We have all heard, time and again, that a high fiscal deficit is inherently bad for the health of an economy. This is repeated so often that most of us take it to be a given truth. We are even told that only around 3 percent of fiscal deficit (relative to GDP) is okay, but anything beyond that is problematic.

Policymakers, the media and economists of a certain hue, would of course want the rest of the world to believe that there are no two ways about it. The reality, however, is that it is not a gospel truth that a high fiscal deficit is necessarily bad for the economy. Before we go into why it is so, let us try to understand what the fiscal deficit is.

In simple terms, the fiscal deficit is the difference between what the government earns and what it spends. Government’s earnings include not just tax revenue but also dividends received from government-owned companies.

Just like households and businesses, the government too needs to borrow to finance its excess spending over its earnings. There are mainly two ways that the government can do that:

1) By printing money (i.e. by borrowing from the Reserve Bank of India, which has the power to create new money); and

2) By borrowing from the market i.e. mainly from banks.

Therefore, a fiscal deficit means fresh borrowings/demand for loans by the government.

We are told that a high fiscal deficit is bad for the economy because it leads to inflation, ‘crowding out’ of private investment and so on.

The argument regarding inflation is that when the government finances public expenditure by creating new money, it increases the stock of money in the economy. The higher stock of money, some believe, automatically leads to inflation, as ‘more money chases the same amount of goods'.

The logic is simple: an increase in money stock increases purchasing power in the hands of the people. This, in the face of an unchanged supply, leads to a situation of excess demand and results in rise in prices.

As is obvious, this argument holds only if supply of goods and services cannot be increased in the face of an increased demand for them. That, in turn, can happen only if all resources are fully employed, i.e. all factories are running at full capacity and there is no unemployment.

Clearly, if an economy is saddled with high unemployment and idle capacity (in factories), an increase in fiscal deficit need not necessarily lead to a rise in prices. In such a situation increase in public spending (via a rise in fiscal deficit) will actually help revive the economy.

Most governments do resort to fiscal deficit and spend the money in a number of ways. It can spend, say, for building infrastructure such as schools, hospitals, roads, etc. or for providing subsidies on various things. So, if the extra money printed goes into the hands of those who did not have enough money to buy goods and services, their consumption will go up. Factories which had cut back on production and had unutilised capacity, will now increase their output. These then lead to increase in production and employment. In short, under such a situation, enlarged public spending financed through a fiscal deficit will help raise production without any impact on prices.

The other argument against a high fiscal deficit is that when financed through market borrowings, it chokes off or ‘crowds out’ private investment. The logic given for this is that a rise in the fiscal deficit raises income, which in turn raises the demand for money. Since the interest rate is determined by the demand for and supply of money, an increase in demand for money inevitably leads to an increase in interest rates. The rise in interest rate, in turn, chokes off private investment as it raises cost for businesses. As a result, even when public spending increases, there is no net increase in employment and output in the economy.

As is obvious, this argument rests on the assumption that money supply in an economy is given. The assumption, however, is flawed as money supply in a modem economy adjusts to demand and hence this by itself cannot result in rise in interest rates. Also, typically when an economy is facing high unemployment and unutilised capacity, banks too would be facing insufficient demand for credit. Under such circumstances, any increase in the demand for money would result in an increase in supply of money, without any significant change in the interest rate.

In fact, many economists say that the fiscal deficit actually ‘crowds in’ private investment. When the government spends, it increases demand not only directly (through its purchases) but also indirectly. Suppose the government purchases products of a set of industries. Increase in demand for these industries’ products will also increase demand for industries linked through backward linkages. Thus, direct purchases by the government from some industries, sets in motion an increase in demand in many other industries. The benefit of that demand expansion accrues to the private sector as well and encourages them to invest. In short, debt financed public expenditure “crowds in” rather than “crowds out” private investment.

In fact, empirical evidence also shows, at least in the case of India, that the fiscal deficit does not lead to either inflation or crowding out of private investment.

But then why are we still told this so often that fiscal deficit is necessarily harmful? One answer to this perhaps lies in what the famous economist of the 20th century Michael Kalecki had said: if the government can induce prolonged state of full employment, through fiscal deficit, then it undermines the importance of big business and the hold they have over government policy and an economy. So an opposition to a high fiscal deficit is a must to maintain that hold.

The views expressed in this piece are those of the author, and do not necessarily reflect the position of CBGA. You can reach Malini Chakravarty at malini@cbgaindia.org.