Stagflation. Or is it recflation?

Since new terms are coined in the field of management education, let?s consider ?recflation??a combination of recession and inflation

Management students are taught that ?stagflation? means an unusual combination of stagnant economy with high inflation rate. Unusual because normally a stagnant economy experiences low levels of inflation while high inflation is generally associated with an overheated economy with low unemployment. There is temptation to use the term ?stagflation? to describe the current Indian situation of falling GDP growth rate together with high and adamant inflation. But, technically, stagflation indicates a virtually stagnant economy, with GDP growth rate close to 0%. That is not the situation in India with growth rate of around 6% even after the big slide. However, the situation is equally difficult and the economy is moving in the direction of stagflation, although it wouldn?t reach there in the foreseeable future. Nonetheless, it?s grave and calls for coining a new term and policy prescription.

Like management education oft coins new terms, here I propose a new term ?recflation??a combination of recession and inflation. Recession happens after three consecutive declines in growth rate, need not be at 0%, which fits the Indian situation. Need for coining a new term is analysis and policy prescriptions to reverse, or at least arrest Indian economy?s advance in the direction of stagflation. To undertake this tough job, let?s first consider the Phillips curve, a cornerstone of macroeconomics, which gives the inverse relation and the classic policy trade-off between inflation and unemployment.

Normally when unemployment is low, purchasing power is high, demand and prices are high and rising, raising profitability, inducing business to invest more by creating jobs, thus combining high inflation with low unemployment, typical of a overheated or prospering economy. And the other way round, when inflation falls, generally economy is in contractionary mode since profitability is falling, dragging investments down and lowering demand for labour, thus causing high unemployment, typical of a recession-hit economy. Going by conventional wisdom, capitalist economies are mostly found to swing cyclically between two ends of Phillips curve, marked by boom and trough, or at least prosperity and recession.

Any attempt by the government to reduce inflation calls for contractionary or restrictive fiscal and monetary policies which leads to falling GDP growth rate and rising unemployment. In fact, ?sacrifice ratio? tells how much GDP growth rate needs to be sacrificed in order to bring inflation down by one unit. In other words, economic policy makers cannot reduce both inflation and unemployment simultaneously, they must choose one at the cost of the other. This is the policy trade-off. Must we accept the trade-off as given or try to shift Phillips curve downwards to the left by trying to reduce both inflation and unemployment, even if at the new low level another similar trade-off may exist? It?s desirable for any economy to move the Phillips curve towards the origin and it?s also possible by intelligent policies, prudent execution and strong political will. It can be done primarily in two ways. One, focus on supply-side to reduce inflation, augment supplies raising productive efficiencies thereby also creating jobs and reducing unemployment. Two, as expansionary policies may reduce unemployment, rather than the newly created incomes going into consumption and raising demand-side inflation, channelise newly created savings into production and augment supplies, so that inflation is averted. In fact, economic development should mean downward shift of the Phillips curve. Management students must widen their intellectual horizons and comprehend this.

However, wrong economic policies, corruption, oil shocks, global crises, unfortunate natural calamities can shift the Phillips curve upwards. One, when prices rise due to supply-side shortages, like happened in case of India, typically costs of production rise and profitability declines with the business sector curtailing new investments and demand for labour declines with unemployment on the rise. Second, adamant inflation raises inflation expectations and economic agents act in a way that further raises inflation, known as ?self-fulfilling prophecy?, but this doesn?t create jobs, thus raising both inflation and unemployment. Third, when bonds, wages and other productive resources are ?inflation-indexed?, they tend to spiral inflation upwards, without generating either productive capacity, or raising employment. Fourth, when monetary policy is tightened to combat inflation by raising rates several times, and especially if the central bank falls behind the learning curve, it makes funds costlier, raises cost of production and inflation rather than reducing it; but in the interim, due to the tight monetary policy, unemployment has already risen. Some such things can shift the Phillips curve upwards to the right, away from the origin, and if it happens for a long time, the economy can arrive at stagflation.

Short of stagflation, there is a long journey of ?recflation?. Indian economy is in ?recflation?, and to reverse the trend by pushing inflation below 5% rather than succumbing to it and raising growth rate above 8% will require long-term measures especially on supply side. Since most business cycle downturns in India have been from agricultural supply shocks, we need to match primary articles supply to the demand by augmenting resources, information and technology diffusion, building physical and social infrastructure across the country as also embarking on the next generation of reforms. Future managers must watch out for ?corporatisation? of agriculture. But these have long gestation period and since voters are myopic, policy-makers oft focus on ?immediate measures?. Good politics, bad economics. But if we can reverse recflation, our macroeconomic fundamentals will strengthen again, and so will our nose-diving rupee.

The author is professor of economics at Symbiosis, IIPM, iiebm, Pune, and can be contacted at shubhadasabade@hotmail.com