In this article we will discuss about deficit financing as an instrument of economic de­velopment.

Deficit financing was originally advocated to deal with a situ­ation of depression in the advanced countries. Now this situation differs from that of the underdeveloped countries in that in the advanced countries both unemployed labour and all the productive capacity which goes with it are readily available and can be used to increase output in a short time.

By contrast, in overpopulated developing countries we either have unem­ployed labour without other productive resources, or underutilised land, labour and savings which are the result of market imperfections, incomplete growth of the exchange economy and other structural defects of the eco­nomic system.

Unlike the unemployed resources of the advanced coun­tries in a depression, the potentially available resources of the underdeveloped countries have to be mobilised over a long period mainly by correcting the structural defects which have given rise to them.


The level of output in the advanced countries in a depression can be expanded by raising the level of aggregate effective demand, but the expansion of output in the developing countries depends more on the way in which the extra funds are injected into particular parts of the economy than merely on the aggregate of the amount of funds that deficit financing creates.

The overall rate of growth of a developing economy is largely determined by the rate of growth of its slowest moving sector, viz. agricul­tural. To try to stimulate the output of the agricultural sector by using only positive economic incentives may be effective , but this means diverting a considerable part of the resources of the manufacturing sector from the capital goods sector to the consumers’ goods sector and slowing down the rate of growth.

On the other hand, however, to try to use negative pressures such as taxation or compulsory collection of product may also lead to a ‘farmers’ agitation’, resulting in a lesser amount of agricultural surplus and slowing down of the rate of growth.

In this situation, many economists have supported the idea of accelerating economic growth by deficit financing which would facilitate this transfer of ‘disguised unemployment’ from agriculture into productive work, particularly in the construction of social overhead capital such as irrigation projects or roads.


They also argue that this type of deficit financing may be pursued without serious long-term consequences since the inflation which it creates will be ‘self-destroying’ — because when the capital projects are completed they will add to the output of agriculture and other consumers’ goods.

This is altogether different from saying that the social cost of making use of the ‘disguised unemployment’ is zero. On the contrary, it is recognised that there is a genuine social cost in doing so in the form of extra consump­tion by the workers on the capital projects who will spend most of their wages on food and other consumers’ goods. In fact, deficit financing is called for because this extra consumption cannot be met out of taxation and voluntary saving.

This means that ‘forced saving’ has to be imposed through inflation. So, while the workers on the capital projects are able to command a larger share of real income through the increase in money income, the farmers, for instance, will find that they have been forced to cut down their level of consumption through the rise in the prices of the consumer goods that they wish to buy.

The idea that inflation will be self-destroying is based on the assumption that the extra money income created by deficit financing will become stabilised at a certain level, so that after a time-lag, the extra output of consumer goods which results from the new capital goods can catch up with it.


This is turn, is based on the Keynesian multiplier theory and the assump­tion of stable marginal propensity to save and consume. In the original Keynesian context, we start from a situation of depression where both labour and the productive capacity which goes with it are unemployed. Deficit financing, therefore, will merely expand employment and output without raising prices of consumer goods whose output can be expanded directly.

Thus, given stable prices it is reasonable to assume that at each round the people who received the extra income will go on saving and spending in certain stable proportions as before; and so long as a certain proportion of income is saved at each round — that is, so long as the marginal propensity to consume is less than 1 — the total resultant income will coverage towards a stable equilibrium level.

In the developing coun­tries, however, we start from a situation with only surplus labour without the necessary productive equipment to go with it. So, surplus labour can at best produce some extra capital goods which only after a time-lag can produce consumer goods. Immediately, therefore, the prices of consumer goods must go up. How far this inflation will be self-destroying depends on how money income will be devoted to saving and spending in stable proportions in the face of the rising prices of consumer goods.

In most developing countries which have just emerged from the orthodox monetary conditions, people may still retain some confidence in money and suffer from the ‘illusion’ that its value will continue to be the same as before.

This orthodox monetary system provides the monetary authorities with some scope for deficit financing without upsetting confidence. But as prices continue to rise, the marginal propensity to consume, which started very high in any case, will tend towards 1.

For one thing, rising costs of living will compel people to spend most of their income and reduce their saving and even borrow for consumption purposes. For another, as soon as people expect that prices will go on rising, they will become increasingly disinclined to save any part of their money income, since this form of saving will be quickly depreciating in value.

They will increasingly tend to spend all their money income, as quickly as possible by hoarding food and other consumer goods, or by buying gold, jewellery and real estate whose value keeps up with rising prices. Once this happens, money incomes will not be stabilised at a certain level in the Keynesian manner; instead we shall be back in the world of the quantity theory where the total volume of purchas­ing power is increased at each round as the original sum of money is multiplied by its quickening velocity of circulation.

The rising cost of living will lead to demands for higher money wages and if they are conceded we shall have the familiar wage-price spiral. In these conditions it seems very difficult to believe that inflation will be self-destroying and this pessimism is confirmed by the typical monetary conditions in developing countries which are marked by the continual tendency to create spiralling inflation or tighter foreign exchange controls to meet the balance of payments crises.

The existing pattern of import-substituting domestic industrialisation in most developing countries has largely grown unplanned under the pressure of short-run balance of payments difficulties arising from deficit- financing and domestic inflation.


So, the rate of domestic inflation has to be controlled by reducing the government budget deficit if balance of pay­ments equilibrium has to be achieved. This is made difficult both by the developing countries’ inability to withstand the political pressures to in­crease government expenditure and their limited capacity to increase taxes.