The global economy on a knife-edge?

The world is on the verge of a synchronised reversal of economic fortunes. The specific forecasts vary, but most in the economic forecasting practice are predicting a dramatic reversal of post-pandemic recovery this year and the next. Food and energy insecurity is looming large as geopolitical conflicts drag on, capital flows to where it is already abundant, and global policy coordination keeps failing the push comes to shove test.

Recession or stagflation?

The World Bank has projected global growth slowing from the record high 5.7% pace last year to 2.9% in 2022 and 3% in 2023. The most notable is their extent of downgrading relative to the projections before the Ukraine war for this year for more than 80% of the advanced economies, 70% of the emerging developing economies, and 80% of the commodity-importing emerging economies, commodity exporters other than energy, and low-income countries. Only energy exporters in the Middle East and North Africa were upgraded.

The International Monetary Fund (IMF) lowered its global growth forecast to 3.6% for 2022, while the Institute of International Finance cut its estimate to 2.3%. "The world may soon be teetering on the edge of a global recession, only two years after the last one", said the IMF in July. The last one was in 2020 when global GDP declined 3.3% while inflation was a tepid 1.9%.

Global recession is defined as contraction in per capita global GDP along with a broad base slowdown in other variables such as employment and wages. Global growth in 2023 could decline to around 1.5% in a worst-case scenario; above 1% that could push the per capita growth rate into negative territory, according to Ayhan Kose, director of the WB Prospects Group.

Output decline is not the only headache. The annual rate of inflation worldwide accelerated to 8% in July 2022, levels not seen in decades in most countries. Inflation and growth are moving in opposite directions with the growth forecast being downgraded and inflation forecast upgraded. This is nearly the opposite of what happened at the peak of the Global Financial Crisis with GDP declining 2.2% in 2009 from 1.7% growth in 2008 as inflation plummeted to 2.9% from nearly 9% respectively.

The global economy is increasingly looking similar to the stagflation of the 1970s. Stagflation has never been precisely defined, perhaps reflecting its historic rarity. The general consensus – a state of high inflation and weak growth for an extended period of time – lacks thresholds for "high", "weak" and "extended". The universally recognised stagflation in the 70s was marked by average global GDP growth of 1.2% and 10.1% inflation in 1974-75.

Inflation is currently high in the greater part of the world. Energy and food prices respectively fell 1.3% and 8.6% month-over-month in July, but the energy price index (WB) was still 71.5% and the food price index (FAO) 10% higher in July than a year ago. A steeply slowing growth until 2024, as projected by most, qualifies as weak growth. The economic horizon is too murky to be definitive about the persistence of this lethal combination.

A sequence of disruptive shocks

The pandemic disrupted pretty much everything in the ordinary business of life irrespective of geography. Layer on to that labour shortage, clogging of trade logistics and a war in Ukraine precipitating a reshuffling of global trade due to sanctions and retaliations, you have the culmination of risks not seen even in nightmares a year ago. The war has magnified the risk from the fragmentation of trade, investment, and financial networks.

Energy and food supply fundamentals have deteriorated. The Russian invasion of Ukraine exacerbated pressures on global energy markets that were already struggling to keep pace with ramped-up pandemic-era demand. Gas shortages have sent the price of coal soaring and diminished electricity supplies in many countries. The global fertiliser markets can't get the natural gas needed to make the fertiliser to produce the crops.

Historic heat waves combined with rain shortfall have made a grain shortage imminent. McKinsey warned a week ago that lingering supply disruptions could leave the world short of 23 to 40 million tonnes of wheat and corn by end 2023 if the recently signed Ukraine-Russia agreements don't work. This deficit is a year's worth of nutritional intake for 3% of the global population. Global rice inventories were ample, but drought in major rice producing economies – India, China, Bangladesh, Indonesia, Vietnam, and Thailand – has created the risk of water intensive rice crop failures.

New inequality variants

The rise in interest rates and bond yields in the advanced economies has pushed much of the world's savings into bonds issued mostly by governments and overcapitalised multinationals. The change in policy stances has misallocated the bulk of capital to the safest bonds issuers and away from the places in the world that need new capital.

The purchase and ownership of bonds by central banks beefs up asset prices in overcapitalised sectors of the advanced economies. Shortages of the working capital needed for small businesses and supply chains could perpetuate stagflation by diverting capital away from the small players, who could provide the solution to the crisis, to the big players.

Energy and food hoarding has succeeded vaccine hoarding by the powerful economies. Europe and the advanced economies in general are storing fuel and food. Russia's cuts to European energy supplies set off a global scramble to secure liquefied natural gas and avoid shortages this winter. China is alleged by the USDA to hold 60% of the world's rice, 69% of maize, and 51% of wheat reserves.

These policies are deepening the inequality that was so problematic well before the avalanche of shocks since the early 2020s. The World Inequality Report 2022 showed how extreme the disparities are. The richest 1% of the global population owns 38% of global wealth, takes in 19% of income, and emits 17% of global CO2.

The dilemmas of developing economies

What was initially seen as a transitory inflation has taken root. Until mid-2021, the predominant view in the US and Europe was that inflation would recede. Supply chain disruptions will be resolved as economies get back to full gear and the pent-up demand fades. The calculus has swung recognising the need to rein in inflation sooner than later through aggressive policy action.

A key feature of the 1970s stagflation was the failure of central banks and governments to clamp down on inflation before it got out of control. The consequent steep increases in interest rates in major advanced economies played a prominent role in triggering a string of financial crises in emerging markets and developing economies in the early 1980s. The tightening cycle this time around is creating the risk of leapfrogging to similar bouts of global recessions and financial crises.

Most countries borrowed heavily during the pandemic to cover increased expenses and sinking revenues. The debt burden of the poor countries rose 12% to a record $860 billion in 2020, according to a WB report last year. Much of that borrowing is in US dollars. Faced with higher US interest rates, these economies are stuck between a rock and a hard place. They have to choose between raising their own interest rates to prevent capital flight and defend the value of their currency, possibly damaging recovery to catch up growth, or allowing the currency to depreciate and face soaring costs for repaying dollar-denominated debt, and inflation.

Economic management in developing economies would be less complicated if rates in the advanced economies were driven by favourable growth prospects, thus bringing an offset through increased demand for their exports. That is not the case. Rates are rising in response to higher inflation and hawkish shifts in central banks' strategy.

The policy imperatives

Central bankers are addressing the demand side. The synchronised monetary tightening across countries is historically unprecedented. The US Federal Reserve has been the most active, raising rates by a combined 2.25 percentage points in 2022 so far. By June 2022, 37 developing country central banks began monetary tightening, in addition to a few that had already entered the tightening cycle last year. More countries in Africa and the Asia-Pacific are entering a similar phase following the half a percentage point policy rate hike, the first time since 2011, by the European Central Bank in July.

Facing an inflation surge that needs to be brought back under control, the spillovers on other countries are less if the central banks in advanced economies clamp inflation down before it gets even more out of control. They have to be clear and transparent to let markets understand the factors driving their policy.

The focus with as much intensity on the supply side is missing. The US has the largest ability in the world to expand production to counteract the price spiral. With the Inflation Reduction Act, the US government is showing signs that it has not become permanently inert. It may not be enough, especially without adequate international coordination. It may not even last. But it's a start. The lack of action is also true of China and Europe.

There is no easy path forward. In a polarised world trying to make an ecological transition, relentless focus on the stability of the food, energy, broad commodity supplies and technological inputs for greening is urgently needed. This is a structural challenge requiring immediate actions on the medium-term solutions.

Zahid Hussain is a former lead economist of the World Bank Dhaka office.