‘Fiscal Deficit’, quite a hot topic in economics, especially after the economic depression caused by covid-19, which has driven governments around the world to infuse excess liquidity (money) into their economy. Not for the purpose of development, but to merely keep the economy alive, to keep the corporates alive, and in some economically backward countries, to keep the ‘people’ alive. So, the question must’ve arisen in your mind, where did the government get this excess capital to infuse in the economy, even after the economic depression which has excessively diminished the government’s sources of revenue? Which are basically taxes and government-owned enterprises (there are probably a lot more, but let’s just keep things simple)
Well, the governments generally have cash reserves, but they cannot rely on just cash reserves to execute their economic, public welfare, and infrastructure policies and especially economic stimulus policies during an economic depression.
So, the governments BORROW. Governments use various instruments to borrow money from the public and overseas lenders. The major instrument used by the government is government securities (G-secs). Which are nothing but government-issued bonds which generally function like fixed-deposits, giving the investors a fixed return, and have variable tenure ranging from a few months to numerous years, for example- 91 days, 1-year bond, 10-year bonds, etc. These bonds also attract big investors who invest in these bonds to keep their money safe and get fixed returns, and the reason for investing in them is similar for normal people. These are generally considered as debt instruments, you’ve heard about certain mutual funds investing in ‘debt instruments’ to keep the investor’s money safe and to hedge against risky investments made by the fund managers. Many foreign investors also invest in government bonds, and especially in US government-issued ‘Treasury bills’ which are considered the safe-haven investment.
The governments can also directly appeal to the World Bank to lend them some capital, the step is mostly taken by less credit-worthy governments. And the government of one country can take loans from another country, take Pakistan for example, you’ve probably heard about Pakistan’s deteriorating economic conditions and how it’s stuck in the debt-trap by taking loans from China and Saudi Arabia, and many other countries.
Fiscal Deficit meaning
Well, the government takes credit from the market and infuses it into the economy, generally by providing economic stimulus to the corporates, direct cash transfers to the people especially the poor, and by providing loan moratoriums and tax exemptions.
But what if the revenue generated by the government won’t be enough to pay back the credit?
That’s what fiscal deficit actually is, Fiscal Deficit is the shortfall in the government’s revenue as compared to its spending. Simply speaking- The government spends much more money than it actually generates.
Well, with what you’ve read till now, you must’ve developed a perception that fiscal deficit is indeed a ‘negative’ sign for the economy of a country. But it isn’t really a ‘negative’ term but rather a positive one (if it isn’t in excess). And common too. Most economists also suggest that it’s necessary to meet the capital requirements of the country and advice the governments to raise their fiscal deficit if necessary, especially in times of an economic crisis. But why?
Fiscal Deficit: ‘Positive’ or ‘Negative’
Well, let’s assume that the government believes that fiscal deficit is a negative force and asserts a fiscal surplus or tries to make things even (amount generated=amount spent). So, in the time of economic depression, it surely would be reluctant to take up credit. And it would be dependent on its cash reserves, but to what extent? The cash reserves would surely end at a certain point. And consequently due to lack of capital expenditure, the economy, which is already sluggish would eventually collapse. And this collapse would surely have future implications for the country. Countries around the world that were affected by the great depression of 2008, undertook excess spending and ran into fiscal deficits that helped the economy to mitigate the effects of the depression and eventually rise up again.
And is it necessary if the economy is doing okay? Absolutely.
A good flow of money in the economy is highly essential for its proper functioning and growth. Especially in developing economies, where the governments try to spend more to boost industries, service, and agriculture sectors together with public welfare and infrastructure development, and the economic development caused by this excess spending, would eventually enhance the government’s revenue which could be used to mitigate these debts.
Fiscal Deficit’s good, but to what extent?
As I said earlier, a fiscal deficit is good for the economy, until it’s in excess.
Excess Interest Payments
As the government takes up loans, it surely has to pay interests on them, which often costs a large chunk of its total revenue. Let’s understand it with some stats-
In the FY 2020-21, the Government of India’s major source of income, Borrowings and Liabilities was 36% of the total revenue. (Other major sources of revenue- GST-15%, Corporation Tax- 13%, Income Tax-14%)
As I said, more the loans, more the interest payments,
The government of Indian spends most of its capital (20%) on interest payments of liabilities. Which is far more than other spendings- 16% on State’s share of taxes and duties, Central Sector Schemes (14%), Finance Commission and other Transfers (10%), and Defence (8%).
So, one can clearly think that if the amount paid on interest payment on liabilities could be reduced and diverted to other sectors like Central Sector schemes or infrastructure would be great for the country’s development. So, if the fiscal deficit is reduced, so would the Government’s expenditure on Interest Payments.
Another major implication of a high Fiscal Deficit could be rising inflationary pressure.
Let’s take the example of a country that has piled up debts and has a large fiscal deficit. The Government, surely, would assume that the income generated in the future, when the economy would start doing better, would also enhance their revenue. And as their revenue would rise, they would easily be able to pay the interests and repay the debts. But, what if the economy continues to be sluggish?
The Government still has to pay the interests, so how to raise money to pay it?
The Governments (not every government) takes the easy path, Direct Monetization of Deficit. In the Direct Monetization of Deficit, the Government asks the Central Bank of the country to print more currencies to help the government to pay the interests and at the same time continue the normal spending operations. The Government gives Government Bonds to the Central Banks in return for printing currencies.
But however, as the government infuses excess money into the economy to enhance the overall demand, this would lead to high inflation. A small increase in inflation is considered good for the economy, but however, a big surge in inflation would be equally destructive for the economy, leading to great macroeconomic instability.
Just think- Buying a kilogram of onion for 500 rupees, quite a nightmare!
Fiscal Deficit of India
Well, as we’ve discussed earlier, Fiscal Deficit is healthy for a developing economy and is often quite high. Such is the case in India and the recent economic depression caused by the pandemic has made it even higher.
Fiscal Deficit of India (Percent of GDP) – Year by Year
2014-15 – 4.10%
2015-16 – 3.90%
2016-17 – 3.50%
2017-18 – 3.50%
2018-19 – 3.40%
2019-20 – 4.60%
2020-21 – 9.50%
The year 2020-21 saw a quantum jump in the fiscal deficit of India, which, as we discussed earlier was necessary for the government for providing stimulus packages to revive the economy. But however, the Government of India didn’t choose the easy path to monetize the deficit, which is direct monetization of deficit (as discussed earlier). This shows the dynamics of our economy, which is supposed to grow at a rate of around 10% according to some of the biggest rating agencies.