The world economy faces a dire prospect of Stagflation—a combination of inflation and recession ahead during the 2020s. The signs of energy price inflation have already been there through much of this year, especially since the start of the Russian invasion of Ukraine (whatever you may think of its justification). Since the two years before 2020 and 2021 were of the V-shaped decline and recovery of the global economy, the situation is yet to fully return to the pre-pandemic normal. So, the new shock has shaken the global economy.
This stagflation is apparent in the US and western Europe. The poor countries are suffering from a crisis due to the debt trap plus rising interest rates (you can take the example of Sri Lanka). Energy prices are high everywhere (though India has a deal worked out with Russia). Recession in the sense of a fall in GDP has been noted in Western Europe but has yet to be in the USA. As per the forecast by Barclays, a eurozone recession will persist until the second quarter of 2023, and there will be a 1.7% contraction in real GDP. Central banks in the US and western Europe have raised their discount rates to control inflation, but there is no immediate expectation of inflation falling. It has slowed down in the USA but is still high by the usual standards.
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Will history repeat itself?
This situation is very reminiscent of what happened during the 1970s and 1980s. Indeed, even the word stagflation was coined at that time. Stagflation refers to an economic cycle with slow growth, high inflation, and high unemployment levels. Until the 1970s, inflation used to be identified with an overheated i.e. fast-growing economy rather than one with a recession. The 70s witnessed the decline of the faith in Keynesian economics and the rise of Monetarism as the cure. Monetarism policies had brought down inflation in the US and the UK. In 1979, when inflation peaked at 20% in the US, the Fed opted for an operating strategy that reflected monetarist theory. In India, inflation was the cause of mass agitation against the Indira Gandhi government led by JP, a nationwide strike by the railway workers and then the declaration of the Emergency.
History may not exactly repeat itself, but across the world, inflation and hard times are now prevalent. Central banks are repeating the policies they tried during the 1970s and 1980s. At that time, Western economies saw a flight of manufacturing industries from their countries to east and south east Asia, which experienced an industrial boom called the Asian Miracle. This allowed Western countries to import manufacturers at lower prices, and inflation came down from the late 1980s onwards until very recently.
Impact of war
This time, it is too early to predict how inflation in energy prices will be contained. The price of natural gas is over $100 per megawatt hour than it was a year ago in Western European countries as Russia continues to cut natural gas supply to Europe amid the war. In the past few months, the geo-strategic importance of Ukraine to the global economy is quite clear. It is impossible to fix the economic woes across the world as long as there is a war going on in Ukraine. At this point, stopping the war in Ukraine could relieve the inflationary pressure on the world economy. That would be a helpful development. But the war could also spread if the China-Taiwan issue flares up. India may also find (though I very much hope it doesn’t) China invading the Himalayan territory. Any of that would light a big fire. Then no prediction is possible.
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India is enjoying some respite due to its oil purchase from Russia, but the rupee was already showing slippage in the summer. Global influences will bring inflation to India. While the RBI has long been hawkish on inflation, fiscal policy tends to be loose, especially in the states. This tendency is unlikely to be reversed as election pressures will mount on states to spend money to provide relief. India is lucky as it does not import as much food grain from abroad (as it used to do in the 1970s) and so can escape food price inflation which is widespread due to the Russia-Ukraine war. The war has disrupted the supply of wheat, sunflower oil and other products produced in Ukraine, straining the supply of food worldwide. UK’s food prices have risen to 12.4% in November, which is the highest inflation rate since 2005.
Taking into account the current geopolitical situation and future projections, the economic outlook is not as bright as expected. My prognostication is gloomy because I prefer being pessimistic to the habit of dreaming of bright lights. Taking the worst-case scenario as likely instils caution in policymakers. There is no harm in having assumed the worst and being proved wrong. It is much worse if you predict bright sunshine and then it rains on your parade.
About the author:
Meghnad Desai, Chairman, MDAE, and professor emeritus, London School of Economics