About the authors: Invalidate Gill is the World Bank’s Vice President for Equitable Growth, Finance and Institutions. Mr. Ayhan Kose is EFI’s Chief Economist and leads the Bank’s global forecasting unit, the Prospects Group.
Around the world, an unusual economic trap has been set, one that even the most sophisticated central banks will find difficult to safely deactivate. The outlook is particularly bleak for developing economies, whose only previous entanglement with this trap has ended in a series of financial crises and a “lost decade” of growth and development.
The catch is this: globally, inflation is now rising faster than monetary policy makers can keep up. In late April, it hit a 14-year high of almost 8%. In advanced economies, inflation is at its highest level in four decades. Central banks, in response, are raising interest rates at the fastest rate in a generation. Last week, the US central bank passed its biggest interest rate hike in nearly three decades, making it clear that increases will continue until inflation is brought under control. Containing inflation now means curbing growth, which had already begun to wane globally.
It’s a predicament that policymakers have feared since the 1970s, when “stagflation” – a combination of high inflation and low growth – first entered the popular lexicon. Then, as now, an era of easy money led to a borrowing binge that left developing economies with record levels of debt, equivalent to more than 60% of GDP. Then, as now, persistent inflation forced a sudden change in the stance of monetary policy. Major central banks in advanced economies abruptly chose to reverse what had been negative real interest rates. After adjusting for inflation, rates rose from minus 2.9% in 1975 to over 4% by the end of 1981. This policy change played a major role in triggering a global recession in 1982.
For developing economies, particularly in Latin America, the reversal has been devastating. In Latin America, total external debt had increased by about 12 percentage points of GDP during the 1970s. In low-income countries, the increase was about 20 percentage points of GDP, and a large part of the debt involved short-term loans in foreign currencies. In 1982, Mexico announced that it could no longer service its debt. Over the next two years, 27 developing economies began to reschedule their debts, more than half of them in Latin America. During the global recession of 1982, more than half of developing economies experienced deep recessions, with disastrous consequences for economic development.
Whether this tragedy will happen again remains to be seen. But there is little doubt that the risks are significant. The debt of developing economies is now at an all-time high, at over 200% of GDP. Global financial conditions, meanwhile, are now tighter than at any time since the start of the Covid-19 pandemic. Global trade is expected to slow significantly this year due to tight supply chains, higher transportation costs associated with the war in Ukraine and a shift of activity towards the less trade-intensive services sector.
The number of economies in debt default will likely increase. So far, the risk of debt distress has been largely confined to the poorest countries, about 60% of which are in or at risk of debt distress. But the distress is also spreading to middle-income economies. Sri Lanka, for example, is currently going through a debt crisis which is also turning into a food crisis.
The trap of stagflation is that it forces policymakers to choose between bad outcomes: high inflation or low growth, or even recession. Since they are unable to meet supply shortages, they must reduce demand to contain inflation. This means raising unemployment just enough to achieve price stability without triggering a recession. The track record of success is not encouraging. In the 1970s, policymakers first avoided raising policy rates decisively, then later rushed to outpace inflation.
Now, after several months of above-target inflation in major advanced economies, a similar risk has emerged: the required rate hikes could be much larger than currently expected. This could lead to a global hard landing.
Waiting is not an option for developing economies. To avoid the risk of 1980s-style crises, policymakers must act quickly and boldly on five major fronts:
- Monetary Policy: Price stability must be the priority of central banks. Communicating monetary policy decisions clearly, leveraging credible monetary frameworks, and preserving central bank independence can help reduce the degree of policy tightening needed to achieve the desired effects on inflation and economic growth.
- Tax measures: Fiscal policy must be carefully balanced between the need to ensure fiscal sustainability and the urgency of protecting vulnerable households. Improving the efficiency of spending should be an immediate priority and fiscal support measures need to be well targeted.
- Financial sector policies: Governments should strengthen measures to deal with non-performing loans and strengthen capital buffers where necessary. They should also improve financial sector supervision and strengthen crisis management and resolution regimes.
- Working environment: Policymakers should protect viable businesses that could support a productivity-driven recovery. They should also improve insolvency frameworks to prepare for the potential increase in corporate financial difficulties.
- Structural policies: To support long-term growth, policymakers should pursue structural measures that boost productivity and competitiveness. Energy conservation and increased investment in renewable energy sources would improve energy security while helping to combat climate change.
These policy-making principles are easy enough to communicate, but they will be difficult to implement. The hard work, however, must begin now. The cost of postponing necessary policy interventions is simply too high, as the stagflation episode of the 1970s so painfully demonstrated. History doesn’t have to repeat itself – by embracing these basic principles, policy makers can help ensure that it doesn’t.
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