The global economy is gradually falling into the bottomless pit of economic slowdown along with the threats of high inflation, which may lead to stagflation. But what is stagflation really? For the unbeknownst, stagflation refers to the situation of rising prices, a fall in the value of the currency, and no real economic growth in the country to increase the level of economic activities, i.e. no increase in job opportunities. The consequences of such a phenomenon might seem unrealistic, but the chances of it actually crippling the world economy is as real as it can get.
Image 1: A pictorial description of stagflation
Global inflation forecasts for the ongoing financial year 2022-23 have raised alarms and economic growth forecasts have undergone significant corrections over the last year (Refer Image 2). The economists are extremely fearful of the resemblance it bears with the horrifying economic slowdown of the 1970s. It also raises concerns about the risk of debt crises in emerging markets- a throwback to the early 1980s, when massive increases in policy interest rates were required to control inflation.
Image 2: Global economic inflation and growth forecasts for years 2022 and 2023
Reasons for Stagflation
Humanistic curiosity drives us to dig deep and ask questions regarding the reason for such a situation. Is it a demand-driven or supply-driven situation? Excessive aggregate demand growth due to loose monetary and fiscal policies by the governments and central banks to push the overall demand influx in the economy post-covid-19 pandemic proved to be fatal. The supply bottleneck due to covid-19, China’s Zero Covid Policy, the shortage of labor supply, and the lockdown of 2020, contributed to the supply side crashing down the economy. Some believe that it is a mix of both supply and demand factors that has led to this economic slowdown. However, in reality, it is the supply side that led to this downfall. All these factors of aggregate demand were actually to cope up with the economic slowdown created by the supply side during covid-19 but post covid-19 crisis, the supply bottlenecks continued to create a gap and widen the gap between the aggregate demand and aggregate supply. This led to an increase in economic prices and subsequent decrease in employment rates and this is why this inflation can be categorized as stagflationary.
The factors stated above make this situation very much similar to the situations of the 1980s. In a similar pattern, global inflation is expected to rise this financial year and drop to near about 3% in October 2023, which will still be one percentage point higher than the average inflation rate of 2019. The reasons that would contribute to this drop in the inflation rate will be a decrease in the rate of global economic growth rate, monetary policy rigidity, fiscal support being phased out, commodity prices stabilizing, and supply bottlenecks alleviating. All these suggest that in the mid-term, the inflation rate would remain well-balanced even if it ends up being on a high note in the short term.
As positive as it may sound to just have a short-term high level of inflation, it may not be the case. Even in the 1970s, economists expected only a short-term rise in inflation that would be at maximum phase out in the medium term. However, the economy experienced continuous above-target inflation and subsequent inflationary shocks. The same could be expected even this time when the scale of the economy is 10 times more than what it was back in 1970.
This has alarmed all the central banks to tighten monetary policy and rope the situation down to the target level of inflation and not face the similar situation of the 1970s. The developed nations have decided to have a 200-400 basis point increase in the monetary policy rates to keep the inflation rates in check. As per historical standards, many economists have praised this decision and called it a moderate increase in the rates.
Image 3: US Fed’s interest rate tightening cycles during inflationary phases
If inflation expectations drop, the interest rate hikes needed to return inflation to the expected rate could be much higher than those presently predicted by the financial system. In comparison, it took six years for global interest rates to double to 14% in the 1970s (1975-1981). Between 1979 and 1981, the US policy rate increased by nine percentage points to 19%. The Great Inflation was ended by concurrent policy raising rates around the world. They did, however, cause a global economic downturn in 1982 and a sequence of debt crises.
How is Stagflation and Debt crisis even on a same sentence?
As we have talked about the intentions of the central banks and the government to lower the level of inflation, these institutions tend to increase interest rates. This tradeoff of intentions to lower inflation and increase the interest rate might boil over to a debt crisis in the economy.
As the economies will start following the policy of hard landing to tackle the situation of inflation, the debts will rise, along with the increase in the inflation rate, and weakened financial positions of each economic unit would make the emerging markets and developing economies vulnerable. Lower real interest rates would lower the returns for these units, pushing them into further debt. Now, if we compare the situation with the case of the 1970s, stagflation overlapped with the global wave of debt accumulation aggravating the condition but at present, we do not have the presence of any such global wave of debt, However, we might have the spillover effect of the Covid-19 slowdown. The depth of the economic hit due to covid-19 is huge and is likely to affect every economic slump for the next decade.
As we talk about the past and try to predict the future, let us look at the trend of debt and interest rates with respect to emerging markets and developing economies. As we can see (Figure 4) there has been a rise in the total debt of the units from both sources, especially private sources since the 1970s. The increase in debt was even higher in the financial year 2020-2021 due to the adverse effects of Covid-19 and supply-chain blockage. These data are indicators of the US economy but similar trends hold true in other economies as well. The condition gets worse in third-world countries, where the low real interest rates and development of syndicate loan facilities pushed these units towards debt. The condition is worst in Latin America and sub-Saharan Africa.
In segment D of Figure 4, we can see the disparity between the nominal global interest rate and the real interest. In some instances, we can see that the real interest is even negative, making the debt-heavy countries and economies put through the worst.
Present Day Scenario
In the present day, such a situation where the developed countries would move toward hard handling of the high inflationary situation, the cost of borrowing will increase. This would again lead to worse conditions for Latin America and African countries which are heavily dependent on debt. Heavy interest payments on the external debt by the LAC will take a hard toll on their GDP and this will be accompanied with an economic slowdown. This would push them into a vicious circle of debt and eventually erupt into a global debt crisis. Approximately 60% of the world’s poorest countries are already in or are at high risk of debt distress.
Image 4: A pictorial comparative study on historic patterns of debt and interest rates
What can these economies do in such a challenging situation?
The hard handling of inflation by the super economies is fixed, as a result, other economies have to be prepared for it. This begins with careful adjustment, credible strategy formulation, and coherent policy communication.
Talking about preparedness, India being one of the fastest-growing economies in the world will also be subjected to this economic slump. While the RBI and Finance Minister refuse the fact that India would be under any economic slowdown or would face any stagflation being a cost-pull or demand-pull, the recent statistics give mixed signals. With the increase in the economic activities of the country, as other economies pull out of manufacturing units from China and see India as a prospective land for it, a positive ray of hope is seen. However, we operate in a global economy, where the effect of one factor spills over to all other economies. So, even if we say that the Indian Economy is robust enough to sustain the slump, its trade with other economies would affect its operation. Moreover, as suggested by the Economists, India would also follow the policy of hard-handling the situation rather than going for a soft one because supply-side stagflation is impossible with soft policies.
All this brings us to one question: what if the stagflation is long-term and hard handling won’t suffice for the solution? This would put the economies further in the debt crisis with no visible ray of hope but as we say “History repeats itself”. If this stagflation is a new picture of the same old scenario of 1970-80, then as history suggests- we will definitely bounce back.
-Prachi Shree
Junior Editor, TJEF
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