However, implicit in this view - that the demand side is quiescent at the moment - is the proposition that monetary expansion, at least via the fiscal deficit, is not the real culprit. One inference that can be drawn - if necessary, when the time comes, as the case may be, and whichever is appropriate - is that the fiscal deficit can be higher than what many would consider prudent from the point of view of inflation. Ergo, don't make it your main policy target.

The Reserve Bank of India [Get Quote], which, like many other central banks, has made inflation its main target, has always had the opposite view. This is that while supply side factors do matter, fiscal deficits matter just as much, if not more. After all, if you can't do much about the price of oil, you can at least make sure that there is less money chasing its own tail in the economy.

It is in this overall context that this paper by J K Khundrakpam and Rajan Goyal of the Department of Economic Analysis and Policy of the RBI, needs to be viewed.  In a recent paper* (unpublished), they ask if globalisation has altered the linkages between "deficits, money, real output and prices such that the deficit is irrelevant for stabilisation."

They go through the customary econometric callisthenics (which are for economists what curd-rice is to Tamil Brahmins - necessary and sufficient), and conclude that "money is neutral to real output only in the long-run despite increasing market subscriptions to government securities and declining subscriptions by the RBI, the government deficit still induces money expansion and this matters for stabilisation."

In short, if the government wants to spend more, it should earn more and borrow less. Of course, the problem is that the government can't earn as much as it needs to because the tax bureaucracy is almost wholly corrupt. Some economist should study how much India's tax officials add to money supply through the money multiplier.

Khundrakpam and Goyal trace the historical causality between deficits, money, real output and prices from during 1950 to 2003. And their finding should help influence policy, but won't.

They show that while there is long-run neutrality of money on real output, in the short run, monetary measures are very effective for manipulating aggregate demand. But, they say, "bi-directional causality between money and prices renders money targeting to achieve the monetary policy objective of price stability a complicated exercise." In short, central banks can't tell the cart from the horse, or what is the same, thing, the old demand-pull vs cost-push thing.

Equally, however, whether or not the cart is indistinguishable from the horse "the fiscal deficit leads to reserve money creation and money supply expansion either by increasing net RBI credit to government or providing liquidity support to the market to fully subscribe to government securities."

Ergo, it is not wholly right to suggest that the fiscal deficit should not be targeted. "Targeting the fiscal deficit as a tool for stabilisation remains valid," say the authors.

It is true that inflation will be so low as to not matter if the fiscal deficit is also low. In China, where the rate inflation rate is 1.5 per cent, the fiscal deficit is around 2.5 per cent. But then, China also has a huge trade surplus, which always helps.

The real question then perhaps is, do economic policies alone make for a massive trade surplus or whether domestic political arrangements and foreign policy also matter. To put it differently, why is there such a huge positive correlation between autocracies that are (or were) pally with the US and large trade surpluses?

*Are concerns over the government deficit still valid in India? A revisit to linkages between deficits, money, real output and prices.