The world economy has clearly started on Act II of the possibly prolonged drama that began with the Great Recession of 2008-09. But if the Government of India is to be believed, the Indian economy is not likely to be very adversely affected by the current round of global financial volatility. Finance Ministry sources argue that the Indian economic growth story is so robust that the current uncertainty will cause no more than a minor blip in its confident trajectory.

But this is definitely an over-optimistic prediction, which makes one hope that the policy makers are actually more aware of the possible downsides, whatever their public pronouncements may be. One important downside is the likely diminished role of the US as a net importer. This is no longer a future possibility - it is already a process that is well under way and is likely to get even more accentuated in the near future. And it means that the rest of the world - including India - can no longer rely on exporting to the US as the means of generating growth in their own domestic economies.

It is true that the US current account deficit increased slightly in 2010 compared to 2009, and has been increasing slightly in the first half of 2011. Even so, in 2010 the deficit was 30 per cent lower than it was in 2008, amounting to $2 trillion less.

More significant for countries like India, which have put so many eggs into the service exports basket, is the pattern of US imports of services. They fell quite sharply in 2009 compared to 2008, recovered in the following year but were still below the 2008 level. In the first six months of 2011, US service imports were only 5 per cent higher than they were in the first six months of 2008, which implies a fall in real terms because of the depreciation of the US dollar in the intervening period.

All this occurred while the stimulus packages still included some amount of fiscal expansion in the US. Unfortunately, the political charade around the debt ceiling that just played out in Washington has almost completely ruled out the possibility of more government expenditure to combat the current fragility - instead, the current watchword is austerity and budget cuts. Quite apart from the implications for employment, welfare and inequality in the US, this is a further constraint on import expansion in the US economy. And the growing resentment among the people that is bound to be associated with these cuts will generate further protectionist pressures that will rebound on outsourcing and related tendencies.

Since fiscal measures are being ruled out by the politics, the only means left for the US to come out of this current stagnation is through monetary policy, though the effects of this are unlikely to be very positive. The real problem with the expansionary and low interest monetary policy being followed by the US Fed in the wake of the crisis is that it has contained no measures to make sure that banks actually lend out in ways that improve economic activity, employment and the financial condition of the mass of consumers.

But still no such actions are planned. Instead, Federal Reserve Chairman Ben Bernanke has just announced that interest rates will remain at their very low levels (close to zero) for the next two years at least. This may be fun for banks, but is not likely to stimulate domestic output or demand in the US directly, especially because thus far the banks have shown little appetite for lending to small producers or distressed householders who are being forced to cut consumption. But this policy will surely contribute to a weakening of the US dollar, which indeed may be part of the intention.

And it will lead to yet another problem for emerging markets like India: the increased tendencies for inflow of mobile capital, in the form of carry trade to take advantage of interest rate differentials and because of perceptions of greater growth potential in these countries. In Brazil this is already seen as a major economic concern, as inflows of hot money push up the currency despite some attempts at capital controls. But policy makers in India are not necessarily as wise, and they may rather interpret the renewed inflows of footloose capital as a sign of the continued economic strength of India.

That would be a mistake, because financial inflows in the current context will push up the exchange rate and further increase the trade deficit, which is already of significant proportions. It will further shift incentives in the economy away from tradable goods to non-tradable activities including real estate, construction, stock markets and debt-based personal consumption.

These are classic signs of a bubble economy. As long as the bubble is in progress, it feels like a boom, but all bubbles do burst eventually. In the Indian case the bursting is likely to be even more painful, because even in the boom the growth process is simply not generating enough productive employment. So a quick ''recovery'' from the current volatility need not be something to celebrate in India if it is because of renewed capital inflows, with their attendant unfortunate consequences.

Meanwhile, in Europe (the other major market for Asian exports), political tensions continue to simmer over the extent to which economic and monetary integration necessarily require fiscal federalism and greater protection of the ''weaker'' segments of the European Union by the stronger countries. At present, the countries with deficits (whether these deficits are public or private) are being forced into massive internal deflations based on swingeing fiscal cutbacks and falling real wages, but thus far these are not contributing to rapidly reducing deficits. Instead, some imbalances are getting worse simply because GDP continues to fall. Meanwhile the stronger surplus countries are also intent on domestic austerity and continue to look to external markets as the source of growth.

Obviously this is not a sustainable situation, and something must give fairly soon. But in any case this means that this region also cannot provide the impetus required if global output is to be on a genuine track of recovery, and indeed the pressure is more likely to be downward.

There are those who argue that the US and EU are no longer the significant sources of global demand anyway, and that the future growth for the world economy will come from the BRIC countries (Brazil, Russia, India and China). Jim O’Neill of Goldman Sachs, who coined the term ''Brics'' has pointed out (''Panic measures will ruin the Bric recovery'', Financial Times August 9, 2011) that ''In the decade that finished in 2010, the Brics added around $8,000bn to global gross domestic product, equivalent to about 80 per cent of that of the Group of Seven leading economies. The Brics will probably add around $12,000bn more over the next decade, double the US and the eurozone combined.'' He believes that if domestic growth in these economies is not thwarted by inflationary pressures, the world economy can treat these economies as the engine of future growth.

But this misses the point that despite some moves towards greater stimulation of the domestic market especially in China, these economies are also dominantly export-driven. Manufacturing exports from China, oil exports from Russia, agricultural exports from Brazil and service exports from India are all crucial in driving domestic growth in these economies, even in the countries that are currently running trade deficits. Any slowdown or reduction in exports to the US and EU is bound to have some depressing effect on both output and employment in these and other neighbouring countries. If it also affects investor expectations, then this can turn into a cascading effect.

The other potentially dangerous effect of the fact that loose monetary policy in the United States has unleashed lots of cheap liquidity on global markets has to do with primary commodity prices. At this moment oil prices have fallen globally, but this may be just temporary respite, and for other important commodities there is no clear decline. Gold prices are rising because of a flight to safety, but investing in other commodities may also keep increasing simply because investors do not know where else to go with their money, and because interest rates are so low that there is little to lose.

This means that further increases in global commodity prices are possible and even likely. The dramatic increase in global food prices has already created havoc and adversely affected consumption of the poor across the developing world. The pressure on food prices in India is already so intense that the country really cannot afford another trigger in the form of renewed global price increases. And this is compounded by other pressures on domestic prices, so much so that when the dust created by the anti-corruption agitation settles, it is likely to become evident that inflation in food and other basic goods is the single most important problem in the perception of most Indians.

Despite macho claims to the contrary, the Indian growth process is a potentially very fragile one. It has been heavily based on global integration, both in terms of new markets for goods and services and the effects of inflows of mobile finance capital that have enabled disproportionate expansion of some sectors, especially finance, real estate and construction.

The threats to this growth process are usually seen as internal, in the form of social and political unrest driven by the greatly increased asset and income inequalities and the growing gap between material aspirations and reality especially among the youth. But the extent to which even these social variables can be affected by signs of external vulnerability should not be underestimated.

Employment in exporting sectors in India has still not fully recovered from the falls during the global recession, though output barely dipped. And the large numbers of young people who have invested heavily in expensive private higher education in the hope of a better future are increasingly entering the labour market only to find that there are simply not enough jobs being created for them, especially in the formal sector. The pressure cooker in India is clearly simmering, and even small signs of external vulnerability and economic fragility can cause it to explode.

* This article was originally published in The Frontline, Volume 28- Issue 18, August 27-September 09, 2011.