The International Monetary Fund report titled ‘World Economic Outlook 2022: Countering the Cost-of-Living Crisis,’ released in October 2022, warns all countries, including India, of an impending economic downturn. The Report points out that with the gradual withdrawal of pandemic-era expansionary monetary and fiscal policies, economies of an increasing number of countries are experiencing either a contraction or at least a slowdown. Record inflation, tightening monetary and fiscal policies, Russia’s invasion of Ukraine, and the never-ending Covid-19 pandemic, all have combined to produce an environment of hunger and want in poorer countries and a cost-of-living crisis in advanced ones.

Looking at the IMF Report in the Indian context, our economy faces a number of challenges; crude prices are predicted to average US$98.20 per barrel in 2022, as against $69.42 per barrel in 2021, which will lead to abnormally high petroleum, fertiliser and food prices resulting in runaway inflation, and an unmanageable current account deficit. Inflation could worsen, should the current trend of the Dollar strengthening against the Rupee continue. Ultimately, growth and employment will be hit, with more people on dole, and the Government having to provide humongous sums by way of MNREGA and food subsidies.

The IMF Report warns that the worst is yet to come: the world economy which is expected to grow at 3.2 per cent in 2022, would slow to 2.7 per cent in 2023 ~ 0.2 percentage points lower than the July 2022 forecast ~ with a 25 per cent probability that growth could fall below 2 per cent. More than a third of the global economy will contract this year or next, while the three largest economies ~ the United States, the European Union, and China ~ will continue to stall. Fuelled by a rising dollar, higher commodity prices and pandemic-related supply-side disruptions in China, global inflation would rise to 4.1 per cent by late 2022. Additionally, the Ukraine war would cause grave energy shortages in Europe and would push up food prices to unconscionable levels, causing serious hardship for low-income households worldwide, especially for the poor in low-income countries.

Central banks around the world are now tightening the money supply sharply in order to restore price stability because persistent inflation is extremely detrimental to future macroeconomic stability. Central banks would have the unenviable task of continuing with a tight monetary policy, even after economies start slowing down, and the public clamours for a loose monetary policy. Central banks have to walk a difficult tightrope; under-tightening would not tame inflation while over-tightening would push the global economy into a recession, disrupting financial markets in the process. However, optimum results will require central banks to act in a coordinated fashion.

Harking back to 2009, Governments and central banks managed to avoid a global economic catastrophe by timely action but the crisis left behind a host of nearly-bankrupt governments. The consequent recession had depressed tax receipts and increased government outlays on unemployment benefits, while the level of many other expenditure items did not come down by a similar percentage, putting significant pressure on government budgets. During the 2009 financial crisis, governments were forced to commit large funds to prevent the financial system from collapsing; at one point, support earmarked for the financial sector, including recapitalisation, guarantees, dealing with toxic assets and other options, reached as much as a quarter of GDP in the EU and the US. In this sense 2022 is comparable to 2009, as subsidies, tax relief, employment retention schemes, and loan guarantee programmes have seen similar expenditures by Governments.

The biggest challenge after the 2009 crisis was the unprecedented deterioration in public finances and increasing Government debt in advanced economies of the Euro area, the US and Japan. Central Banks responded to the financial turmoil by sticking to their medium to long-term policy: ensuring price stability over the medium term. Governments came out of the 2009 crisis, by implementing a credible medium-term fiscal consolidation strategy and maintaining government fiscal integrity by offering credible exit strategies and embracing profound financial sector reform.

Such prudent actions consolidated their economies and restored sound public finances. Later on, most advanced economies had to create fiscal buffers to tackle unexpected and unavoidable future events. Commitments of this magnitude were possible only because the financial credibility of Governments remained intact. Perhaps, orderly and resolute medium-term fiscal consolidation had boosted confidence among households, enterprises, investors and savers. Central banks and governments had forayed into uncharted territory in 2009 because empirical relationships do not hold in extraordinary economic circumstances.

Drawing lessons from the 2009 experience, a large-scale downturn can be avoided in 2022. The challenge now is to formulate proper fiscal policies by all countries that would address the inter-related cost-of-living, energy, and food crises with the additional onus on bigger economies to take up a facilitating role. Fortunately, many countries, including the United States, the United Kingdom, and the euro area, but not India, are seeing historically low unemployment rates and high levels of vacancies and despite rapidly rising prices and wages, are yet to experience a wage-price spiral.

Firstly, countries where the Covid-19 pandemic is subsiding, need to rebuild fiscal buffers. Secondly, fiscal policy needs to work in tandem with central banks’ monetary policies to quell inflation. A mismatch between fiscal and monetary policies would prolong the fight against inflation, delivering short-term economic shocks that would derail long-term inflation expectations, and increase funding costs and financial instability. The close coordination between RBI and the Finance Ministry in India augurs well for us, but more proactive actions are required from both. Thirdly, the energy crisis, especially in Europe, is not a one-off happening.

The geopolitical re-alignment of energy supplies in the wake of the Ukraine war is likely to become permanent. Fiscal authorities the world over, including India, need to plan for future energy security. Fourthly, Governments need to send price signals i.e., take proactive steps on the price front to curb demand and stimulate supply, while protecting the most vulnerable in society through targeted and temporary transfers. Fiscal policy should be applied instead of administrative measures like price controls, untargeted subsidies, or export bans that are fiscally costly and lead to excess demand, undersupply, misallocation, rationing, and black-market premiums. Here Indian planners are still at sea; administered prices, burgeoning subsidies and foreign trade restrictions hobble our progress.

Fifth, fiscal policy should focus on investments in expanding productive capacity: human capital, digitalization, green energy, and supply chain diversification can make economies more resilient to face the next crisis in a better manner. Unfortunately, as the current debate on subsidies indicates, these simple principles are not being followed in India, where, outsized, poorly targeted, and broadly stimulative fiscal packages are regularly offered by the Central and most State Governments and poor expenditure on the social sector prevents the rise of human capital. For many emerging economies like India, the appreciating dollar is increasing the cost of imported goods, fuelling inflation, and worsening financial conditions.

The dollar is now at its highest level, driven mostly by fundamental forces, such as the tightening of monetary policy in the United States and the energy crisis in most parts of the world. The appropriate response from RBI may be to calibrate monetary policy to maintain price stability, while letting exchange rates adjust, conserving valuable foreign exchange reserves for the time when financial conditions really worsen because of financial turmoil, which may prompt investors to come out of emerging markets and seek the protection of safe-haven investments, such as US Treasury Bonds, which would push the exchange rate of the dollar even higher. Even now many low-income countries are in or close to debt distress.

Progress toward orderly debt restructurings may be urgently needed to avert a wave of sovereign debt crises for poor countries. Also, in light of the extreme climate events in the current year, the world needs to implement climate policies that will ward off catastrophic climate change. Such policies may have some immediate adverse implications but costs to society and the economy would rise sharply if we delay the green transition any further: a timely and credible transition, in addition to being critical for our planet’s future, would also help macroeconomic stability.

In any case, difficult times lie ahead, as no clear solution is in sight. Probably, what Paul A Samuelson, the Nobel Laureate, said about the 2009 crisis: “What we know about the global financial crisis is that we don’t know very much,” holds true about the present crisis also.