Fiscal Deficit - Boon or Bane

Fiscal Deficit: Boon or Bane

Fiscal deficit refers to the excess total expenditure of the government over the revenue it generates. A yearly accumulation of these deficits is called the national debt. The size of the deficit is generally measured in % of GDP.

There has been a lot of discussion among economists in the world regarding fiscal deficits. Many of them suggest that the deficits are harmful as they result in lower savings, higher interest rates, stunted economic growth and an ever increasing national debt. Let’s delve down a little bit more to get a better idea about the concerns surrounding the fiscal deficits.

The budget deficit can be thought of as the amount the government borrows. This is usually done by selling bonds to the private sector. If the deficit is large then it may become difficult to attract sufficient investors to buy these bonds. This may result in higher bond yields causing the deficit to be more expensive to finance. If, in this case, the central bank starts printing more money to buy bonds, the result would be inflationary as there will be more liquid money in the market (unless the economy is in liquidity trap). If the deficit increases sharply then the government may be forced to increase the tax rate to overcome the deficit. This can cause a decrease in aggregate demand resulting in recession and hence lower growth. Also, a significant part of national income may go in the interest payments as the accumulated debt will keep rising. Another concern related with high deficit is that when government effectively borrows from the private sector, the private sector will have lower funds to spend and invest. The government therefore will effectively be ‘crowding out’ the private sectors with respect to investments and this will hinder the growth prospects of the economy as the government spending is generally inefficient than that of the private sector.

Does this necessarily mean that the fiscal deficit is always harmful for a country’s economy? Let’s discuss a few more factors before reaching to a conclusion in this regard.

Here, one should also consider the timing of the deficit. Suppose the deficit is rising during a recessionary period. During recession, private sector spending falls and the savings rise leading to unused resources. Government borrowing is an effective way of utilising these unused savings and ‘kick-starting’ the economy. The deficit spending can help promote higher growth, which will enable higher tax revenues and the deficit will fall over time. If the government tries to balance the budget in a recession, the recession may become deeper.

The issue of ‘crowding out’ of the private sector will only arise when the country is experiencing strong economic growth. During recession, the government spending will actually help the private sector in being comfortable with spending and investing again. This would actually lead to ‘crowding in’ rather than ‘crowding out’

One more thing that needs to be considered is the reason why the government is borrowed. If the government borrowed to invest in improving infrastructure, it may be able to overcome the recession and improve the productive capacity of the economy. The return from this investment may be greater than the cost of borrowing and so in the long-term, the economy benefits from government borrowing and