Introduction:

Have you ever met before the term “Necessary Evil”? These two words are
somewhat in contrary to its individual definition. Does borrowing becomes a good
action for us to be more productive? Does inflation really have a positive result
towards the economy productivity? It’s quite confusing, right? I, myself also
bewildered to understand the complexity and the contrary of this subject matter.

This is the government’s deficit financing which can boost the economy’s productive
capacity. From the topic itself in the first glance, you might say that, how come that
deficit financing can boost the economy’s productivity? Where in fact it gives us the
negative connotation relatively on the topic presented.

Deficit Financing applies if revenues are inadequate to fund planned expenditures,

the government has three options to finance the budget gap: borrow, print money,
or increase taxes. In the past, the Philippine government has resorted to external
and domestic borrowing to finance its deficits.

When public savings are negative, the government is said to be running a budget
deficit. To spend more than tax revenues allow, governments borrow money and run
budget deficits, which are financed by borrowing.

Contrary to what it may sound like, a budget deficit is not always a negative
indicator of economic health. This year the administrative economic team aims to cut
the deficit to GDP ratio 6.1% and further trim it to 5.1 % by 2024. The continue
downtrend is expected by 2025 at 4.1% slash the ratio to 3.5% and 3.2% by 2026
and 2027 respectively.

How is this possible? Lifting the economy through deficit financing out of depression
will attract and arise more investors which will create more income and job
opportunities. Moreover, this is to instigate the ideal resources and divert it from
unproductive sectors to productive sectors with the main objective of increasing
national income, leading to higher economic growth.

Leading towards this desirable action of the government, foreign financing,

Inflationary Financing, and Noninflationary Domestic Financing has to do with it.
The technique of deficit financing may be used to promote economic development in
several ways. Nobody denies the role of deficit financing in garnering resources
required for economic development, though the method is an inflationary one.

Economic development largely depends on capital formation. The basic source of

capital formation is savings.

In view of all these, it is said that deficit financing is an ‘evil’ but a ‘necessary evil’.
Much of the success of deficit financing will be available to the economy if anti-
inflationary policies are employed in a just and right manner.

If money collected through deficit financing is spent on public good or in public

welfare programmes, some sort of favourable distribution of income and wealth may
be made.

The financial strength of the government is determinable if deficit financing is made.

As a result, the government finds this measure handy.

Basically, deficit financing has certain multiplier effects on the economy. This
method encourages the government to utilize unemployed and underemployed
resources. This results in more incomes and employment in the economy.

Therefore, we agree that deficit financing has a larger impact towards achieving the
economic productivity with the substantiating facts and evidences that will probably
show that deficit financing really have a bigger role if you’ll just see it in a wider
perspective. Economic wise decision has to be made by the government upon
arriving to such actions like these.
Arguments and Evidence:

One of the most important and lasting contributions of J. M. Keynes’s thought to the
development of modem economic theory has been the central role he assigned to
fiscal policy in stabilizing output. Within the Keynesian framework, the economic
result of the fiscal sector, whether a deficit or a surplus, is the most important
balancing factor in the economy. The magnitude of the deficit or surplus is the
central piece in the determination of the levels of aggregate demand, income, prices,
and, eventually, in an open economy, of the balance of payments.

A point that has been considered as fundamental in the theory developed by Keynes
is that an economy may converge to an equilibrium that is stable but which may be
suboptimal or undesirable since it may involve unemployment or inflationary
pressures.

In the Keynesian model, fiscal policy is the main instrument that has the power of
shifting the economy from one equilibrium position to another. The implicit
assumption of this Keynesian view is that the government has the means and the
will to regulate the size of its revenues and expenditures and, in such a way, direct
the economy toward a desirable level of equilibrium.

This view is based on the conception that it is feasible for the fiscal authority to
control, at each point in time, the size of the fiscal balance so as to bring it close to
what the government wants it to be.

Deficit financing is a good course of action for the government as long as its intent
and methods of financing the deficit result in economic plans and the development
of government projects. Putting this money into a government-run generating
project will benefit both the economy and the people.

In deficit financing through Foreign Financing, up to recent years, the recourse to

foreign financing of a fiscal deficit was somewhat limited. In the second half of the
1970s, however, as foreign loans became more readily available and deficits larger,
and as this occurred at a time when politically, or technically, tax limits seemed to
have been approached or reached in many countries, foreign financing became more
and more common. This financing must distinguish between grants and
concessionary loans on the one hand, and commercial credit on the other; and
between short-run and long-run financing. If a country can finance its fiscal deficit
through foreign grants (or through concessionary loans with a long maturity period),
then the deficit may not have detrimental implications for the economy. If the
additional expenditure is directed mainly toward imported goods, the additional
demand can be satisfied by higher imports financed by grants. However, the country
must avoid locking itself into types of public expenditures (such as pensions,
consumer subsidies, larger bureaucracy) that cannot be reduced without great
difficulties should the grants dry up, unless it has a sure commitment from the
relevant sources that this revenue will continue at the needed level for the
foreseeable future. Unfortunately, there are experiences of developing countries that
came to rely on these grants for the types of expenditures described above and that
faced serious hardships when these revenue sources dried up.

The second most attractive foreign source of financing of the fiscal deficit is provided
by loans with long maturity (say, over ten years). If these loans carry real interest
rates low enough to make many potential projects pass a relevant cost-benefit
criterion, and if they are, in fact, used toward those projects that rank highest in
terms of a cost-benefit (or present value) criterion, then the country will be fully
justified in running the deficit and in financing it in this way. The problems arise,
and, unfortunately, they are common ones, when (1) the loans carry interest rates
high enough to disqualify most projects, (2) the loans are not utilized to finance
productive expenditures but are used to support subsidies of various kinds, and (3)
when long-run projects are financed with short-term loans.

Fund programs always paid attention to the level and the time profile of a country’s
total foreign borrowing, and particularly, to the public sector’s borrowing, to ensure
that the limitations on the fiscal deficit imposed by domestic credit ceilings were not
made useless by foreign borrowing. Operationally, this control was achieved by
putting ceilings, in a Fund program with a country, on the central government’s
foreign borrowing with maturities of between one and ten years. This control was
not always fully effective as, at times, countries violated its spirit by having public
enterprises borrow abroad or by increasing short-run borrowing. Recent programs
have thus often attempted to make these controls more effective by extending them
to public enterprises and to short-term credit.

Shifting attention now to domestic financing, we need to make the basic distinction
between domestic financing through inflationary means and domestic financing
through noninflationary sources. Of somewhat less importance is the further
distinction between voluntary and compulsory financing.

Noninflationary financing is normally associated with the sale of bonds to the public.
The extent to which this source of financing is possible in a specific country at any
given time depends on two considerations.

The first is the size and sophistication of the country’s capital market. As is well
known, there is great disparity among developing countries as to the scope and
sophistication of their capital markets. In some, the capital market is as developed
as that of many industrial countries; in others, the financial structure is still relatively
undeveloped, so that, under the best of circumstances, there would be substantial
limitations to the sale of bonds to the public.

The second important factor, and one that is emphasized in Fund programs, is the
interest rate policy being followed. A country that wishes to finance a substantial
share of its fiscal deficit through the domestic sale of bonds cannot, at the same
time, pursue a policy of financial repression whereby interest rates are maintained at
levels that are below, and sometimes much below, the expected rate of inflation.
Financial investors buy bonds when their return is attractive. Whenever their return
is low or negative, the possibility of financing the Fiscal deficit through this source
will be severely limited, regardless of the size and financial sophistication of the
country’s capital market. In this situation, savers will buy goods, or will try to invest
their financial assets abroad, thus reducing the capacity of the government to
finance its fiscal deficit, while at the same time aggravating the balance of payments
problem (see Tanzi and Blejer (1982)).
As far as Inflationary Financing begins, insofar as the specialized interest of the Fund
is in the balance of payments of a country, the fiscal deficit acquires particular
importance when it increases the money supply. As will be discussed in detail in the
next section, the major connection between the Fiscal deficit and the balance of
payments comes from the effect that the deficit is likely to have on money creation.
A deficit that is not associated with an expansion of the money supply can, of
course, still have several effects on the economy, which, depending on the situation,
may be desirable or undesirable (Penati (1983)). However, for the majority of
developing countries, it is rare when sizable fiscal deficit docs not bring about an
expansion in the money supply. It is for this reason that the fiscal deficit plays such
a large role in the Fund’s adjustment programs.

The connection between financing of the deficit and monetary expansion (normally
referred to as inflationary finance) can come in several ways. First, the central bank
may buy government bonds directly, in which case monetary expansion is
immediate. Second, the government may sell bonds to the public, including the
commercial banks, and the central bank may in turn buy the bonds from the public.
In this case, the connection between financing of the deficit and monetary
expansion is not as immediate and direct as in the previous case, but the end result
is the same. Third, the central bank may extend credit to public enterprises at highly
concessionary rates. In this case, the monetary expansion may not show up as a
direct financing of the deficit, so that one may fail to recognize the connection
between the fiscal deficit and money creation (see Wattleworth (1983)). However,
consideration of the whole public sector and not just of the central government
would make this connection more explicit.

In all these cases the net result is an increase in the amount of money, in nominal
terms, in circulation. If the economy is growing at a fast pace and the income
elasticity of the demand for money is high, its growth will be accompanied by an
increase in the demand for money; therefore, part of the monetary expansion will
satisfy this additional demand without necessarily leading to price increases or to
balance of payments deterioration. However, given the income elasticity, the greater
the growth of the money supply compared with the growth of the economy, the
more likely are inflationary pressures to arise. The effect of monetary expansion on
prices and on the balance of payments will depend on variables such as inflationary
expectations, the size of the monetary base, and the elasticity of the liquidity
preference schedule. Normally, an increase in inflationary expectation will lower the
real stock of money that people wish to hold. A fall in the real stock of money will
imply that the financing of a given deficit through monetary expansion becomes
more inflationary.

Deficit financing has several economic effects which are interrelated in many ways.
First, in deficit financing and inflation, it is said that deficit financing is inherently
inflationary. Since deficit financing raises aggregate expenditure and, hence,
increases aggregate demand, the danger of inflation looms large.

However, whether deficit financing is inflationary or not depends on the nature of

deficit financing. Being unproductive in character, war expenditure made through
deficit financing is definitely inflationary. But if a developmental expenditure is made,
deficit financing may not be inflationary although it results in an increase in money
supply.

To quote an expert view: “Deficit financing, undertaken for the purpose of building
up useful capital during a short period of time, is likely to improve productivity and
ultimately increase the elasticity of supply curves.” And the increase in productivity
can act as an antidote against price inflation. In other words, inflation arising out of
inflation is temporary in nature.

The most important aspect of deficit financing is that it generates economic surplus
during the development process. That is, if total output exceeds the volume of
money supply, the multiplier effects of deficit financing will be greater. As a result,
the inflationary effect will be mitigated.

It is the deficit financing that meets the liquidity requirements of these growing
economies. Above all, a mild dose of inflation following deficit financing is conducive
to the whole process of development. In other words, deficit financing is not anti-
developmental provided the rate of price rise is slight.
However, the end result of deficit financing is inflation and economic instability.
Though painless, it is very much inflation-prone compared to other sources of
financing.

Second, deficit financing and capital formation and economic development. During
inflation, producers are largely benefited compared to the poor fixed-income
earners. Saving propensities of the former are considerably higher. As a result,
aggregate savings of the community becomes larger which can be used for capital
formation to accelerate the level of economic development.

Further, deficit-led inflation tends to reduce consumption propensities of the public.

Such is called ‘forced savings’ which can be utilized for the production of capital
goods. Consequently, a rapid economic development will take place.

It has to be kept within the ‘safe’ limit so that inflationary forces do not appear in
the economy. But nobody knows the ‘safe’ limit. In view of all these, it is said that
deficit financing is an ‘evil’ but a ‘necessary evil.

Third, deficit financing and income distribution. It is said that deficit financing tends
to widen income inequality. This is because of the fact that it creates excess
purchasing power. But due to inelasticity in the supply of essential goods, excess
purchasing power of the general public acts as an incentive to price rise. During
inflation, it is said that rich become richer and the poor becomes poorer. Thus, social
injustice becomes prominent. However, all types of deficit expenditure, not
necessarily tend to disturb existing social justice.

Finally, during inflation, private investors go on investing more and more with the
hope of earning additional profits. Seeing more profits, producers would be
encouraged to reinvest their savings and accumulated profits. Such investment leads
to an increase in income—thereby setting the process of economic development
rolling.

In spite of this, deficit financing is inevitable. Much success of it depends on how

anti-inflationary measures are employed to combat inflation. Most of the
disadvantages of deficit financing can be minimized if inflation is kept within limit.
And to keep inflation within a reasonable and tolerable level, deficit financing must
be kept within safe limit. Not only it is difficult to lay down any ‘safe limit’ but it is
also difficult to avoid this technique of financing required for planned development.
Still then, deficit financing is unavoidable.

It is an evil but a necessary one. Considering the needs of the economy, its use
cannot be discouraged. But considering the effects of deficit financing on the
economy, its use must be made limited. So, a compromise has to be made so that
the benefits of deficit financing are reaped too.
CONCLUSION:

In spite of this, deficit financing is inevitable in LDCs or Low Developing Countries.

Much success of it depends on how anti-inflationary measures are employed to
combat inflation. Most of the disadvantages of deficit financing can be minimized if
inflation is kept within limit.

Precautions in the Use of Deficit Financing should be used in moderate doses, it

should be in constant watch on price index, prices of consumer goods and essential
raw materials should be effectively controlled, ensure a corresponding increase in
the availability of goods, concentrate on quick yielding projects, in order to keep
down the prices of food grains, food imports should be arranged well in time and in
adequate quantities, rise in wages and salaries should be checked lest the country
be caught in a vicious circle of poverty, excess money supply should be mapped up
through taxation and borrowings, ensure clean and efficient administrative system
tackling the difficult economic situation with whole hearted cooperation from the
people.

As to the measures to minimize inflationary pressure of deficit financing – there

should have a proper disinflationary fiscal policy, restrictive monetary policy to
control non-essential private investment, economic controls through selective credit
control, physical and fiscal controls, in order to influence the behavior of private
investment and channelize it into desirable lines, proper allocation of resources with
major focus on agriculture and small and medium scale industries, and developing
import surpluses for increasing the supply of goods.

Moreover, fiscal policy has come to be recognized as the potentially most powerful
instrument of economic stabilization. (a) Government spending: During inflation the
government is supposed to decrease its own spending to counteract an increase in
private spending. The government must simultaneously reduce expenditures and
increase revenues to achieve a cash surplus to be used in an anti-inflationary
manner. (b) Taxes: It is axiomatic that during inflation the existing tax structure
should be retained, that tax cuts should be resisted, and the new taxes should be
adopted or tax rates increased, if possible – to reduce the amount of spendable
money in the hands of general public. But care must be taken not to deflate the
money incomes of the country via taxation so much as to provoke a recession of
economic activity. (c) Savings: Saving is a type of public borrowing which has a
deflationary effect on the money supply and effective demand. The most effective
anti-inflationary public borrowing takes the form of compulsory saving. (d) Debt
Management: Public debt may be managed in such a way as to reduce the money
supply or to prevent further credit expansion.

These are some matters to be considered as to entering into deficit financing

decisions. It may be referred as the “necessary evil” action of the government but
these manifestations must be within the safe limit and be through fiscal policy
arrangements. Knowing the factors how to finance the deficit, makes a negative
connotations but it really plays an integral role in lifting the economy’s productivity.

If the intention is all for good and for the general welfare of the people, then, we
will rely unto that, as long as the money or budget which use to finance to deficit
will go to beneficial projects that is income generating in nature. Furthermore,
through deficit financing and foreign borrowing, we will attract more investors to
come in to invest, in that way we will also can provide many opportunities for the
people. In doing so, the deficit might be gradually achievable in nature.

Understanding this deficit financing will really teach you and the government which
prioritization needs to be prioritized, its nature on the government expenditures and
its whole system approach towards achieving a desirable and productive economy in
the Philippines.
References:

Deficit Financing - MA Economics Karachi University (google.com)

Deficit Financing: Meaning, Effects and Advantages (economicsdiscussion.net)

PCED Deficit Paper Final (econstor.eu)

Policy Basics: Deficits, Debt, and Interest | Center on Budget and Policy Priorities (cbpp.org)

Budget Deficit - Overview, Components, Implications, and Theories (corporatefinanceinstitute.com)

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