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Deficit Financing

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updated on April 17th, 2019

Deficit Financing

The act/process of financing/supporting a deficit budget by a government is deficit financing. In this process the government knows well in advance that its total expenditures are going to turn out to be more than its total receipts and enacts/follows such financial policies so that it can sustain the burden of the deficits proposed by it.

First used in the area of public finance in the early 1930s in the USA, today the term is being used by the corporate sector, too and such financial management of a firm might be followed by it as part of its business strategy. Again, a sick firm might need to follow the deficit financing route for many years to come as required by the firm to make it come out of the red (i.e., doing away with the losses).

Need Of Deficit Financing

It was in the late 1920s that the idea and need for deficit financing were felt. It is when the government needs to spend more money than it was expected to earn or generate in a particular period, to go for the desired level of growth and development. Had there been some means to go for more expenditure with less income and receipts, socio-political goals could have been realised as per the aspirations of the public policy. And once the growth had taken place, the extra money spent above the income would have been reimbursed or repaid. This was a good public/government wish which was fulfilled by the evolution of the idea of deficit financing.

It was by the early 1930s that the US first tried its hand at deficit financing soon to be followed by the whole Euro-American governments. Through this route, the developed world was able to come out of the menace of the Great Depression (1929).15 The idea became popular around the world by the 1960s. India tried its hand at deficit financing in 1969 and since the 1970s it became a routine phenomenon, till it became wild and illogical, demanding immediate redressal. The fiscal deficits in India did not the only peak to unsustainable levels but its composition was also not justified and not based on sound fundamentals of economics. Finally, India headed for a slow but confident process of fiscal reforms that is also known as the process of fiscal consolidation (to be discussed in the coming pages).

Means Of Deficit Financing

Once deficit financing became an established part of public finance around the world, the means of going for it were also evolved by that time. These means, basically are the ways in which the government may utilise the amount of money created as the deficit to sustain its budget for developmental or political needs. These means are given below in the order of their suggested and tried preferences.

(i) External Aids are the best money as a means to fulfil a government’s deficit requirements even if it is coming with soft interest. If they are coming without interest nothing could be better.

When India went to borrow from the IMF in the wake of the financial crisis of 1990–91, the body advised India to keep its fiscal deficit to the tune of 4.5 per cent of its GDP and noted it to be sustainable for the economy. What was the rationale behind this data? Basically, in those times with foreign aids (soft loans either from the WB or from the Aid India Forum), India was able to manage its budget to the tune of 4.5 per cent of its GDP. In 2002, when India’s fiscal deficit was around 6 per cent (5.7 percent to be precise) the IMF validated it to be sustainable, the reasons were two—first, India was able to show a check on fiscal deficit and secondly, at the same time the forex reserves of the country were suitably higher to neutralise the negative impacts of the higher fiscal deficit than the suggested levels (4.5 percent).

External Grants are even better elements in this case (which comes free—neither interest nor any repayments) but it either did not come to India (since 1975, the year of the first Pokhran testings) or India did not accept it (as happened post- Tsunami, arguing grants/aids coming with a tag/condition). That is why here this segment has not been discussed as a means to manage the deficit.

(ii) External Borrowings17 is the next best way to manage fiscal deficit with the condition that the external loans are comparatively cheaper and long-term.

Though external loans are considered an erosion in the nation’s sovereign decision-making process, this has its own benefit and is considered better than the internal borrowings due to two reasons:

(a) External borrowing bring in foreign currency/hard currency which gives extra edge to the government spending as by this, the government may fulfil its developmental requirements inside the country as well as from outside the country.
(b) It is prefered over the internal borrowings due to ‘crowding out effect’. If the government itself goes on borrowing from the banks of the country, from where will others borrow for investment purposes?

(iii) Internal Borrowings come as the third preferred route of fiscal deficit management. But going for it in a huge way hampers the investment prospects of the public and the corporate sector. It has the same impact on the expenditure pattern in the economy. Ultimately, economy heads for a double negative impact—lower investment (leading to lower production, lower GDPs and lower per capita income, etc.) and lower demands (by the general public as well as by the corporate world) in the economy—the economy moves either for stagnation or for a slowdown (one can see them happening in India repeatedly throughout the 1960s, 1970s, 1980s). The situation improved after the mid- 1990s.

(iv) Printing Currency is the last resort for the government in managing its deficit. But it has the biggest handicap that with it the government cannot go for the expenditures which are to be made in the foreign currency. Even if the government is satisfied on this front, printing fresh currencies does have her damaging effects on the economy:
(a) It increases inflation proportionally. (India regularly went for it since the early 1970s and usually had to bear double digit inflations.)
(b) It brings in regular pressure and obligation on the government for upward revision in wages and salaries of government employees— ultimately increasing the government expenditures necessitating further printing of currency and further inflation—a vicious cycle into which economies entangle themselves.

Now, it remains a matter of choice and availability of the above-given means, and which means a government adopts and in what proportion, for fulfilling its deficit requirements.

Composition Of Fiscal Deficit

The Keynesian idea of deficit financing, though he advocated it, had a catch in it also which was usually missed by third world economies or intentionally overlooked by them. The catch is related to the question as to why an economy wants to go for fiscal deficit. Thus, it becomes essential to go for an analysis of the composition of the fiscal deficit of a government.

Out of the two broad expenditure obligations of a government—revenue expenditure and capital expenditure—the following combinations of expenditure composition are suggested:

(i) A fiscal deficit with a surplus revenue budget or a zero revenue expenditure is the best composition of fiscal deficit and the most suitable time for deficit financing.
(ii) The deficit requirements for lower revenue expenditures and higher capital expenditures are the next best situation for deficit financing, provided revenue with the deficit is eliminated soon.
(iii) The last could be the situation when a major part of deficit financing is to fulfil revenue expenditures and a minor part to go for capital expenditures. The total money of the deficit might go to fulfil revenue expenditure, which could be the worst form of it.

Basically, there should be a judicious mix of plan and non-plan expenditure as well as revenue and capital expenditures in India. Lesser non-plan expenditure or higher plan-expenditure are better reasons behind deficit financing in India (though India has a typical feature of capital expenditure which makes this combination of deficit financing not a suggested form—discussed ahead).

Third world economies (including India) though went for higher and higher fiscal deficits and deficit financing, they either did not address or failed to address the composition of deficit favourable towards capital and non-revenue expenditures.

The various sources of funds to finance economic development in the modern states are (i) taxation, (ii) public borrowing, (iii) government savings, (iv) surplus of public enterprises, (v) deficit financing, and (vi) external assistance.

When the government cannot raise sufficient resources through taxation, public borrowing and so on, it resorts to deficit financing to meet its development expenditure.

Meaning

Deficit financing, in general, refers to any public expenditure that is in excess of current public revenue.

In the Western countries and the USA, the term ‘deficit financing’ is used in a wider sense while in India, it is used in a narrower sense.

In the Western countries and the USA, government expenditure financed through public borrowings (i.e. from people, commercial banks, and the Central Bank) are included in deficit financing.

In India, on the other hand, government expenditure financed through borrowing from people and commercial banks are excluded from deficit financing. These are known as market borrowings.

According to the Planning Commission, deficit financing in India includes:

(i) withdrawal of past accumulated cash balances by the government;
(ii) borrowing from the Central Bank, that is, the Reserve Bank of India; and
(iii) Issuing of new currency.

As observed by Misra and Puri, “when the government borrows from the Reserve Bank of India, it merely transfers its securities to the Bank which, on the basis of these securities, issues more notes and puts them into circulation on behalf of the government. This accounts for the creation of money”.

In short, the deficit financing in the Indian context connotes a direct increase in money supply through the issue of fresh currency by the government in order to meet the budget deficit.

Concepts

The Government of India recognizes five concepts of deficit financing. They are:

  1. Revenue Deficit When revenue expenditure of the government is more than its revenue receipts, it is known as revenue deficit. The revenue expenditure of the government comprises the resources spent on those items which do not create assets like expenditure on civil administration, defense, law and order, justice, interest payment, subsidies and so on. The revenue receipts of the government include tax revenues and non-tax revenues.
  2. Budget Deficit When the total expenditure of the government is more than its total receipts, it is known as a budget deficit or overall budgetary deficit. The total expenditure of the government includes both revenue expenditure and capital expenditure. Similarly, the total receipts of the government include both revenue receipts and capital receipts.
  3. Fiscal Deficit Since 1950, the Government recognized the above two concepts of the deficit. Later in 1986, the third concept of the deficit, called fiscal deficit, was introduced on the recommendation of the Sukhmoy Chakravarty Committee (1982–1985) on the Review of the Working of the Monetary System in India. The fiscal deficit refers to budgetary deficit plus market borrowings and other liabilities of the government. It measures the total borrowing requirements of the government from both internal and external sources.
  4. Primary Deficit It indicates the fiscal deficit minus amount of interest paid by the government. It is also known as the non-interest deficit. This concept of the deficit was introduced recently.
  5. Monetised Deficit The budget deficit can be financed in two ways: either by borrowing from the public or by borrowing from the Reserve Bank of India (RBI). When it is financed through borrowing from the RBI, it is called Monetised Deficit. In other words, it is increasing in the net RBI credit to the Government.

Role

Modern states have resorted to deficit financing under three different circumstances:

  1. Depression The developed countries of Europe and the USA resorted to deficit financing during the great depression of the 1930s to deal with the problem of mass unemployment. It was J.M. Keynes who suggested the logic of deficit financing to fight cyclical depressions in capitalist countries and to eliminate mass unemployment. He opined that the main cause of unemployment in a developed country is lack of effective demand (for goods) which depends on the propensity for consumption. To overcome this problem, Keynes suggested deficit financing to finance public works projects. In case public works are not available, the governments should, according to Keynes, ask people to “dig wells and fill wells”. This increases the purchasing power of people and results in effective demand for goods. This further increases employment which again increases effective demand and hence employment and so on. Keynes called it “multiplier effect”. In this way, the economy can be revived and lifted from the morass of depression.
  2. Economic Development The developing countries including India have resorted to deficit financing for financing economic development. This is because these countries do not have sufficient resources to finance public investment to accelerate the process of development. Deficit financing helps rapid capital formation for economic development. It breaks bottlenecks and structural rigidities in the economy and thereby increases productivity. Thus, it provides a stimulus to economic development by financing investment, employment, and output in the economy. However, it has a negative effect on the economy, that is, inflationary rise in prices of goods and services. This is because the deficit financing increases the supply of money in the economy without a corresponding increase in the supply of goods and services. This inflationary character of deficit financing changes the pattern of investment by people, results in forced savings, adversely affects the balance of payments, increases economic inequalities, increases credit creation by banks and so on.
  3. War The modern states have also resorted to deficit financing to finance war operations. The financial resources raised by the governments through taxation and borrowing do not suffice to meet the cost of war. Hence, the governments have no alternative except to create new money by printing more currency. This war deficit financing brings in circulation a large quantity of money in the economy. This increases the monetary incomes and demand for goods. Such a situation results in inflation due to the absence of a corresponding increase in the supply of goods.

Safe Limit

Deficit financing is a necessary evil. On the one hand, it is essential for economic development and on the other hand, it is intrinsically inflationary in nature. Hence, it should be kept within the safe limit so that it leads to capital formation without an inflationary rise in prices. The various factors which determine the safe limit of deficit financing (or the measures needed to keep the deficit financing within safe limit) are as follows:

  1. Effective efforts should be made to mop up surplus money by higher taxation and increased loans.
  2. The quantity of money injected into the economy should be to the extent of the rate of growth of the economy.
  3. The newly created money should be used for productive purposes like irrigation, industrial development and so on.
  4. The deficit-inducted additional money should be used for the promotion of those projects which have short gestation period. This will increase the supply of goods quickly and thus check the price rise.
  5. Efforts should be made to transfer the non-monetised sector (barter part of the economy) into the monetised sector.
  6. There should be effective regulation of prices of goods and distribution of goods through rationing.
  7. The import of capital equipment, industrial raw material, and food grains should be encouraged and that of luxury and semi-luxury goods should be discouraged.
  8. The people should have the spirit of sacrifice and extend their cooperation in the implementation of the policies for reducing the price effect of deficit financing for capital formation.
  9. The government should offer incentives to increase production in the private sector.
  10. Credit creation policies should be integrated with deficit financing to regulate the increased credit creation by banks.

PS : How to prepare Indian Economy for UPSC ?

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