The new orthodoxy

The latest annual meetings of the Bretton Woods institutions — the World Bank and the International Monetary Fund — have been dominated by discussion on how economies can respond to and recover from the Covid-19 pandemic. What is striking many observers is the degree to which the consensus in the policy and financial community is for a large increase in borrowing — which may, indeed, be open-ended — in the developed world. In some ways this fits the broader intellectual currents that had begun to dominate even before the pandemic hit. The United States Federal Reserve, for example, had taken notice of the fact that in spite of years of supportive policy, a historic expansion of its balance sheet, and record low unemployment, inflation was slow to return to the US economy. This was perhaps because of micro-economic structural changes of various sorts, including the development of the gig economy, which broke the link between a tight labour market, wage increases, and generalised inflation. Either way, it made it clear that the spectre of short-term inflation had lost power as an argument against accommodative monetary policy. Given this realisation essentially predated the pandemic, it is not surprising that the pandemic response and recovery focus far more on a vast expansion in fiscal and monetary policies than on sustainable debt trajectories in the advanced world.

The implications for the world economy are not clear. It is important to note that this consensus is one that applies only to advanced economies, where central banks and the currency have built up solid credibility and where there is still an unmet hunger for “safe” assets. Emerging-market sovereigns and monetary authorities are still playing by a very different set of rules, and entities like the Reserve Bank of India must remain more cautious than their developed-world counterparts. If nothing else, India and similar emerging markets are hardly as safe from inflation as are the structurally low-growth and even deflationary economies of the global north. It is true that inflation has been largely benign through this crisis — partly because of the destruction of demand and the weakness of commodity prices — which has allowed emerging-market central banks to dip their toes in the water of unusual and novel counter-cyclical policies. But it is clear that far less space is available to them.

What is certain is that emerging markets, including India, will have to prepare for a world in which open-ended expansionary policies are considered the norm in the developed economies. This has both positives and negatives. In some cases it will fuel a search for yield in emerging markets, as was seen during the long recovery from the 2008 global financial crisis. Asset price inflation will also recur, with the consequent distortion of real estate, gold, and some commodity markets. That said, the vast expansion of what assets are defined as “safe” in the richer world will mean that it will get ever harder to woo the kind of high-quality and patient financing needed to fund infrastructure in the emerging world. Foreign direct investment (FDI) flows globally may stay subdued, and there is greater competition for FDI. The developing countries that are able to prosper in this environment are those that can commit themselves to sustainable fiscal paths, enforceable contracts, and property rights.

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