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Spending India's money wisely

Publication Date : 18-07-2012


Despite India’s credit rating taking a dive, the government is confident of maintaining fiscal deficit at the projected level of around 7 per cent.

But the dismal global economic scenario makes it imperative that we take a hard look at deficit financing.

The role of deficit financing as an effective tool to contain the spectre of unemployment has become less effective since the Great Depression. However, it still has its uses in forestalling the spectre of unemployment.

At the very outset, it may be expedient to relay the warning sounded by the well-known aphorism--"What is sauce for the goose is not sauce for the gander". Similarly, what is wise for an individual may turn out to be harmful for a nation. Let me elaborate. A prudent and foresighted man adjusts his monthly/yearly expenditure in accordance with his income and not the other way round. But strict adherence to this principle may not always be advisable for the government of a nation.

An individual’s credit rating plunges if he fails to balance his income with his earnings. But, a government can increase a nation’s real wealth and foster prosperity despite running up a debt. Highly industrialised nations periodically suffer from unemployment brought about by individuals bent upon pursuing a policy of frugality.

This strategy of prudence pursued by individuals often spells disaster for the national economy, compelling the government to launch a counter-offensive by spending more than it earns. Such a policy initiated by a government is what is known as deficit financing and is resorted to during bouts of cyclical unemployment. Economic depression is a phenomenon best described as a period of "poverty in the midst of plenty".

The remedy prescribed by governments for such situations is almost reckless spending without a thought to earning enough revenue. Such a situation may appear to be paradoxical, nevertheless, that is what happens.

Every economy experiences fluctuations in the volume of trade and commerce. When market demand is strong, sales are high and trade is buoyant. In such a situation, working class people and owners of resources reap the harvest of trade buoyancy. This, in turn, boosts demand for goods and services, which again props up further demand leading to all-round prosperity. But the bubble bursts soon, resulting in slackening of demand and a spectacular drop in the volume of trade.

Workers’ incomes plummet and the cumulative effect leads to falling demand, paving the way for the trade cycle to set in. This is a situation where too many goods chase too few buyers with reduced income.

During cyclical unemployment, goods are plentiful, but people cannot buy them owing to lack of purchasing power and they suffer from want. This happens when the economy is almost bursting at the seams.

What this suggests is that effective demand follows a downward trend, caused by a slump in income.

The total income of a community is the aggregate of its spending. When a section of the community does not spend all its income, its total income is reduced. People with low levels of income spend all they earn, resulting in reduction of savings. The high-income group does not step up its consumption at the same rate, as they have a propensity to save. If all the savings are used up for production of capital goods, that will augment the income of those engaged in the production of capital goods. The investor is sure to report higher income and ensures possible production of larger wealth in future and as such, expands the capital base of the economy.

The real villain of the piece is hoarding--or reduced spending, that is idle money. The obvious remedy is to give a boost to spending, but individuals are reluctant to do this. Falling prices indicate appreciation in the value of money, and nobody will spend when the value of money is rising. During a period of falling prices, that is deflation, when the prospect of selling is not very encouraging, producers are reluctant to borrow even at lower rates of interest. In such a situation, the government resorts to deficit financing.

Spending money collected as tax revenue involves no additional expenditure as it is merely a transfer. The present-day government achieves this by selling treasury bills as against printing more paper currency notes. To bridge the gap between tax collection and expenditure in the short term, governments sell treasury bills to raise short-term loan for themselves.

Usually, these bills are bought by financial institutions such as banks, insurance companies and the like that have short-term investible funds. They get the bills discounted by the Reserve Bank of India (RBI) which does it simply by expanding credit. Banks need not necessarily take away cash but draw on them by cheques as and when necessary.

The RBI is at liberty to expand the deposit base without restriction but cannot print currency notes at will. Printing of currency notes and expanding deposits are virtually identical processes. These are the means of creation of additional purchasing power. This extra spending creates and stimulates additional effective demand. The RBI mops up profit so that the government, on balance, does not have to bear any cost. This method of deficit financing is quite cheap and convenient and most modern governments prefer it.

The perspective on deficit financing may best be illustrated with an empirical situation. During cyclical unemployment, let us suppose, the economic growth reaches the apogee where factors of production, such as land, labour, capital and others are per force doomed to remain idle. Let us also assume that all these factors--capable of rejuvenating the economy--remain largely unutilised for lack of effective demand.

The government creates crores of rupees and spends them, thus pushing up the earnings of the beneficiaries. This increased income has a multiplier effect that helps the economy recover from the worst recession to climb to the top. Thus, when a nation spends beyond its means--but wisely--it can foster prosperity and increase real wealth.

In the Indian context, cyclical unemployment does not pose a formidable challenge. Unemployment in a developing country such as India does not mean that the factors of production do not actually exist to the extent of capacity utilisation. In a vast country such as ours with a billion-plus population, a reserve army of workforce, largely unskilled, unorganised and still living in penury, there is immense scope of development. Untapped potential, natural resources and mineral wealth, unexplored forest areas, river basins and non-existent infrastructure all cry out for development and effective employment.

Over and above, idle wealth waiting to be exploited contribute in no small measure to the inelasticity (unresponsiveness to price changes) of the traditional factors of production. The conditions are favourable for phenomenal increase in purchasing power without a corresponding jump in production.

An abundant money supply not commensurate with increased production pushes up prices. Economists humourously describe such a condition thus: “You go to market with a bagful of money and return with a pocketful of goods”.

Deficit financing as envisaged by the Indian government does not provide a viable solution to our economic ills. The proper remedy lies in exploiting its untapped resources and judicious management of the same for the development of the country and its people.

The writer is a retired headmaster


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