Deficit Financing and Inflation Explained Simply

Normally, any entity spends basis its earnings or how much money is in their bank. But, governments are an exception to this behavior. If government has to spend, they spend. They may not exactly care if they have the money to spend or not. If they don’t have the money, governments will simply print some money and spend it. Pretty cool, isn’t it? Well, not exactly.

A government’s deficit budget means its spending exceeds both earnings and borrowings.

Any entity (or even you and I) ideally cannot spend more than the sum of its earnings and borrowings. But, governments (at least some of them) consistently spend more than the sum of their earnings and borrowings. Governments finance for the gap between their spends and their sum of earnings (tax) and borrowings by printing money. This form of financing the gap between spends and the sum of their earnings and borrowings is called as deficit financing. Take for example, in the current times of COVID, governments are under severe pressure as tax income is lower, deposits are lower and even borrowings are difficult to come by. In such a situation, it resorts to one last option, which is to print money and pay for the spends.

As we discuss this, India is setting itself for a huge deficit financing program. Below are two news articles showing the same. No worries, India is not alone, there are other countries too planning this now.

On the outset, it looks okay to do this. But, this is disastrous for the economy and for the common man like you and me. Why? The answer is: it leads to inflation; our money loses its power.

Say for example, all the people who are working very hard in a country are going to work double hard from tomorrow for the next one year and therefore they are going to get double their current salary. Since people worked double hard, they would produce double the goods. So, even if their salaries are doubled, there are twice the number of goods too in the market. So, double money is chasing double the number of goods and hence the value of what one unit of money (one dollar or one rupee) can buy will be the same as what it is today. So, doubling of salaries won’t lead to inflation.

But, when government prints money to finance its spends, it doesn’t create any goods in the economy or the market. Therefore, when government prints money, there will be more money in circulation in the country and the number of goods will still be the same. So, one unit of money (one dollar or one rupee) will buy little less number of goods now (after the money is printed). So, the dollar or rupee loses its value. This is called as Inflation. For example, if inflation in your country is 6%, it means every year the prices of goods are increasing by 6%, and in 12 years the prices are going to be double of what they are today (basis the rule of 72). So, what costs 100 today will cost 200 after 12 years. So, if you earn interest on your money equal to inflation, your money will grow to maintain the same buying power. But, if you lose 6% for inflation every year, your buying power will reduce to half in 12 years i.e. if you have 100 dollars today, in 12 years (at 6% inflation) it can only buy what 50 dollars can buy today because prices have doubled in 12 years at 6% inflation. That’s how dangerous inflation is. So, to counter it, you should at least get inflation level interest from your money every year.

Why does the government do deficit financing when it knows that it is dangerous?

Typically, governments get most of their earnings from taxes. They also borrow from domestic and international markets (primarily consumer deposits) and from agencies such as IMF. Just like individuals have credit ratings to get loans, countries too have credit ratings to borrow at certain interest rates. When the country’s growth outlook and monetary situation is not very positive, the credit ratings will automatically drop and it becomes that much harder to borrow money from international markets at low interest rates. So, governments will try to increase some sort of taxes on people and businesses. Typically, governments go after increasing direct taxes so that it affects only the rich, but as a secondary option they may also increase indirect taxes that affect every citizen equally. Nevertheless, sometimes increasing tax is also not viable beyond a point. So, the government is left with the last option to print money for its needs.

Or the reasons could be political too. This is why you should elect good leaders. Because bad leaders can reduce the power of your money. Let’s say the top politician of the country (say India) wants to start a scheme to give 10 kilograms of rice at one rupee to its poor. Now, the government has to fund this. Simple, print money and pay for it. In India, deficit financing was at its peak during the Gandhi (Indira Gandhi and Rajiv Gandhi) regimes promising ridiculous schemes for votes. Thereafter, there is some sanity in the overall fiscal discipline with the central bank. Central banks are the ones which decide how much money should be chasing how many goods in the market or economy, essentially controlling inflation by interest rates. If the central bank feels there is too much money chasing fewer goods, it will increase interest rates to increase deposits and reduce money circulation. If the central bank does infuse some deficit financing like this, it will later have to increase the interest rates to increase deposits and reduce the quantity of money circulating in the economy, driving reduction in inflation. If it cannot do so, then this inflation from deficit financing is here to stay. So, the common man always pays for the government spends, either in the form of tax or in the form of inflation.

Currently, with COVID pressure, governments across the world too are facing this as the last resort now. There are multiple governments such as India, Australia, UK and Turkey now considering this option for seriously large amounts of deficit financing.

Read my post on Monetary and Fiscal Policy to get a holistic picture after this post.

Hope this is useful, thank you.

References:

Budget surplus or deficit of different countries as a percentage of GDP -https://www.cia.gov/library/publications/the-world-factbook/rankorder/2222rank.html