Economy showing symptoms of stagflation

Rajendra Narayan P | Updated on May 30, 2021

Expansionary fiscal policy, especially increased govt spending, is needed to overcome the pandemic-induced disruptions

Iranian oil workers’ strike and subsequent surge in fuel price during 1970s brought world economies to their knees. The US economy, under Jimmy Carter’s presidentship, experienced a peculiar economic phenomenon — a period of rising inflation, declining output growth and high unemployment levels. Economists coined the term stagflation to describe this double-edged sword.

The Indian economy appears to be heading towards a similar scenario. The y-o-y headline inflation in April 2021, as measured by WPI, was a whopping 10.49 per cent — the highest level in the last one decade. This sharp rise in inflation is mainly attributed to the unprecedented surge in global oil price, from a mild $19.90 per barrel in April 2020 to $63.40/barrel last month, an increase of more than 200 per cent.

This may worsen once the effect of the fuel price rise passes on to other commodity prices. The WPI inflation in primary articles and manufactured products is already high at 10.16 per cent and 9.10 per cent, respectively, in April 2021.

Recent CMIE data show that rural and urban unemployment rose to 8.57 per cent and 11.42 per cent respectively. This can eventually lead to demand depression which in turn can further worsen the unemployment scenario.

Even otherwise, the situation is not expected to improve in the near term, as the second wave of the pandemic has now penetrated the rural and semi-urban parts of the country, which house majority of our workforce, especially in the informal sector.

Complex situation

The disruptions in the rural economy will not only affect demand but also agricultural production and small and medium industries, causing supply-side problems. With domestic inflation in India mostly supply driven, this can further add to inflation expectations.

Policy response in such a complex situation is tricky and tough. The RBI is having little choice to foster demand-driven growth as the threat of inflation looms large. Key policy rates, the biggest weapon in its armoury, may prove counterproductive in such a situation. Any dovish position with respect to interest rate may push up inflation , and further weaken demand and growth.

In this context, policy czars should take a cue from Keynesian economics and shift their focus to fiscal measures. When monetary policy has little to offer, prudent and timely fiscal policy can be the saviour, specifically policies related to government expenditure. However, there are arguments against increased expenditure — one, the inflationary pressure it can create; two, the problem of huge public debt; and, finally, the efficiency of these policies because of leakages.

Though in general expansionary fiscal policies are considered to be inflationary, given the situation that aggregate demand is already low, any additional demand pressure on prices is highly unlikely. On the contrary, with output at below full employment level, the additional demand can lead to better utilisation of unemployed resources and, thereby, improve output and reduce unemployment.

The second problem in the current situation is revenue collection is expected to fall on account of lockdown in many parts of the country. However, quite contrary to the expectations, the GST collection in April stood at record high of ₹1.41 trillion, a 14 per cent increase compared to March 2021.

In any case, reasonable levels of increase in public debt shouldn’t be a deterrent for the government to spend, especially in a situation where the life of people and revival of the economy are at stake.

Also, plugging leakages in the system is something that the government and policymakers need to address. Are the benefits of government spending reaching the poor and needy? It is in this context that direct benefit transfer (DBT) turns out to be relevant.

According to the government, in FY21, ₹4,33,210 crore was distributed through DBT, reaching more than 11 crore beneficiaries by covering 314 schemes under 54 ministries. This has resulted saving ₹1,78,396 crore in leakages. If used effectively, DBT can help offset the economic or financial damage caused by the pandemic.

For example, direct cash transfers can be an effective tool to boost demand, especially consumption demand, as these are targeted at the poorer sections. With prices of food and fuel picking up momentum, direct transfers in kind, especially food, will reduce the impact of price rise on real income. This will eventually boost demand and lead to a healthy recovery of the Indian economy.

The writer is on the Economics and Finance faculty, IIT Patna

Published on May 30, 2021

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