Deficit Financing

Introduction

• Deficit financing is nothing but financing the budget deficit incurred due to excess government expenditures. 
• It means generating funds to finance the deficit which results from excess expenditure over revenue. The gap is being covered by borrowing from the public by the sale of bonds or by printing new money.

Brief History of Deficit Financing 

Until 1997, the budget deficit was financed by printing currency.  This practice was used because

• India’s savings ratio being less than 9% was insufficient to finance investment and welfare activities.
• Government’s revenues from taxes, public borrowings, and small savings was very less.
• External aid was too little for funding our developmental demands. 
• FDI was discouraged which resulted in scarce investment.
• Thus, borrowing through monetization (printing currency) became essential. 

• From April 1997, a new scheme called Ways and Means Advances is being ushered in. Under this system the government can get only temporary loans to overcome the mismatch between its receipts and expenditures. 
• The Ways and means advances have replaced ad hoc treasury bills for lending to the central government. 

Purpose of Deficit Financing

• To finance defence expenditures during war
• To lift the economy out of depression so that incomes, employment, invest­ment, etc.all rise
• 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
• To raise capital formation by mobilizing forced savings made through deficit financing
• To mobilize resources to finance massive plan expenditure

Means of Deficit Financing

• External Aid: This is the best way to finance the deficit even if they are coming with soft interest rates.
• External Borrowings: This is the next best way to manage the fiscal deficit with the condition that they are coming with a cheap rate of interest and are of long term.
• Internal Borrowings: It is the third best way to finance the deficit. But it hampers the investment prospects of the government and the public sector.
• Printing Currency: It is the last resort to finance the deficit and should be used only in exceptional circumstances. Its negative effects on the economy are: it increases inflation proportionally and it also increases pressure on the government for increasing wages and salaries of government employees-ultimately increasing government expenditure.

Disadvantages of Deficit Financing

• It is a self-defeating method of financing as it always leads to inflationary rise in prices. Unless inflation is controlled, the benefits of deficit-induced inflation would not fructify. 
• Deficit financing-led inflation helps producing classes and businessmen to flourish. But fixed-income earners suffer during inflation. This widens the distance between the two classes.
• It distorts investment patterns. 
• Deficit financing may not yield good results in the creation of employment opportunities. 
• As purchasing power of money declines consequent upon inflationary price rise, a country experiences flight of capital abroad for safe return—thereby leading to a scarcity of capital.