Deficit Financing

Deficit financing is understood in different ways in different countries. It is understood as the excess of current expenditure over current revenue which is financed either through public borrowing or the creation of new money by the government. So the deficit budget is also called deficit financing in USA. But in India deficit financing is understood in a different way from deficit budget. While the former refers to a situation where the current expenditure exceeds current revenue of the government, the latter is taken to mean the excess of aggregate expenditure (both on current and capital accounts) over aggregate revenue. The former is called deficit budgeting and the latter deficit financing in India.

Deficit Financing

Deficit financing in Indian context refers to the meeting of budgetary deficit through the creation of new money adding to the existing money supply in the economy. Deficit financing includes any or all of the following in India:

  1. The government withdrawing its cash balance with the Central bank,
  2. The government borrowing funds from the Central bank, and
  3. The government resorting to printing of new currency notes with a view to cover the budget deficit

Purpose of Deficit Financing

There are several purposes for resorting to deficit financing. The following are the major purposes:

  1. War Finance: A country in war experiences severe shortage of financial, resources, especially the cost of modem warfare is so prohibitive that the country resorts to deficit financing. During this period the country cannot resort to taxation or public borrowing because of the situation in the economy. But it should be noted that such a method of financing the war expenditure is very dangerous, as during the war period apart from the destruction of the existing assets, there is no possibility of increasing the production. Further allthe productive activities will be to meet war requirements. Hence with the addition of money supply, there is no corresponding increase in the production. As a result, deficit financing during the war time should be highly inflationary in nature.
  2. Economic Depression: During the period of depression the purchasing now of the people is very low and the private investment will not be possiblebecause of the gloomy picture all round. Therefore economists like Keynes suggested that public investment should be increased in large scale. The funds for such a dose of public investment can come from either taxation or public debt or deficit financing. If taxation is resorted to for raising funds for public investment, as it means only a transfer of purchasing power from the people to the government, while during depression what is required is new additional, public expenditure. Public borrowing or public debt as a source of public expenditure is also having its own limitations. For example, public borrowing only means addition to the financial burden of the government and the pubicin terms of debt servicing or payment of interest on public debt. Therefore as a third alternative deficit financing is considered. Though there are objections to this alternative stating that it is basically inflationary, Keynesian supporters argue the other way. During depression the economy is in a pit and all the resources are remaining unutilized or under utilized. In such a situation, if the government resorts to deficit financing it will only help to increase employment, output and investment. So there cannot be any inflation until the economy reaches-the lull employment level, no more deficit financing should be allowed as it then becomes highly inflationary.
  3. Economic Development: In their effort to build up the nation, developing countries were in need of heavy dose of funds. This is all the more felt because some of these countries selected planning as a strategy of economic development. They had only three alternatives to raise funds for their development efforts. They are taxation, public borrowing and deficit financing. Taxation as a source of raising funds was ruled out because of the nature of war shattered economy, low purchasing power of the people and also the political reasons prevented this alternative as most of the countries turned to be democratic one. Public borrowing also could not be resorted to as people were already impoverished and there was no way of inducing them to lend more. Further the debt servicing was expected to over-weigh the government’s financial burden. Then every country preferred to use deficit financing as a method of financing their economic planning and economic development. Of late deficit financing has become a permanent source of funding of planning requirements.

Limits of Deficit Financing

Economists have favored deficit financing for several reasons. To them a country needs enormous resources to achieve a higher rate of growth. Especially a developing country will require huge resources for public expenditure projects. This can be arranged for in different ways. One way is taxation, the second is public borrowing and the third is deficit financing. While taxation in a developing country would bring down the effective demand, the public borrowing may add to the financial burden of the people as the cost of debt servicing and management of public debt is so prohibitive that this cannot be an ideal source of funding economic recovery. Hence only deficit financing is left with as an alternative. If it is administered with proper care and diligence, it should in fact be growth stimulating rather than inflationary. Therefore, resorting to deficit financing need not be considered as a wrong step. It is often said that if the, government can keep the inflationary rise in price below a certain level, say 3% then deficit financing is the ideal method of financing economic growth.

However, several precautionary steps are to be taken to ensure that deficit financing is justified and plays the role expected of it. The following are some of the suggestive measures:

  1. The government should note the rate of growth of real income. If the real income grow at a faster rate than the rate of money supply, then there will be very limited increase in price. On the other hand if the growth of real income is less than the rate of money supply, then the economy will experience inflation. Hence, the government should carefully monitor the growth rate of real income.
  2. The government should, as far as possible use the funds obtained through deficit financing in promoting short period income generating projects which are productive in nature. This will facilitate absorption of increased purchasing power by the increase in output.
  3. A developing economy with the existence of a large amount of unutilized physical and human resources may realize that deficit financing is helpful in higher utilization of these resources. In that case the inflationary pressure should be very much under control.
  4. Though deficit financing is the easiest way of raising resources for the government, the government should use this source judiciously. This means it should be conscious of the efficiency of its administrative machinery and capacity.
  5. The government should not use the funds raised through deficit financing in funding long period gestation projects even if they are highly productive. The investment in such projects will yield the return only over a period of time and by that time the inflationary pressure might set in the economy.
  6. The impact of deficit financing on balance of payments situation of a country should be studied closely so as to avoid any inflationary pressure affecting the economy. Usually the favorable balance of payments is inflationary in character and so the government must resist the temptation of adopting deficit financing while there is balance of payments surplus.

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