Coates-Ulrichsen notes. “Domestic repression of opposition and human rights activists increased markedly last year ahead of Bahrain’s October parliamentary elections, as did Shiite groups’ belief that the regime was not serious about political dialogue or meaningful reform. These contributed to a situation of growing tension that was susceptible to the winds of change blowing through the Middle East, and which was greatly magnified by the authorities’ heavy-handed response to the initial protests on February 14. The killing of protestors transformed the demonstrations and also the nature of their demands, from reform within the system to large-scale calls for the removal of the system.”

More Gathering Storms

Just as the October elections in Bahrain were taking place, Coates-Ulrichsen jointly published an analysis forecasting potential political unrest spreading throughout the region, based on what he observed in the Gulf nation. Now that it has occurred, he says the unrest’s changing nature demonstrates that even Bahrain’s wealthier neighbors are not immune.

“Although Bahrain’s socio-economic and political problems are not replicated across the region, the Gulf States do contain large numbers of poor nationals living in relative poverty and without much economic hope for the future,” he says. “This is particularly the case in Saudi Arabia and Oman, which have larger national populations, but is also true of the Bedouin in Kuwait and the United Arab Emirates (UAE). Social and economic conditions of hardship do exist and contain the potential to intersect with political demands as has happened in Bahrain.”

Cappelli was in Egypt when Mubarak’s government began facing a popular challenge, and he remembers how people made comparisons to Tunisia, largely because of unemployment and concerns over corruption. For the same reasons, he says, people didn’t see the unrest unfolding in the Gulf. Like Gultekin, he says the unrest is a contagion, but he adds it is mutating to affect each country in the region.

“The contagion effect is everybody who has a grievance feels like the idea of taking to the streets might actually make some sense,” he notes. “Now in Egypt, they’re protesting about the sort of stuff that unions protest about. It’s not contained within a collective bargaining model, so it’s all becoming political. That’s the most interesting aspect of the contagion. It is going over to grievances that are more typical in civil society. To that extent, they’re quite likely to spill over to the rest of the Gulf and indeed, every place that doesn’t have institutions in civil society that can contain those disputes.”

The response in several Gulf countries has been to promise additional subsidies and salary increases for its native citizens. Oman has promised to raise salaries for its nationals working in the private sector. Gulf governments have also begun to proactively assess areas needing help. In the UAE, for example, the President Sheikh Khalifa ordered a full evaluation of the Northern Emirates services and infrastructure — a region dogged by power shortages and other quality of life concerns. In addition, Sheikh Mohammed bin Zayed, the Crown Prince of Abu Dhabi, made a trip to the region to hear concerns.

But Gultekin says subsidies and other benefits are a “short-term measure. In the long run, as societies change, they have to share power, they can’t stay on the current structure. Right now, people are happy, and economically at peace, but eventually they’ll probably look around and ask for other things as their prosperity increases. They’ll have to modernize themselves in their own unique ways.”

Domino Effect

The violence against protestors, all agree, has sealed the fates of both the royal family in Bahrain and the Gaddafi regime. In Libya, Coates-Ulrichsen says, “the Gaddafi regime is now in an existential battle for survival.” Gurdon, managing director of Menas Associates, says the key for the Libyan leader’s grip on power for the short-term will be maintaining control of Tripoli.

“Whether or not Libya exports oil, the government still has enough funds for the short term,” Gurdon says. “But under pressure, the West may freeze their overseas assets, obviously threatening their survival over the medium- to long-term.” He adds that the chance for government dialogue with the Libyan people is over. “This is not an Islamic revolt. The opposition is to Gaddafi’s 42 years of rule and spending fortunes on foreign adventures. Kuwait is similar to Libya. But look at the living standards between the two. Libya wasted 42 years of development.”

If Gaddafi is removed, Coastes-Ulrichsen adds, “the balance of power would shift to the popular social movements that are bringing about the downfall of regimes long considered impregnable. It would also generate a decisive domino effect that already is gathering great momentum following Mubarak’s fall.”

Cappelli feels some sympathy for Bahrain’s royal family because his experiences of the country are far different from the events of the past two weeks. “From their perspective, it is very unfortunate; they really were trying to modernize and open up opportunities for democracy. They were trying to push along at least some modest reforms, and they were stymied by the extended power structure in Bahrain. Now the monarchy is really in a pickle, because they are the symbol of power there, but it’s not clear now what kind of things they could do.”

Ultimately, Cappelli sees the unrest bringing a better understanding of dialogue between the region’s governments and their citizens. “What it signals to leaders is that you have to have some institutions in civil society if you want to prevent these things. It’s impossible to ever buy out all the discontent; it’s probably easier to keep them down with oppression. And in places like Libya and Iran, they’re probably going to use force, but for those who want to embrace the global community it’s just too costly.

“The big lesson, which is a good thing, is to point out that, going forward, you have to have institutions of civil society, which include elections; maybe it includes unions and other mechanisms for solving disputes other than people just taking to the streets. Maybe what Bahrain is showing us is that those institutions can be in place, but they can’t be limited to one segment. They have to be available to all.”