Deficit financing: Re-examining conventional wisdom

During most deliberations on the budget, the one economic indicator that attracts the disproportionate attention of most commentators is the question of budgetary deficits. The Economic Survey 2000-01 also waxes eloquent on the subject of the fiscal deficit. While predicting a fiscal deficit of around 5.5 percent of the Gross Domestic Product (GDP), the survey sounds a grim warning by stating that “a high fiscal deficit puts upward pressure on market interest rates and international risk premium and raises the cost of capital for all producers. Crowding out of private investment by public borrowing also remains a potential threat to any industrial recovery.” This clearly presupposes debt financing to bridge the budgetary deficit. Deficit financing, (which simply means the printing and distribution of more currency) is not considered, presumably because of the fear of runaway inflation.

However, the conventional wisdom of a direct nexus between deficit financing and inflation needs to be re-examined. The reality is that deficit financing is something that not just this country but several other developed nations have had to resort to, for varying reasons. For instance, responding to concerns that computer problems would lead to bank failures in the year 2000, the U.S. government printed and distributed $ 200 billion of currency.Our own experience seems to suggest that the argument that deficit financing can result in runaway inflation is not tenable. Although there is no doubt that increase in money supply leads to inflation, the issue, like most economic truisms is a bit more complex and cannot be considered in isolation. There are other macroeconomic factors, some peculiar to the Indian economy, which could negate the textbook formula. For instance, the surplus foodgrain stocks and the current idle capacity in industry can act as a cushion to absorb the deficit. Further, one must also remember that even now, the most important and basic commodities are subjected to administered prices and are therefore independent of market forces of demand and supply which cause inflation.

Moreover, the General Price Index is more sensitive to the prices of these basic goods than others and since these are subject to price controls, the effect of increased money supply on inflation in the Indian context is not as drastic as feared by the pundits. In fact, the inflationary tendencies in the economy are more directly attributable to the high-cost structure of Indian industry rather than money supply in isolation. It is more a question of cost-push rather than demand-pull. In any case, although deficit financing would result in some inflationary trends, the fact remains that given the current size of public debt, it may well prove to be a superior alternative to further increasing public borrowings.

In fact, given the current economic slowdown (thankfully, not yet a recession), if deficit financing can stimulate demand it may prove to be a blessing in disguise. Some price rise is of course inevitable, but as the distinguished economist L.K. Jha never tired of asking; between inflation and stagflation, which should we prefer?
The author is a Chartered Accountant specializing in International taxation and corporate law.

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