Three problems for the world economy

Business Standard, 21 March 2022

Three big questions now matter for the world economy. In the US, macroeconomic stability is threatened by an inflation crisis, and there are concerns about monetary policy strategy there. In China, a big non-market economy was built up, but it suffers from internal contradictions, and there is a spot of distress. While Russia is a small economy, the combination of war in Ukraine and the suddenness of the economic collapse can generate ripples into the world economy. We should worry about the possibility of tail events in the coming year.

US monetary policy

The most important element of global macro is the United States. US macro policy played well in counteracting the pandemic, and India has been one of the beneficiaries of expansionary macro policy in the US and in other developed markets (DMs). But in the din and fury of the battle, US macro policy over-compensated.

The US central bank is organised around a 2% inflation target. But US inflation has gone well beyond 2%. There are signs of a `wage price spiral', where wage growth feeds into higher prices and then back into wage growth. In the `great moderation' of the last 40 years, when all DM central banks moved to inflation targeting, such difficulties had been abolished.

The present stance of the US Fed consists of two things. It is expected that there will be a hike in the policy rate of about 150 basis points in a year, and it is claimed that this will suffice to bring inflation under control. The problem with this position is that even after the short rate has been raised by 150 basis points, it will remain negative in real terms. We run the risk that through calendar 2022, monetary policy is in fact not disinflationary.

The US Fed deeply gets the idea that the only contribution that a central bank can make to the economy is to deliver predictable 2% inflation, i.e. to create conditions of macroeconomic stability within which households and firms can plan better. If the calm journey to monetary policy normalisation, that they have sketched for 2022, does not make a dent on inflation, they will become more hawkish from late 2022 onwards.

US monetary policy has a major impact upon the whole world. When interest rates in the US (and in other DMs) are low, financial capital goes out into risky and illiquid corners of the world economy, to things like quirky technology companies and real estate in India. When DM interest rates go up, global allocators shift back more to DMs, and capital retreats from more illiquid and risky corners of the world economy. The central banks that try to do exchange rate policy get burned, e.g. as happened in India in 2013.


The second problem for the world economy is China. While China is a big economy, it does not have good institutions, and in many respects, resources are allocated by officials and not the price system. This results in fragility. For years, officials have goosed up growth through policies that encourage borrowing and high real estate prices. With the failure of Evergrande, and many other real estate companies, the economy is facing distress.

From the late 1970s, global firms felt they could commit to China, trusting in its evolution into a mature market economy located in a liberal democracy. After Xi Jinping took charge, China has turned inwards, into nationalism and authoritarianism. The process of advancement into good institutions has broken down. As a consequence, global asset allocators and non-financial firms have been reducing their prioritisation of China. China's share in US imports has been declining, owing to MNCs shifting production out of China.


The third problem for the world economy is Russia. While Russia is a small economy, even smaller than India, the suddenness of the war and economic sanctions has generated a large economic shock for them.

The main focus for most people is the war in Ukraine, and that is of course very important. But the magnitude of the damage to the Russian economy (through war spending and through economic sanctions) could trigger off unexpected impacts in the world economy. As an example, countries such as Sri Lanka, Egypt and Turkey have been drastically affected. Some financial firms, with large exposures in Russia, could go bust.

Pulling these together

As with China, in Russia also, global firms once felt they could commit, trusting in its evolution into a liberal democracy and market economy. Now all external players are holding large losses in Russia. This gives one large economy (China) and one small economy (Russia) where external participants have been disappointed.

The central problem in globalisation is `home bias', the bias in the minds of DM asset allocators and boards, to stay within DMs to a disproportionate extent. Large losses in China and then Russia will reinforce home bias, raise the bar for the minimum institutional quality that India needs to show the world, and adversely impact on the world economy.

These three problems are hitting the world economy at once: concerns about US inflation and monetary policy, concerns about macro stability in China, and a sudden collapse in a small economy, Russia. Each of them would have been easier to comprehend and absorb, if they had come alone. But all three are in motion, and will interact nonlinearly.

It is likely that problems will erupt in various elements of the world economy, in response to these stresses. The precise causal chain will surprise us, as we do not understand economics enough to pinpoint the precise ways in which things will go wrong. There will be normal business failure, and there will be scandals, as recessions uncover what auditors do not.

Most decision makers in Indian firms or policy roles tend to have a short-term and execution focus. This is a time to be more strategic, to understand the wheels of global general equilibrium, and to watch for unexpected channels of influence.

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