DEFICIT FINANCING

wThe term deficit tinancing is used to denote the direct addition to

national expenditure through budget deficit when the deficits
the gross capital account."
are on evenue or -Indian Planning Commission
Introduction
In ancient period there were neither deticit budgets nor any deficit
financing., The state expenditure was confined to the then availabie
fnancial resources of the state. The theory to cut one's coat according
to one's cloth existed. The state expenditure was confined to civi
administration and defence of the country against foreign invasion.
However, now the position has absolutely changed. The modern state is
a welfare state. Besides civil administration and defence it has to incur
heavy expenditure on the welfare programmes, such as, social insurance,
subsidies, unemployment allowance, free medical aid, free education,
child welfare, labour welfare, supply of water, electricity and gas etc. at
concessional rates. Thus, there is a rapid increase in state expenditure.
The state expenditure exXceeds revenue income. Now in order to meet
the increasing gap between expenditure and revenue income two
alternatives are available with the state : (1) to increase the
income by increasing taxation and imposing fresh taxes, (ii)revenue deficit
0inancing,. The scope of first alternative is limited because (i) there is a
limit to it, and (i) the state might have to face severe
public. Under these circumstances the state has to resort opposition of the
alternative, ie., deficit financing. Deficit financing to came the second
into
prominence in 1936 with the evolution and spread of
Now deficit
financing has become the burning topic Keynes philosophy.
of the day. What to
ay ox underdeveloped and developing countries,
had toresort to deficit even developed countries
financing
MEANING AND DEFINITION OF DEFICIT FINANCING
mean any ermdeficit financing' or ´deficit spending' is generally used tO
governmenttheCxpenditure
revenue, However. which is in excess of its current
term deficit financing' carries different
theconnotations in the westerntermcountries including U.S.A. and in India. In
western countries
ntries including U.S.A, deficit financing implies
implies an excess
234 | PublicFinance government over its current revenue, The
expenditure incurred bythe could be financing either through public
of
deficit in the budget so incurred
creation of new currency (issuing of fresh
the would result in deficit
borrowings or through
government. Both the methodswestern countries deficit
Currency) by the to
"In
Dr. K. K. Sharma,expcnditure by Government
financing. According
referrcd to cxcess of receipts even if it is covered
financing is and expenditure over revenue the term 'deficit
including capital But in India,
obtained through loans." sense. Deficit financing in Indian
by receipts interpreted
financing' is in a narrower deficit is financed by the
when the budgetary
sense may be said to occurcreation of new or additional currency. Thus
government through theinterpretation of the term 'deficit financing the
according to the Indian from the public are not treated as deficit
borrowings of the government the public loans are raised out of the
financing. The reason being that they result merely in the transfer of
genuine savings of the publichands and
purchasing power from the of the public to the government
without adding anything to the totalbeen money supply of the community. The
deficit inancing in India has financing defined by Indian Planning
Commission as, "the term deficit is used to denote the direct
addition to the gross national expenditure accounts." through budget deficits
whether the deficits are on revenue or capital In short, deficit
financing in the Indian sense involves the creation of new purchasing, i.e.,
issue of fresh currency by the government in order to meet the budget
deficit.
OBJECTIVES OR PURPOSES OF DEFICIT FINANCING
The main objectives or purposes of deficit financing are as follows :
(1) To Finance War Expenditure. Nowadays war is considered as
the most costly affair. When the financial resources raised through
taxation and public borrowings ctc. do not sufice to meet the cost of war,
the government of a country has no other alternative except to resort to
deficit financing to raise the necessary fnancial resources for the success
of the war. During the First and Second World Wars, most of the
governments resorted to deficit financing as an effective method of war
finance. It results in the inflationary spiral and may play havoc with the
country's economy and may ultimately lead to its complete ruination.
Therefore, it is suggested that it should be the last and not the first
method to be followed for financing war.
(2) To Promote Economic Development. The use of deficit
financing has also been considered essential for promoting economic
development mainly in the
Certain social, economic andunderdeveloped and developing countries.
institutional factors work as obstacles in
these economies. Underutilisation of natural resources, lack of capital,
backward state of technology, absence of modern enterprise,
institutional deficiencies and other non-economic causes keep colonialism,
country poorer. The private investment is a poo
undertake the challenges for economic inadequate and The unable to
development. fiscal
 Deficit Financing | 235
economies is not so efficient as to
apparatusof these cconomic raise the sufficient
for the
additionaltaxation, inthese countries, had adevelopment.
resources
revcnuc For instance,
very narrow base
on accCount
ofthe universal poverty of the people. Similarly, public borrowings, as a
source of finance, had a limited SCope on account of low incomes and
souroroinal propensity to consume ot the people. Moreover, most of
the underdevelopedandddeveloping countries had a democratic political
set-up. T
Therefore, there is limited scope of additional taxation on
politicalgrounds. Under these çircumstances, the governments of under-
developedand developing countries, therefore, found it more expedient
to raise additional financial resources through deficit financing, i.e.,
printing more paper Currency. Further, deficit financing, as a method of
inance. arouses little opposition trom the public. That is why India teo
took shelter under deficit financing for
deficit financing its Five Year Plans.
3) To Uplift the Economy out of Depression. Prof J. M. Keynes
adncated the use of deficit financing as an instrument of economic
policy touplift the econony out of the depthof economic depression and
also to raise the level of output and employnent. Atsuch a time, private
investment becomes slack on account of the allround pessimism in the
economy. Prof. J. M. Keynes looked upon public investment as an effective
antidote to declining private investment during depression. Public
spending would result in an increase in output, employment and income.
Deficit financing or rather deficit spending as the term used byProf. J. M.
Keynes is the only way to comc out of depression and to raise the level of
output and employment.
(4) Mobilisation of Surplus, ldle and Unutilised Resources in the
Economy. Deficit financing is also advocated as an instrument for the
mobilisation of surplus, idle and unutilised resources in the economy of a
Country. They remain inactive unless the additional purcaasing power is
created in the economy and skillfully used as a positive means of
mobilising the surplus, idle and unutilised resources in the economy. No
one can deny the fact that dcficit financing is an effective instrument tor
mobilising the surplus, idle and unutilised resources in the economy Of a
ouniry. l is more true in case of an underdeveloped and developing
country.
underdeveloped and
9) 1o Prevent Unemplovnent. What to say of facing the chronic
developing countries even developed countries are
problem of unemployment. According to Prof. J. M. Keynes, the only
of eradication of unemnloument is the deficit because financing. The
there is
period of is responsible for unemployment
considerabledepression
Keynes reduction in effective demand
gave the theory of public spending
during
during
this period. Prof. J. M.
depression period. It
which could
was a sort the state
of deficit spending on the part of employment manifold
ultimately
through the
rai_e the level of income, output andgiven below:
interaction of ithe multiplier process
 EFFECTSOF DEFICIT FINANCING
OR
CONSEQUENCES OF DEFICIT FINANCING
Deficit financing involves an expansion of currency created either
by the banks which expand credit or by the government in the form of
issue of fresh currency. No doubt that deficit financing helps in increasing
 Deficit Financing | 237
the pace of cconomic devclopmcnt in underdevcloped and developing
countries, but some of its other consequcnces may somctimcs upsct the
expectations of the planners. The cffccts or conscquences of deficit
financing may be studied under the following hcads :
(1) Effects of Deficit Financing on Price Level. The immediate
effect of deficit financing is a sharp rise in general pricc level of the
country. Through the creation of new money, deficit financing results in
an incrcase in the aggregate monetary demand for the cxisting supply of
goods and services in the community. While aggregate monetary demand
increases consequent upon deficit financing, the supply of goods and
services in the community does not increase in the same proportion. This
produces the inevitable inflationary gap in the economy of a country,
causing prices to rise to higher levels. This happens particularly at the
time of war, when the money supply in the economy rises at an
extraordinarily fast rate, while the available supply of goods and services
for civilian consumption actually registers a fall, causing severe scarcity
conditions in the economy. The rise in the price level in wartime economy
may be in a proportion grcater than that warranted by the increase in the
supply of newly created money by the central bank/government. Thus
deficit financing, during war, results in an inflationary spiral which
increases the general price level at an extraordinarily fast rate. It is also
evident from severe rise in price level in India during First and Second
World Wars.
It is argued that deficit financing for development is quite different
from that undertaken for financing a war. In the latter case, there is extra
Cxpenditure without any increase in the output of wealth, and therefore
inflation is inevitable. On the contrary, deficit financing for development
increases the pro oroduction of goods and services in the future and its
inflationary effect is, therefore, neutralised by the increase in output, i.e.,
goods and services. But the increase in production would be only after a
time lag, and the longer the time the project takes in maturing, the longer
is the time lag between the increase in demand and increase in supply.
Moreover, inflation provides incentive for increased private investment.
As prices rise, profitability of private investment increases and that
encourages further investment. Thus deficit financing is a peacetime
developing economy and may not, therelore, be considered as unsafe and
dangerous as in a wartime cconomy.
(2) Inerease in Money Supply. Deficit financing results in the direct
addition to gross national expenditure or in the creation of IreSh
purchasing power in the hands of the
of money supply in circulation as a resultgovernment. It results in expansion
of deficit financing.
() Etects of Deficit Financingon Employment. Prof. J. M. Keynes
advocated the use of deficit financing as a means of climinating masS
unemployment in a developed country
Accord1ng to Prof. J. M. Kevnes, the main duringcause ofdepresscd
unemploymenteconomy.
in a
developcd country is the deiciency of effective demand, i.., the demand
238 Public Finance
of consumption goods and investment goods. The cffective demand
depends upon the marginal propcnsity to consume. Thus, for
the cffective demand and removing the conditions of uncmplcyment iincreasing
devclopcdcconomies during the period of depression, Prof. . M. Kevm
advocated deficit financing to linance public works projects. This will
incrcase purchasing power in the hands of the public. Hence, the
cffective demand will thus be increased. This will further increase
employment which again will increase cffective demand and, hence
cmployment and so on. Prof. J. M. Keynes called it 'multiplier effect'.That
is why several devcloped countries, particularly U.K. and1930'sthe U.S.A.
resorted to deficit financing during the great depression of to deal
with the problem of mass unemployment.
But this does not hold good in underdeveloped countries, as the
assumptions, on which Keynes' analysis is based are not foundidle true to
underdeveloped countries. They are as follows : (i) Existence of and
unutilised capacity in industrial and agricultural sectors. (i1) Supply of
working capital is relatively elastic. (ii) The multiplier concept does not
hold good in underdeveloped countries on account of the lack of
entrepreneurship, technical know-how etc. (iv) There is long-term
chronic unemployment. (v) There is chronic shortage of capital resources
in relation to the rapidly increasing population. Thus, deficit financing is
helpless in removing the conditions of unemployment in underdeveloped
countries. Even then if an attempt is made to liquidate unemployment in
an underdeveloped economy through the application of the technique of
deficit financing, far from eliminating unemployment, it may plunge the
inelasticity of the
country into an inflationary spiral on account of the
supply curve of output.
financing is
(4) Deficit Financing and Capital Formation. If deficit country, it
development of a
applied according to the needs of economiccapital formation is one of the
increases capital formation. We know that
underdeveloped and
basic conditions for the economic development of in the following
developing countries. Deficit financing increases capital
huge profits during
ways : Firstly, industrialists and businessmen earnpossesses high saving
inflation period. Since this section of the society demand of
tendency, it increases capital formation. Secondly, the
increase in their
consumer goods is likely to reduce on account of rapid
goods industries to
consumer
prices. It may divert some resources from formation. Thirdly
capital goods industries. It may also lead to capital
making the best use of idle,
deficit financing may prove helpful ineconomy.
unutilised and surplus resources in the Thus, deficit financing
production. This
can be used as an effective instrument for increasing
may also lead to capital formation.
Income. Deficit financing
(5) Deficit Financing and Distribution ofGenerally,
affects adversely the distribution of income. it is considereo
one
character. On
that the deficit financing is potentially inflationary in during
inflation
side the industrialists and businessmen earn huge profits
 Deficit Financing | 239
neriod. On the contrary, labourers and fixed income groups suffer on
account of the sharp reduction in the purchasing power of their
hard-earned money during intlation period on account of the rise in price
Jevel. Thus, the disparity of incomes increases as the rich
rich and the poor become more poor. become more