The Indian economy has not been doing well for the past year or so.

The currency has spiralled downwards versus the dollar (and other currencies), growth projections have been revised downwards, and the central bank has very publicly warned that the rate of non-inflationary (should actually be called nonaccelerating inflationary) growth has been substantially impacted by, inter alia, supply constraints, commodity prices and fiscal pressures. India is facing stagflation, with stagnation being re-defined as simply a drop in the growth rate. There is a standard narrative that underlies most explanations of whats happening. The United Progressive Alliance (UPA) gov ernment, prodded and misguided by Sonia Gandhi and the National Advisory Council (NAC), has spent way beyond its means. Fuel subsidies, NREGA (national rural employment guarantee Act), Right to Food, etc., are all manifestations of this. Fiscal discipline has been thrown to the dogs, and now were bearing the consequences. The standard narrative is intuitively true, almost trivially so. It seems obvious that a profligate government causes inflation and impedes growth. That is how most banana republics have conducted macroeconomic policy in modern history. That is how India got its high inflation of the 70s and the 80s, resulting finally in a balance of payments (BoP) crisis in 1991. And that is how we have landed in the mess that we have. There is just one small catch. The standard narrative is at odds with received macro-economic theory, both orthodox and heterodox. Let me explain. Inflation Most intermediate textbook treatments of inflation will identify three causes of inflation: cost-push, demand-pull and monetary. The first operates through the supply side, e.g. a bad monsoon will push food prices up. The second through the demand side, and the third through central bank (in)competence. This rather sterile slicing and dicing is easy prey to the Milton Friedman challenge: Supply-side and demand-side inflations are about relative prices, which do not necessitate an increase in the overall price level. Inflation is everywhere and always a monetary phenomenon.
Don Patinkin, a Chicago-trained macroeconomist who created the post-1950 monetary economics orthodoxyfollowed by monetarists and Keynesians

alikein his magnum opus Money, Interest & Prices, used to quip that this was not a particularly edifying formulation. Since the price level is the inverse of the purchasing power of money, he likened it to the banality that the price of potatoes is a potato phenomenon. Epic as that take-down is, its useful to retain Friedmans maxim for analytical purposes. We will see why. At heart of the Patinkin-Friedman debate is a fundamental disagreement over the interpretation of the quantity theory of money (QTM), which has been the orthodox right-of-centre neoclassical position on money and the price level since David Hume. QTM states that the long run level of prices depends on the level of the money supply, formalized in the equation of exchange MV = PY, with V and Y held constant, or more properly, fully anticipated, so that M is proportional to P. As Friedman also said, in the 200 years since Hume we have moved one derivative beyond him, so that we now believe that delta M (changes in money supply) is proportional to delta P (inflation). The Patinkin-Friedman disagreement is about whether the causality in the equation of exchange must be established through other means (Patinkin) or whether it could be taken as obvious - delta M causes delta P (Friedman). To infer causality from (or impose causality onto) an equation thats always true is an ill -disguised sleight of mind, so I tend to go with Patinkin. However, the Friedman conception has an important insight to offer. If you believe in the autonomy/free will of the central bank, and if you believe in the special character of moneyboth fairly uncontroversial positionsyou must ask yourself, what was the central bank doing? If youre investigating inflation, you must pause and askwhat is the central banks reaction function? If there is something, a bad crop, a technological change, a profligate government, anything really, that puts upward pressure on some prices, does it follow that the economy must experience an increase in absolute prices? Moving one derivative beyond, if there is unanticipated inflationary pressure somewhere, must the overall inflation rate of the economy increase? So what does all this arcane monetary theory have to do with Indias fiscal deficits and inflation? Well, simply thisby the orthodox theory, for fiscal deficits to cause inflation, those deficits have to be monetized. The central bank has to bankroll the government. Thats what banana republics do. Thats what India and RBI used to do. However, in line with most of the world, Indias fiscal deficits have been bond-financed for quite some time now. When the sovereign credit is commercially bought and sold and commented upon, fiscal profligacy should simply result in an increased interest rate on government securities (GSecs). Broad-based inflation does not directly follow. Theres a heterodox left-of-centre challenge to this orthodoxy Neo-Chartalism in which fiscal deficits are even more benign. Governments, as monopoly issuers of their own currency, never run the risk of default on domestically held debt, so real interest rates dont spike. Monetary quantities are endogenously determined in the macroeconomic system and thus not really of separate interest, and while fiscal deficits may cause inflation, this is a soft constraint that only really matters when the interest rate on government debt starts approaching the growth rate of the economy. At 15% (nominal) annual GDP growth and 8% (nominal) yield on government debt, India is not even close. So regardless of what you believe about the fiscal profligacy of the Indian government, and whether you choose to side with the orthodoxy or the heterodoxy, it does not necessarily follow that there must be inflation. The writer is a London-based consultant. This is the first of a five-part series in which Priya examines the macroeconomics of inflation in India through the lens of the fiscal deficit, NREGA, tax policy and investment. These are the authors personal views. A fiscal deficit is simply the excess of government spending over its revenue. Spending minus taxes. G-T, national income accounts wise. G-T is positive when the government runs a deficit and negative when it runs a surplus. Beginning with the standard macroeconomic identity that: Y (expenditure) = C (consumption) + I (investment) + G (government spending) + NX (exports minus imports)............ (1) Private sector savings (S) are private sector disposable income not consumed. S = Y(income)-T(taxes)-C(consumption) .............(2) Combining (1) and (2) gives S = I + G - T + NX. Or, (S-I) = (G-T) + NX.

This rather simplistic identity goes by the name of the sectoral financial balances (SFB) approach, with Wynne Godley, a British economist known as the Cassandra of the Fens for his bleak and accurate predictions about the UK economy, being its foremost exponent. Among other things, Godley was among the first to warn that the euro zonea currency union without a fiscal unionwould be disastrous in the medium term and would collapse before too long. Given the accuracy of his predictions, the raging debate around fiscal deficits, current account deficits etc., it is time to take a closer look at SFB. The macroeconomic world has been split up into three seemingly autonomous sectorsgovernment, private and foreign. It seems scarcely believable, but playing around with this identity seems to give some heterodox theorists additional analytical edge and real-world relevance over mainstream macro-theory. Witness, for example, Martin Wolf, a former World Bank economist and the premier finance and economics journalist in the world. How in the world does a definition add insight? Well, here it is. S-I is the net private sector financial surplus. G-T is the fiscal deficit. NX is the net foreign sector surplus. At a given level of NX, a private sector surplus is necessarily matched by a fiscal deficit. Read that carefully, again. A private sector surplus is matched by a government deficit. Ceteris paribus, or all other things being equal, an increase in government deficits increases the private sector surplus. A decrease in government deficits crashes the private surplus. The government (and net exports) creates financial wealth for the private sector. Most importantly, if your NX is negative, i.e., you have a current account deficit like India, you cannot possibly have a private sector surplus unless the government runs a deficit. Read that again too. A government deficit is almost a foregone conclusion if you want to invest sustainably (through domestic savings) in the face of a current account deficit. Now lets back out a bit. This cant possibly be true. It does violence to our carefully built intuitions. Private sector wealth should not be positi vely related to government deficits. All our received wisdom says otherwise. And yet, there it is, an arithmetic identity, the last thing in the world which can be jaundiced by ideology. So whats going on? Obviously, ceteris is not paribus. The equation is true at all levels of Y, I, C etc. It says nothing about the evolution of those quantities over time. Arguments against government spending and deficits must have some implicit behavioural assumptions that affect the course of these quantities over time. G-T creates S-I, sure. But does it boost S (good) or crash I (bad)? Does it hold NX constant, or does something happen to crash NX while G was increasing? The equation does not say. Ultimately, what that equation reveals depends on other equations implicit in your mental model. But just as in the Friedman quote on inflation, even if not particularly edifying when taken literally, the sectoral financial balances approach gives us pause. It makes us understand that one plausible role of the state is that of a financial intermediary. Government deficits may be helping the private sector achieve its desired levels of savings and investment, letting the household sector and the corporate sector make their spending and saving decisions independently while soaking up any gaps (or absorbing any excesses) to ensure that the plans of neither sector are frustrated. So again, what does all this arcane theory of government finances have to do with Indias current woes? For one, lets get out of the mode of twin deficits. Even the Reserve Bank of India governor mentions this in his speech, but while its an OK phenomenon to invoke when analysing currency price movements narrowlyboth a fiscal deficit and a current account deficit point towards a weaker currencyit does not add much value to a discourse on overall macroeconomic stability and performance. A country with a current account deficit will almost always have a twin deficit. Second, recall that the fiscal deficit is typically split up into two partsthe primary deficit, and interest payments. The primary deficit is the main measure of the sustainability of a governments revenue balancee.g. do our taxes cover for the salary payments of our armed forces? Interest payments are on the outstanding government debt. They are nominally fixed. They will spike only if G-Sec (government securities) investors believe that the government is running a Ponzi scheme, and thus each rollover of government debt will imply a worsening fiscal situation. Otherwise, any inflation only helps to bring the fiscal balance under control, by reducing the real value of government debt payments. Now, Indias total public debt (state plus central) is 68% of GDP. The average maturity of that debt is 10 years. The benchmark 10-year G-Sec yields 8% per annum, but the average interest payment is of the order of 7% as this debt was contracted when yields were somewhat lower. Seven percent of 68% is 4.7%. (All figures from here.) The interest payments of the Indian state are thus in excess of 4% of GDP. Indias total fiscal deficit is around 6%. Indias primary deficit is thus less than 6% - 4% = 2%. Round that up to 2%, and read that slowly again. Indias fiscal deficit is being driven largely by its interest payments. Of course, theres also a primary deficit, so that reducing the interest payments themselves unilaterally by simply not rolling over the debt is not immediately feasible. But go back to the concept of the state as a financial intermediary. The Indian state is taking on debt mostly to pay interest on debt. That sounds like a Ponzi scheme! So, what exactly is the government doing here? The government is creating a pool of credit-risk-free financial assets at all maturities of the term structure. The government is creating the way in which you and I are able to park our funds in two-year, five-year, 10-year fixed deposits. It is creating the source of income for closed-end mutual funds. It is running a Ponzi scheme, albeit one that is perfectly sustainable as long as the expected growth of the economy is in excess of the interest rate on government securities. This is the state as a financial intermediary, what the Columbia University monetary economist Perry Mehrling calls a social mutual fund. Now you may wonderhow in the world did a bunch of poorly incentivized bureaucrats and politicians come up with such a fantastic, commercially viable role of the state. I dont want to push the point, but the answer perhaps lies in Hayekian spontaneous order. We dont have to be well meaning and in possession of a master blueprint to organically stumble upon beneficial arrangements, and beneficial arrangeme nts need not be restricted to the market. Perhaps, we copied the advanced states. Perhaps, some regulator just gave in to some market pressure for kick-backs and asked for a new and improved term structure of government debt. Who knows? The point to remember isyes, fret about the fiscal deficit, but recognize the fact that it mostly arises not from profligate spending, but from the state playing a financial intermediary. Arguments challenging the viability of the latter will take a very different form than those that challenge the viability of the former. For one, the key variable to look at is not inflation, but interest on benchmark 10-year government debt versus the growth rate of the economy. With yields at 8% and growth rates at 15% (both nominal), the operating space that the Indian government has on this front is rather large currently. The writer is a London-based consultant. This is the second of a five-part series in which Ritwik Priya examines the macroeconomics of inflation in India through the lens of the fiscal deficit, NREGA, tax policy and investment. These are the authors personal views.

The flagship spending scheme of the United Progressive Alliance (UPA) government has been the National Rural Employment Guarantee Act (Nrega). Put very simply, this scheme promises to pay Rs.120 a day for doing public-related work for 100 days to rural labour unable to find work. Though the Right to Food Bill, etc., have come under heavier fire, Nrega is the one actually held responsible for the downward turn in public finances, for its the only one that has been implemented for a substantial amount of time. Now many people cry hoarse about anything that Sonia Gandhi/Jean Dreze devise. But some have actually attempted some conceptual economic theorizing and predictions around Nregabased around simple demand and supply analysis. Rural markets are inefficient, so rural supply curves are steep. Thus, shifting the rural demand curve through doling out income will only lead to an increase in prices, not in real income and consumption. While this analysis is intuitively appealing, it is severely incomplete. It talks of specific markets, not the broad-based economy. It is a microeconomic argument for the quintessential macroeconomic phenomenon of broad-based inflation. What if we were to draw the demand/supply curves as macro aggregate demand (AD) and aggregate supply (AS) curves? Then, the argument is that the aggregate supply curve is steep. Recall that the AS curve is simply the expectations-augmented Philips curve. (The original Philips curve was about the tradeoff between inflation and employment, but as macroeconomists realised, the argument can be split up into inflation/growth and growth/employment.) So were ostensibly doing nothing but invoking the Phelps-Friedman-Lucas argument circa 1970, that there is no such exploitable tradeoff, that the expectations-augmented long-run Philips curve is vertical. A pure income effect is a pure price effect. You cant help rural families by doling out funds. Now, what if the AS curve is not vertical, simply steep? Then some output/ consumption can be increased by simply raising incomes. Its not clear why t his increase is to be mocked away simply because most of the income has gone into prices. Say even 90% of the increase in nominal output is absorbed by prices. So? Why shouldnt we let inflation increase by 9 percentage points, if that does mean growth increase by 1 percentage point? Why do we care about the level of prices? Why do we care about the rate of change of these prices? Why shouldnt we exploit the Philips/ AS curve until it becomes vertical? There are two challenges to this -- the first is the classical macro-theory challenge of an accelerating rate of inflation. Inflation expectations become endogenized fast, so that the risk of over-shooting the Philips curve is imminent and non-trivial. This is what RBI worries about when Subba Rao says that the non-accelerating inflationary rate of growth in India has dropped to 7%. The second is that inflation is a regressive tax with distributive consequences. The macro literature that tries to prove this distributive consequence through consumption effects goes into several hoops, with the result critically dependent on the assumption of economies in scale in credit provision. The other way to get a distributive consequence would be to posit that poor people are more likely to have their assets in cash or other such nominally fixed holdings, and are thus losing real wealth faster. This is quite true in as far as it goes, but consider the other effect of inflationto lower the real value of nominal debts. To the extent that poor people are more likely to be in debt, an inflation tax is actually progressive. Further, inflation in India typically takes the form of food or fuel inflation. The former actually benefits most of our rural poor. (Only one-third of the price of food reaches producers, yes, but this is as true of the extra price as the original price. A poor supply chain is not a poor-er supply chain.) The latter (fuel inflation) is globally driven. In all, the distributive consequences of inflation in India are unclear. The worst hit are the urban poor, who are neither food producers nor Nrega beneficiaries, nor in possession of inflation hedge assets. We need to look out for them, but they are not the only constituency in the calculus of macroeconomic welfare and that indicates towards a safety net for them, not the removal of safety nets for others. With that in mind, lets analyse what Nrega does for inflation. In more recent times we have heard how Nrega has caused a shortfall in farm labour/ lowskilled industry labour, by giving people money for nothing (lets assume that the public works envisioned in Nrega are of absolutely zero value). Rs.120/ day*100 days = Rs.12,000. Rs.12,000 per annum is all it takes to make people give up the desire to earn money, apparently. I find it almost a perversion of empirical logic to posit that there is a shortage of unskilled labour in India, but lets say that there is. So what? What about the price system? There is a shortage at the current prices of unskilled labour. Why are we assuming that current prices must continue? The rural labourer takes a non-zero risk that he will not have a job when he scampers off to make some money-for-nothing in Nrega. So his reservation wage has not been raised by the full Rs.12,000. What businesses/ farms are these that cannot pay their unskilled labour about Rs.5,000-10,000 more per annum, and still be profitable? What fundamental right do these businesses have to exist and make profits? These capital ownerswhether of farms or businesseshave to bid up wages to get their labour back, or get out. This will increase the inflationary pressure, yes, but as we saw it is not immediately clear what the big dangers of inflation are. (Its worth noting that this is not to be added on top of Nregait is just a mechanism through which Nrega creates inflationary pressure, a proper macro one at that and one that lends itself more suitably to analysis through AS/ Philips curves). Note that what Im saying is not particularly leftist. Here is Tyler Cowen, a self-described libertarian and co-author of Marginal Revolution, one of the most popular economics blogs in the world, talking about how the way to improve the condition of workers is to increase the utility of unemployment. Raise the utility of unemployment to workers. This could be a guaranteed annual income, better unemployment insurance, more food stamps, whatever. Call it the welfare state. Improving the welfare state will improve worker bargaining across virtually all workplace dimensions and in the longer run limit the scope of all the employer depredations. Were back to the point that what helps is to give people cash, or something cash-like, including when it comes to the dimensions of workplace quality. It is also a huge help to institute policies which will raise rather than lower worker productivity. He is talking about employed labour in organized first world environments, which anyway doesnt suffer from the debilitating endowment failures that rural labour in India does. The argument is even stronger in our case, where were talking about people who live at the very edge o f decent existence. Nrega, shorn of public works, is a cash transfer, pure and simple. There was a time when cash transfers were supposed to be the right way of implementing redistribution, especially by those on the right. So why the outcry when the cash transfer was finally enacted? For one, we distrust our delivery mechanisms, we suspect leakages. Massive government programmes are massive opportunities for rent-seeking. This is the right reason to dislike Nrega. But this has nothing to do with inflation. For another, we distrust the upward creep in the size of the government that redistribution entails; so that we would like indirect subsidies cut first before cash transfers are enacted. This has merit, but again it is a public-choice issue, not a macroeconomic issue. And third, we may simply believe that we were at the right level of redistribution as it were. So anything further shifts the

balance. You could say that, and I would have no argument to offer because then we would have widely different priors, to the point that wed talk past each other. But if we dont believe that, then we have to analyse Nregas macroeconomics as the macroeconomics of a just, redistributive cash transfer. And then the corollary observations followNrega increases the fiscal deficit only when it is not backed by an equivalent increase in tax receipts. It is you and I, salaried income city dwellers, who are causing the fiscal deficit. And then, we have to go back to the questions raised in part 1 and part 2 of the serieshow does this fiscal deficit translate into inflation when it is not money-financed, and when government bonds are showing no spikes in interest rates? The writer is a London-based consultant. This is the third of a five-part series in which Ritwik Priya examines the macroeconomics of inflation in India through the lens of the fiscal deficit, NREGA, tax policy and investment. As we saw earlier, if we admit the possibility that the redistributive cash transfers implied by the National Rural Employment Guarantee Act (NREGA) are an OK policy by themselves, we are left with the corollary possibility that the fiscal deficit is a result of not raising tax rates, rather than the spending itself. To paraphrase the 19th century British economist Alfred Marshall, asking whether spending or taxes are responsible for the deficit is a bit like asking which blade of the scissor does the cutting. However, tax policy is the sine qua non of the political and commercial legitimacy of the state, and is hence a question as much of political philosophy as of economics. Ethical judgements are indispensable and Im posi ting the view that the increased government spending for redistribution is perhaps ethical, so that what is truly unethical (or unsustainable, coming back to the more grounded economics of the fiscal deficit) is the lack of corresponding increase in taxes. This is where finance minister P. Chidambarams exhortation to share the burden with increased taxes is important. Predictably, he was hounded for first having emptied the treasury and then calling for higher taxes. But the higher taxes are unavoidable. If so, what could those taxes be? The economics literature on public finance and taxation is vast and varied. There seem to be some broad agreements on the design of optimal tax policy, though. Broad base, low rate. Tax consumption, or income, if you must. Avoid taxing capital. Definitely dont tax corporate income. Tax wealth in a lump-sum manner if you wish to solve for endowment failures. Tax luxury transactions. The arguments are many and hard to summarize, but Scott Sumners post over at the Economist makes a cogent case for the mainstream theoretical position. Note that consumption taxes, which everyone seems to love when presented as VAT/GST (value added tax/goods and services tax), are basically the same as the sales and excise taxes decried as the taxes that all of us, including the domestic help, pay to feed the beast. The big benefit is the simplified regime (which will tremendously slash supply chain costs across the country, for one). Consumption taxes are also great at acting as automatic fiscal stabilizers though the farm loan waivers of 2008 are invoked very often, by far the bigger fiscal action taken that year to keep private consumption and production up in the face of a global recession was to lower sales and excise taxes substantially. Some have argued that consumption taxes are regressive (especially when thought of as a flat tax), as the poor consume a hi gher proportion of their income than the rich. Some combination of a highly progressive wage income tax and luxury taxes should fix that. Capital income taxes are slightly more tricky, with the usual argument that they are double taxation being counter-balanced by arguments about equitable taxation between capital and labour. A more original argument comes from Earl Thompson, the highly original UCLA economist, who argued that the biggest beneficiaries of national defence are capital owners, and capital taxes thus exist to solve for the disproportionate consumption of that particular public good. In general, though, the broad thrust for tax policy remains clear. Get to the GST regime faster. Do all you can to eliminate corporate income tax. Get the income taxes rightbroad-based, and hopefully low. The implications of this for India are interesting. For one, a declining corporate tax would mean that all talk about eliminating personal income tax should be consigned to the bin. Secondly, a GST, while hugely beneficial in many ways, will not necessarily boost revenue by much as we already pay a bunch of sales and excise taxes. Big reforms that would be needed are the inclusion of farmer incomes in the income tax net and a reduction in the income bracket that qualifies for 0% tax. Most of the public finance budget analysis in India around personal income taxes is urban, elitist, ill-informed and simply backwards. While the need to include farmers into the income tax fold is widely recognised, increases in the minimum tax bracket are celebrated. Leaving out corporate profits, depreciation, indirect taxes and transfers etc. from the GDP to arrive at personal income, we get a figure of around Rs.70 trillion, earned by the 390 million people employed in the labour force in India. Of this, agriculture income accounts for nearly Rs.14 trillion (16% of GDP), earned by some 225 million people employed in agriculture. The remaining 165 million earn Rs.56 trillion. Even if we assume that the urban labour force earns the same on average as rural non-farmers (fishermen, forestry product traders)a fairly generous assumption likely to underestimate urban income -- we get the mean urban income as Rs.3.4 lakh per annum. The median is probably closer to Rs2.5-Rs3 lakh. Given the personal income tax slabs in India and the special concessions and deductions available, which push the zero-tax income to about Rs.3 lakh, this means that more than 50% of the urban labour force pays no income taxes. And that figure of tax-to-GDP ratio17%is itself worth mentioning. Its very low on the global scale, and among the lowest in emerging countries. While we may like to fret about our huge and inefficient government, we are among the least government-supplied states in the world, whether its per-capita policemen, per-capita armed forces, per-capita diplomatic staff etc. If we want a proliferation of private schools, private hospitals, etc. then we have to recognise that these entail significant redistribution demands, which again raises the need for tax and spending. India is an under-taxed state, our government is under-funded. Its inefficiency in collecting even the revenue that its entitled to is glaring, with obnoxious last-ditch attempts like delaying deserved refunds on tax paid earlier. Of course, all this makes the inefficiency of the state and the dabbling in unnecessary enterprises all the more palpable. But what that also means is that at current margins, this is not the time to starve the beast. Lowering taxes to lower spending does not guarantee that wasteful spending will be reduced. If anything, an inefficient and perverse beast is likely to cut the justified spending just as muchif not moreas the wasteful spending. Improving the public-choice performance of the government is an activity that goes hand in hand with getting the size of the government right, and does not need to force it this way or that. The directional size of the Indian government currently needs to go up, with or without the need to close the fiscal deficit. In an inflationary environment, the scope to raise consumption taxes (which raise prices across the board) is low. What that should mean is more income taxes and luxury taxes. I fear that what it would mean, unfortunately, is higher corporate taxes.

The writer is a London-based consultant. This is the fourth of a five-part series in which Ritwik Priya examines the macroeconomics of inflation in India through the lens of the fiscal deficit, NREGA, tax policy and investment. These are the authors personal views. Its worthwhile to do a quick recap of the main concepts that I have argued for earlier before we try to tie them all up together. 1) Fiscal deficit does not directly lead to inflation. It has to be monetized or something spiky has to happen in the government bond markets. 2) To the extent that India has a fiscal deficit, the interest payments (though numerically smaller than the expenditure outlays) are what are driving the deficit at the margin. Interest payments look sustainable at current interest rates and growth rates. The Indian state is playing a commercially viable financial intermediary, creating a pool of assets at various maturities that services the savings demand of our households. 3) To the extent that India has a primary deficit that casts questions on sustainability of government finances, it results from being under-taxed, not overspent. 4) Flagship spending schemes have a plethora of public-choice issues, but the pure macroeconomics behind them is quite simple and uncontroversial. The effects on inflation, if any, are best analysed through the lens of an AS/ Philips curve. 5) Points 1 and 4 imply that to have any shot at understanding inflation, it is imperative to look at the central banks monetar y regime, and its evaluation of aggregate supply. RBIs monetary regime The Reserve Bank of India (RBI) officially tries to maintain inflation at around 4% in the medium term, while maintaining growth prospects and allowing the currency to float as per the market and trying to reduce the volatility in currency price. Its an admirable, if somewhat convoluted, set of macroeconomic stability goals. But the actual performance of Indias inflation seems to fly in the face of what its central bank is trying to do. We have consistently overshot 4%, and not just in the last couple of years. At least since 2005, inflationwhether measured by final consumer prices, wholesale prices, or the GDP (gross domestic product) deflatorhas been at more than 6% every year. Yet, RBI seems to have a relatively credible inflation-fighting stance, with most of its criticisms being directed at currency interventions or micro-management of the financial sector. Even more surprising than the credibility is the fact that RBI itself seems to be wary of monetary tightening to actually try and achieve its goal to keep inflation at 4%. Ostensibly, this would not do much for inflation but kill growth. Recall the AD/AS diagram. RBI believes the AS curve is horizontal on the downside shifting the AD curve inwards reduces real growth. At the same time, it seems wary of monetary easing to actually try to boost growth, because this would only create inflation, not boost growth. Which is to say RBI believes the AS curve is vertical on the upside! This is RBI in its own conception operating between a rock and a hard place, operating at that miraculous inflection point on the AS curve where it turns from being near-horizontal to near-vertical. If you dont buy this story as it stands, thats because you shouldnt. One can indeed land at such a jarring discontinuity i n the AS curve, but it has to be a matter of sheer fluke, rather than a series of fiscal failures, that gradually led to the discontinuity. And if the central bank manages to optimize within this shoddy hand that the government has dealt it with, that will also be a matter of fluke, not effective monetary policy. One should expect to see either accelerating inflation or growth in a downwards spiral with stable prices/inflation. Not both at the same time. But what if RBI was, through design or default, optimizing something completely different. Neither growth nor inflation, separately. A combination of the two, taken together, treated inseparably. What if it was targeting nominal income growththat simple idea which has taken the popular macro/monetary discourse in the developed world by a storm. (The idea is that a central bank should keep the total nominal spending, the nominal GDP, which is equal to the total money flow in the economy, on a stable path. This path could be of 5% growth, 0% growth or 15% growth, depending on the economy. But it is deviations from this path, and not any other measure, that signify whether monetary policy is too loose or too tight). The evidence would certainly suggest so. Nominal GDP at factor cost (GDP at market prices net of the indirect taxes and transfers of the government) has grown at a remarkably consistent rate in India. Over the past six years, the average growth has been 16% per annum, with a standard deviation of 1% (both logarithmicall data calculated from national income accounts available with MOSPI). Its the nominal aggregat e in India with the lowest coefficient of variation (standard deviation divided by mean). As far as macro-stabilization goes, this is what is being stabilized. Not the price level, whether measured through consumer prices or the GDP deflator. Not nominal GDP at market prices. Not real GDP. Nominal GDP, at factor cost. Has RBI been living a Sumerian dreamstabilizing aggregate demand (net of fiscal stabilizers) and letting the supply side play itself out? If yes, how? It could be by designRBI governor D. Subbaraoalways strikes me as a remarkably well-clued man, but thats not enough. It could be by default, trying to stabilize some other key metric (like credit growth) and ending up stabilizing the nominal gross domestic income because of certain stable relationships in the Indian economy that havent broken down as yet. We dont really know, but the implications are interesting. For one, all inflation is stagflation. Or, more accurately, any increase in inflation will necessarily be seen as a decrease in growth. Just like the twin deficits, this is not a double whammy, but two sides of the same economic fact resulting from the central banks monetary policy reacti on function. Second, there are no inflation expectations driven independently by the central bank, but whatever we see is a result of the interplay between the private sector and the government. Its not the AS curve that has the strange kink, it is the AD curve. This story flies in the face of what RBI claims to be doing, but it explains the stylized facts. It is also consistent with the intuition of the standard antigovernment narrative in India, when that intuition is suitably enhanced through the argument that expectations of inflation in India may be dependent on the fiscal stance, macro theory notwithstanding. We are so used to monetized deficits causing price rises that we continue to believe the same even though the fiscal regime in India has actually changed substantially, through design or default. (Christopher Sims, last yearss Nobel prize winner for economics, has an explanation of how inflation expectations may be fiscal and how rate hikes by the central bank may be counter-productive in that scenario. His argument invokes the fiscal theory of the price level, which I dont quite agree with, and works through the nominal rates on government debt, which seems quite stable, so one doesnt have to take it at face value. However, just like Friedmans maxim

and the sectoral financial balance approach, the Sims conception adds a dimension and mechanism in the operation of macroeconomic policy that we should keep in mind.) With this in mind, what remains to be analysed is if the AS curve becomes more steep, causing stagflation, what comes firstinflation expectations or a supply crunch? And if there is a supply crunch, what is it? Investmentthe crucial link So what is the expectation of inflation in India? Recall the fact that 10 year G-secs trade at close to 8% yield. The current inflation is in excess of that. If the current inflation is expected to continue, savers are ok with negative real rates on their savings. In a capital-deficient country like India, this seems rather absurd. If you think that this may be the result of financial suppressionof the central bank mandating banks and investors to hold a certain proportion of their assets as G-secsconsider the fact that when the statutory liquidity ratio was recently cut from 24% to 23%, most banks were anyway sitting on 2829% of their assets as G-secs (plus gold). There are two possibilities: Inflation expectations really are high, and real interest rates really are that low. If that is true, then the degree of risk aversion implied by that fact means that within 5-10 years, lending and spending of all forms will drop and India will see macroeconomic woes that will make our current predicament seem like a walk in the park. Then, we will know what true stagflation is. But if that is not the case, and real interest rates are positive, this means the current inflation is perceived as transitory and inflation expectations in the medium term are actually tracking RBIs target quite closely. If so, that would be a tremendous macroeconomic achievement by our central bank and fiscal authoritieswe have adjusted to the new fiscal regime and RBI is able to stabilize current aggregate demand even while maintaining medium term price stability. So we should turn back our focus on the current supply bottleneck. And what could that bottleneck be? The most solid empirical evidence, in research conducted by the International Monetary Fund, points to investment. This is especially important because todays investment is tomorrows capital. An investment bottleneck i n the AS curve is most likely to persist from the short term to the medium term. Current inflation is most likely to be endogenized if it results from an investment shortfall. Even if we have somehow achieved macroeconomic nirvana, an investment shortage can bring us back to our ugly past. This is not a particularly right-ist view. Axel Leijonhufvud, a Swedish-American economist who is perhaps the foremost parser of true Keynesian thought, has done some excellent work exploring the micro-foundations that affect this crucial link between inflation and investment. His main argument is that proper financial intermediation breaks down in periods and regimes of high inflations, especially for longer term capital needs. His work focuses on monetary regimes that are substantially less stable than RBI today and high inflations, for which Indias 8-10% per annum does not really qualify. But it arguably holds even for RBIs regime, if people are likely to go back to the old ways of thinking about our profligate government, and if our particular investment needs are especially long term. Indias and the United Progressive Alliances greatest failure on the fiscal front has been their utter failure to prevent the fall in investmentand indeed abetting the fall through some bone-headed moves. Conclusion So, in the end, if it all does come down to a fiscal failure, and it does come down to supply bottlenecks, and if it does come down to how inflation expectations in India may possibly be fiscal, just why has so much electronic ink been spilt? If the standard narrative is broadly true, why try to dismantle it before putting it back together again? Its important to come to the right conclusions, but it is also important to do so through the right analytical frameworks. I t helps you focus your criticism, and it helps you see some successes where you may only have imagined macroeconomic failures. I hope I was able to clarify how its i nvestment, not government spending, that we should focus our minds on. I hope I was able to demonstrate how the 10-year yield is an important variable to watch out for. India has great macroeconomic challenges in front of her. Unless we focus on the right levers, we risk losing the plot to minor irritants. The writer is a London-based consultant. This is the last of a five-part series in which Ritwik Priya examines the macroeconomics of inflation in India through the lens of the fiscal deficit, NREGA, tax policy and investment. These are the authors personal views.