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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 USA,13 today the term is being used by the corporate sector, too and such a financial management of a firm might be followed by it as part of its business strategy. Again, a sick firm might need to follow 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).
It was in the late 1920s that the idea and need of deficit financing was felt. It is when government needs to spend more money than it was expected to earn or generate in a particular period, to go for a 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.14 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 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).
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 order of their suggested and tried preferences.
(i) External Aids16 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 the 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 per cent 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 per cent).
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 deficit.
(ii) External Borrowings17 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 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 Borrowings18 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.19 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.
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 composition20 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 deficit is eliminated soon.
(iii) The last could be the situation when 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.