The Great Unraveling

Relevance: GS3- Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment. Inclusive growth and issues arising from it.

(Source: Indian Express, 08/08/2023)

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Why in the news?

• The author, Sajid Z Chinoy, chief India Economist at JP Morgan, has discussed the fiscal policy of the advanced countries in the article titled "The Great Unraveling" published in the Indian Express on 8th August 2023.
• Deglobalization and muscular industrial policy was another major concern for countries across the world.

What were the consequences of the 2008 Financial crisis?

• The policy response to the Global Financial Crisis (GFC) of 2008 accentuated the concerns about globalization, inequality, and employment in the West.
  • Although globalization in the 1990s and 2000s had contributed to development, it had also led to concerns over blue-collar jobs and inequality, especially in the aftermath of the “China shock”.
• This was followed by dramatic and injudicious tightening of fiscal policy in most of the advanced economies.
  • According to the IMF, “Structural” fiscal deficits in advanced economies tightened by about five to 10 percentage points of GDP between 2007 and 2017.
  • The tightening of these deficits had ideological causes like the sequestration fights in the U.S.A., and the complex and inflexible nature of European fiscal rules that emphasized austerity.
• As a result of the fiscal tightening, advanced economies recovered very slowly from the crisis.
  • By 2018, the GDP gap from the pre-GFC trend was 13% in France, 17% in the U.S.A., and 22% in the UK.
  • This stagnation was clearly amplified by fiscal policy rather than slow-moving forces like demography.
• The excessively tight fiscal policy led to an excessively loose monetary policy which struggled to combat the economic stagnation that had occurred in the aftermath of the crisis.
  • The amount of money in the Central banks’ balance sheets increased.
  • The Central Banks also committed to keeping interest rates low
  • The Central Banks thus began to use their special tools such as interest rates and controlling the money supply to help the economy, because other ways such as government spending, were not proving to be successful.

Why was the tight fiscal and loose monetary policy a wrong decision?

• Contradictory policy: The fiscal policy and monetary policy were not complementary and thus ended up working against each other.
  • Labor markets in the advanced economies also struggled to recover from the crisis.
• Employment stagnation: As a result of the excessive easing of monetary policy, asset prices were distorted and inflated.
  • This contributed to accentuated inequality and kept zombie firms alive which led to a substitution away from labor towards cheap capital.
  • As a result, the stagnation and struggles in employment were worsened.
• Lack of necessary reforms: Quantitative easing was used to solve every problem instead of adopting the fundamental reforms that were necessary for advanced economies.
  • These included re-tooling and re-skilling workers, building infrastructure, easing regulations, and establishing smarter safety nets to compensate those who had been displaced by globalization.
• Deglobalization: This encouraged the spread of deglobalization in the advanced economies which was accentuated by parochial politics.
  • This led to the emergence of the Brexit ideology and the U.S.-China trade war.
• Poor performance of Fiscal policy: By 2018, there was a widespread understanding that fiscal policy had not performed as necessary.
  • Inflation and interest rates were presumed to permanently remain low which implied that borrowing costs would always stay below nominal growth and that public debt could easily be sustained in advanced economies.
  • Instead of introducing temporary and state-contingent fiscal support, structural fiscal deficits surged in advanced economies as fiscal policy became counterproductive.
  • Private sector demand was kept strong through fiscal transfers while supply shocks propelled inflation.

Beggar-thy-neighbor Approach

• Rising geopolitical uncertainty is inducing multinationals to de-risk their supply chains and accentuating the pre-Covid deglobalization tendencies justified by claims of resilience and national security.
  • Muscular industrial policies in the West such as the Inflation Reduction Act, and the Chips Act aimed to improve production and boost domestic blue-collar job creation.
  • This is likely to lead to increased incentivization and protectionism.
• There are concerns that the actions of the U.S.A. could create a demonstration effect with South Korea, Japan, Taiwan, and Europe all responding with their own version of subsidies.
  • This will encourage emerging markets to become more protectionist as the “beggar-thy-neighbor” industrial policy becomes more popular.

Risks of the beggar-thy-neighbor approach

• Allocative efficiency is adversely impacted when the state starts to pick winners and losers.
  • This could hurt medium-term productivity, competitiveness, and growth.
• Re-shoring and friendshoring will lead to economic balkanization which could undo the gains made by the advanced economies in the last three decades.
  • These include global growth, development of low-income countries, structural reduction of inflation, and poverty alleviation.
• The major problem faced was how the gains of globalization were shared, and how domestic policy has failed to correct the skew.
• Technological advancements and AI threaten to increase the share of capital versus labor, like other industrial revolutions, and could impact white-collar jobs similar to how the China shock affected blue-collar jobs.

Way Forward

• An intelligent and coordinated global response to these challenges through education, skilling, and training of workforces in a manner that complements technology rather than their replacement.
• In order to do so, we need to replace the counterproductive protectionist approach with institutions that will enable creative destruction in response to technological change, robust safety nets to protect those left behind, and a tax system that can finance this.
• Similar to how the Bretton Woods Conference created a new global architecture to protect against beggar-thy-neighbor currency devaluations eighty years ago, a new approach is needed to protect against beggar-thy-neighbor industrial policy as well as the gains from globalization.

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FAQs

MCQs

Question: Which one of the following statements appropriately describes the “fiscal stimulus”?

(a) It is a massive investment by the Government in manufacturing sector to ensure the supply of goods to meet the demand surge caused by rapid economic growth

(b) It is an intense affirmative action of the Government to boost economic activity in the country

(c) It is Government’s intensive action on financial institutions to ensure disbursement of loans to agriculture and allied sectors to promote greater food production and contain food inflation

(d)  It is an extreme affirmative action by the Government to pursue its policy of financial, inclusion