Deficit finance can be effective tool of development provided

Deficit finance can be effective tool of development provided if has no inflationary bias”. Comment.

Discuss the justification of deficit financing. How it can be minimized?

Define Deficit financing. Indicate the conditions under which deficit financing would be justified in an economically less developed country like India.

Ans.

Meaning of Deficit Financing

Deficit financing in advanced countries is used to mean an excess of expenditure over revenue the gap being covered by borrowing from the public by the sale of bonds and by creating new money. In India, and in other developing countries, the term deficit financing is interpreted in a restricted sense. The National Planning Commission of India has defined deficit financing in the following way. The term ‘deficit financing’ is used to denote the direct addition to gross national expenditure through budget deficits, whether the deficits are on revenue or on capital account.

The essence of such policy lies in government spending in excess of the revenue it receives. The government may cover this deficit either by running down its accumulated balances or by borrowing from the banking system (mainly from the central bank of the country).

The ‘Why’ of Deficit Financing or Objectives of deficit financing :

There are some situations when deficit financing becomes absolutely essential. In other words, there are various purposes of deficit financing.

To finance war-cost during the Second World War, massive deficit financing was made. Being war expenditure, it was construed as an unproductive expenditure during 1939-45. However, Keynesian economists do not like to use deficit financing to meet defence expenditures during war period. It can be used for developmental purposes too.

Developing countries aim at achieving higher economic growth. A higher economic growth requires finances. But private sector is shy of making huge expenditure. Therefore, the responsibility of drawing financial resources to finance economic development rests on the government. Taxes are one of such instruments of raising resources. 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.

In view of this, the easy as well as the short-cut method of marshalling resources is the deficit financing. Since the launching of the Five Year plans in India, the government has been utilizing seriously this method of financing to obtain additional resources for plans. It occupies an important position in any programme of our planned economic development.

What is important is that low incomes coupled with the rising expenditures of the government have forced the authorities to rely on this method of financing for various purposes. There are some situations when deficit financing becomes absolutely essential. In other words, there are various purposes of deficit financing.

(i) To finance defence expenditures during war. (ii) To lift the economy out of depression so that incomes, employment, investment, etc. (iii) 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. (iv) To raise capital formation by mobilizing forced savings made through deficit financing. (v) To mobilize resources to finance massive plan expenditure.

If the usual sources of finance are, thus, inadequate for meeting public expenditure, a government may resort to deficit financing.

The ‘How’ of Deficit Financing: A budget deficit arises when the estimated expenditure exceeds estimated revenue. Such deficit may be met by raising the rates of taxation or by the charging of higher prices for goods and public utility services. The deficit may also be met out of the accumulated cash balances of the government or by borrowing from the banking system.

Deficit financing in India is said to occur when the Union Government’s current budget deficit is covered by the withdrawal of cash balances of the government and by borrowing money from the Reserve Bank of India. When the government draws its cash balances, these become active and come into circulation.

Again, when the government borrows from the RBI, the latter gives loan by printing additional currency. Thus, in both cases, ‘new money’ comes into circulation. It is to be remembered here that government borrowing from the public by selling bonds is not to be considered as deficit financing.

Conditions under which deficit financing would be justified in an economically less-developed country like India or favourable effects of deficit financing an economic growth-

(1) Mobilisation of Surplus and Unutilised Resources: In underdeveloped countries labour and other resources are not fully utilised because of the lack of financial resources. These resources remain unexploited. The government gets enough financial resources through deficit financing. By procuring money through deficit financing the government provides employment to unemployed resources. Consequently, output increases and the rate of economic growth rises. In underdeveloped countries the production capacity is less in agricultural and industrial fields. This production capacity is increased as a result of deficit financing. Increase in production capacity leads to increase in output. The prices may rise in the beginning but a little rise in prices will encourage increase in production.

(2) Deficit Financing and Creation of New Resources : Underdeveloped countries suffer from lack of voluntary saving. The available quantity of saving is not sufficient for implementing plans. When deficit financing is undertaken in these countries, the prices rise. But the people’s income does not rise much and therefore they have to consume less. In other words, they have to do forced saving. This saving can be utilised for creation of new resources for economic growth. Consequently, the rate of economic growth accelerates. Prof. Lewis is of the opinion that “Inflation for the purpose of capital formation is self destructive”

(3) Utilisation of Natural Resources : Natural resources are found in abundance in underdeveloped countries. But they are not profitably exploited in the absence of adequate financial resources. Government monetary resources are increased as a result of deficit financing. Government can spend more amount of money on proper utilisation of natural resources. The increase in expenditure can be met by resorting to deficit financing.

Therefore proper utilisation of natural resources can be made possible through deficit financing.

(4) Increase in Employment: The renowned economist, Lord J.M. Keynes was in great favour of adoption of deficit financing. According to him, the main cause of unemployment found in developed countries is deficiency in aggregate demand. It is necessary to increase aggregate expenditure in the country in order to compensate for the deficiency in aggregate demand. Therefore deficit financing will be of great help. As a result of deficit financing, aggregate demand can be raised by increasing public expenditure. Increase in aggregate demand leads to more opportunities for employment. In underdeveloped countries, investment increases as a result of deficit financing. Increase in investment leads to more demand for workers. They are paid more wages. As a result of increase in wages and employment, disguisedly unemployed from the rural areas will get employment in the towns. Consequently, employment will increase without there being any decline in the output in rural sector.

(5) Increase in Infrastructure: In underdeveloped countries there is lack of infrastructure, that is, railways, roads, canals, power projects, schools, hospitals etc.. Much money is needed for their development. In underdeveloped countries the government is not in a position to collect sufficient revenue through taxes, loans and other sources of income. Therefore increase in infrastructure is made possible by procuring funds through deficit financing. Its development accelerates the rate of economic growth of the country.

(6) Financial Resources for Economic Planning: A great amount of financial resources are needed to implement economic plans in underdeveloped countries. This finance cannot possibly be arranged through ordinary budgetary resources. The government has to adopt deficit financing to achieve this end. The finance for economic planning can be easily arranged through deficit financing.

(7) To Meet the Monetary Demand: In developed economies demand for money increases for various reasons; for example, (i) Demand for money increases as a result of non monetary sector changing into monetary field, (ii) Transactions increase as a result of increase in investment, (iii) Income rises as a result of economic planning. Consequently, demand for money increases because of increase in the demand for liquidity (iv) Increase in imports as a result of increasing foreign aid, raises the demand for money. This increased demand for money is met by deficit financing.

(8) Rapid Rate of Growth: The agricultural and industrial development as well as development of infrastructure are necessary for accelerating the rate of growth. Money in adequate quantity can possibly be procured for their development through deficit financing..

Measures to Control Adverse Effects of Deficit Financing

Deficit financing is like a poisonous but efficacious medicine. If it is not taken in proper quantity it can do enough harm. It is difficult to fix the safe limit of deficit financing. It is determined by the effect it has on prices. If there is not much rise in prices, deficit financing will not be considered harmful. The following steps are suggested to serve as safeguards against the bad effects of deficit financing:

(1) Developmental Investment: The money procured as a result of deficit financing should be invested in productive and developmental activities.

(2) Additional Income: If additional income due to deficit financing is collected by the government in the form of taxes and savings there will be no fear of inflation.

(3) Gestation Period: If the funds obtained as a result of deficit financing are invested in minor projects of short gestation period, the effect of inflation will be little. But if investment is made in major projects, with long gestation period, that is, long period between investment and that of the production, then such an investment will be inflationary.

(4) Control over Prices : Inflation can be checked if the government is in a position to control prices of foodstuffs and other necessities and regulate adequately the distribution of raw material. The government should make adequate arrangements for rationing and public distribution.

(5) Control over Wages: If wages do not increase as a result of deficit financing, there is a little chance of inflation because the cost of production will not increase much. Therefore, deficit financing will be safe.

(6) Unutilised Capacity: If a country possesses unutilised production capacity, this capacity will be fully utilised through deficit financing, production will increase and prices will not rise.

(7) Hoarding: If people keep the saving as a result of increase in income facilitated by deficit in liquid form.

(8) Co-operation of the Public: The safe limit of deficit financing depends on cooperation of the public. If people are willing to cooperate with the government and bear the burden of increasing taxes, inflation can be checked. People have to make some sacrifices.