Deficit Financing| Need| Consequences| Important Types

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Deficit Financing

Deficit financing is the budgetary situation where expenditure is higher than the revenue. It is a practice adopted for financing the excess expenditure with outside resources. 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.

Nowadays most governments both in the developed and developing world are having deficit budgets and these deficits are often financed through borrowing. Hence the fiscal deficit is the ideal indicator of deficit financing.

In India, deficit financing is defined as “borrowings from the Reserve Bank of India against the issue of Treasury Bills and running down of accumulated cash balances”. When the government borrows from the Reserve Bank of India, it merely transfers its securities to the Bank. On the basis of these securities the bank issues more currency and puts them into circulation on behalf of the government. This amounts to the creation of money.

Why we need deficit financing

For developing countries like India, higher economic growth is a priority. A higher economic growth requires finances. With the private sector being shy of making huge expenditure, the responsibility of drawing financial resources rests on the government.
Being poor, these countries fail to mobilize large resources through taxes. Thus, taxation has a narrow coverage due to mass poverty. A very little is saved by people because of poverty. In order to collect financial resources, government relies on profits of public sector enterprises. But these enterprises yield almost negative profit. Further, there is a limit to public borrowing.
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 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.
There are some situations when deficit financing becomes absolutely essential. In other words, there are various purposes of deficit financing. These are:
1. To finance defence expenditures during war
2. To lift the economy out of depression so that incomes, employment, investment, etc., all rise
3. To activate idle resources as well as divert resources from unproductive sectors to productive sectors with the objective of increasing national income and, hence, higher economic growth
4. To raise capital formation by mobilizing forced savings made through deficit financing
5. To mobilize resources to finance massive plan expenditure

Different Means of Deficit Financing

These means are given below in order of their suggested and tried preferences.

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. 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).

External Borrowings are 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 preferred 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?
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.
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 other 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.

What are the consequences of Deficit Financing?

Deficit financing can have a useful role during the phase of depression in a developed economy. During this phase, the level of expenditure falls down to a very low level and the banks and the general public are in no mood to undertake the risk of investment. They prefer to accumulate idle cash balances instead. The machinery and the capital equipment are all present there but the incentive to produce is lacking due to a deficiency in aggregate demand. It is in this scenario that the government pumps in additional purchasing power in the economy through deficit financing the level of effective demand is likely to increase.

Capital accumulation in developing countries through deficit financing is likely to generate inflation because in these countries “the propensity to consume is high, there are many market imperfections, there is little excess capacity in plant and equipment, and the elasticities of food supplies are low”.

As a consequence of deficit financing, the demand for food items is likely to be pushed up to a far higher level as compared to their supply resulting in an inflationary spiral in their prices. It is being held by economists that even if deficit financing tends to be inflationary it carries no danger as long as the inflationary pressures are mild.

Inter-linkage between Deficit financing and inflation

Deficit financing is inherently inflationary. Deficit financing increases aggregate expenditure which logically enhances aggregate demand. Consequently, the danger of inflation is always there. At times deficit financing has also resulted in hyper-inflation.

However, the critical variable is the nature of deficit financing which has a bearing on whether deficit financing is inflationary or not. If the deficit financing is unproductive in character (for example, war expenditure made through deficit financing) it is definitely going to be inflationary. However, the net consequence is different if a developmental expenditure is made via the instrumentality of deficit financing. In this case, deficit financing may not be inflationary although it results in an actual increase in money supply.

It is being held that “Deficit financing, undertaken for the purpose of building up useful capital during a short period of time, is likely to improve productivity and ultimately increase the elasticity of supply curves.” In this case, the productivity is raised which acts as an antidote against price inflation.

The most crucial thing about deficit financing is that it produces an economic surplus during the process of development. By economic logic, the multiplier effects of deficit financing will be larger if total output exceeds the volume of money supply. Consequently, the inflationary effect will be neutralized.

Deficit financing helps in meeting the liquidity requirements of the growing economies. Actually, a mild dose of inflation following deficit financing is helpful to the whole process of development. Deficit financing is not anti-developmental if the resultant inflationary spiral is only moderate. However, in most cases, deficit financing causes inflation and economic instability. It is very inflation-prone compared to other sources of financing.

Some amount of inflation is bound to happen under the following circumstances:

(a) If the economy is fully employed, the raised level of money supply enhances aggregate money income via multiplier effect. Since no excess capacity in the economy is there such increased money income leads to a raised level of aggregate expenditure. Consequently, it incentivizes inflationary rise in prices. Deficit financing immediately releases monetary resources leading to excessive monetary aggregate demand creating demand-pull inflation.

(b) It is held that the method of deficit financing is actually a vicious circle. It is very difficult to escape from the vicious circle of deficit financing once this popular method of financing is adopted. The inflationary impact becomes stronger once persistent deficit financing is adopted.

Once the prices zoom up and the government fails to stabilize the price level, rising prices lead to an increased cost which forces the government to mobilize additional revenues through deficit financing. This surely threatens price stability. Thus a vicious circle of rising price level and increased cost sets in. On the whole, deficit financing has the potential to create demand- pull and cost-push inflationary scenarios.

Does deficit financing promote economic development?

The instrumentality of deficit financing may be used to promote economic development in several ways. It is very difficult to deny the role of deficit financing in garnering resources required for economic development. It is quite another matter that the method is prone to create an inflationary spiral.

Capital formation has an important role in economic development. The fundamental source of capital formation is savings. But some poor countries are characterized by low saving-income ratio. In these low-saving countries, deficit financing becomes an important source of capital accumulation. The case of developed countries is quite different. In developed countries, deficit financing is utilized to increase effective demand.

Inter-linkage between Deficit Financing and Income Distribution

It is held that deficit financing can potentially widen income inequality. This happens as it creates excess purchasing power. However, there is inelasticity in the supply of essential goods. Consequently, the excess purchasing power of the general public ends up incentivising price rise. During inflation, it is said that the rich become richer and the poor become poorer. Thus, social injustice becomes quite prominent as sufferings of the poor magnify.

However, there is an important caveat here. All types of deficit expenditure do not necessarily threaten existing social justice. If the money collected through deficit financing is spent on public good or in public welfare programmes, some sort of favourable distribution of income and wealth may be made. Ultimately, an excess dose of deficit financing leading to an inflationary rise in prices will exacerbate income inequality. Overall it depends on the volume of deficit financing.

Advantages and Disadvantages of Deficit Financing:

(a) Advantages:

Massive expansion in governmental activities has forced governments to mobilize resources from different sources. As a source of finance, tax-revenue is highly inelastic in the poor countries. Above all, governments in these countries are rather hesitant to impose newer taxes for the fear of losing popularity. Similarly, public borrowing is also insufficient to meet the expenses of the state.
In India, deficit financing is associated with the creation of additional money by borrowing from the Reserve Bank of India. Interest payments to the RBI against this borrowing come back to the Government of India in the form of profit. Thus, this borrowing or printing of new currency is virtually a cost-free method. On the other hand, borrowing involves payment of interest cost to the lenders.
Financial resources (required for financing economic plans) that a government can mobilize through deficit financing are certain and known beforehand. The financial strength of the government is determinable if deficit financing is made. As a result, the government finds this measure handy.
Deficit financing has certain multiplier effects on the economy. This method encourages the government to utilize unemployed and underemployed resources. This results in more incomes and employment in the economy.
Deficit financing is an inflationary method of financing. However, the rise in prices must be a short run phenomenon. Above all, a mild dose of inflation is necessary for economic development. Thus, if inflation is kept within a reasonable level, deficit financing will promote economic development —thereby neutralizing the disadvantages of price rise.

During inflation, private investors go on investing more and more with the hope of earning additional profits. Seeing more profits, producers would be encouraged to reinvest their savings and accumulated profits. Such investment leads to an increase in income—thereby setting the process of economic development rolling.

(b) Disadvantages:

It is a self-defeating method of financing as it always leads to inflationary rise in prices. Unless inflation is controlled, the benefits of deficit-induced inflation would not fructify. And, underdeveloped countries— being inflation-sensitive countries—get exposed to the dangers of inflation.
Deficit financing-led inflation helps producing classes and businessmen to flourish. But fixed-income earners suffer during inflation. This widens the distance between the two classes. In other words, income inequality increases.
It distorts investment pattern. Higher profit motive induces investors to invest their resources in quick profit-yielding industries. Of course, investment in such industries is not desirable in the interest of a country’s economic development.
Deficit financing may not yield good result in the creation of employment opportunities. Creation of additional employment is usually hampered in backward countries due to lack of raw materials and machineries even if adequate finance is available.
As purchasing power of money declines consequent upon inflationary price rise, a country experiences flight of capital abroad for safe return—thereby leading to a scarcity of capital.
This inflationary method of financing leads to a larger volume of deficit in a country’s balance of payments. Following inflationary rise in prices, export declines while import bill rises, and resources get transferred from export industries to import- competing industries.

Conclusion:

Much success of deficit financing depends on how anti-inflationary measures are employed to combat inflation. Most of the disadvantages of deficit financing can be minimized if inflation is kept within limit.

It is an evil but a necessary one. Considering the needs of the economy, its use cannot be discouraged. But considering the effects of deficit financing on the economy, its use must be made limited. So, a compromise has to be made so that the benefits of deficit financing are reaped too.

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