Tuesday, November 8, 2011

Economic Concepts...

Debt & Deficit are same things?
-        when you’re spending more than your income = you're in deficit
-        when you borrow money to fill that gap / deficit = you're in debt.

Why deficit?
·      Ideally, Govt. should not spend more than what it earns.
·      but, in real life situation its not that easy.
·      Govt. has to spend crores of Rs. in military, poverty removal schemes, floods, draughts, tsunami reliefs etc. so they're bound to run in deficit. And ultimately have to borrow from someone to fill that gap.

Is Deficit bad?
that depends on whether you’re borrowing for Development work or not?.

there are 2 types of Govt. Expenditure (spending)

Revenue Expenditure

·      = when Govt. spends money paying salaries to its employees.
·      or buys some machine guns or missiles.
·      such Expenditure is non-productive (Of course these things are essential to run the nation, but its 'non-productive' in this classification)
·      this spending Doesn’t create assets* but money wasted in
o      Salary & perks to Govt. employees
o      Administration
o      Defense – law –order
o      Interest payment on previously borrowed loans
·                   Subsidy <-- majority  of tax payers’ money goes here. (I’ll talk about subsidy in another article)

*by the way what are assets?

·      Asset is something that generates money. For example you purchase a house & rent it to someone- then you’reearning money. Thus its your asset.
·      NPA = Non-performing Asset. = its not generating money / making losses. (for e.g. you buy house but you neitherlive in it nor you rent it to others.)
Borrowing to fill up Revenue deficits is poisonous for the health of nation. (e.g. Currently Revenue deficit of UK  is 60% of its GDP)

Capital Expenditure

·      When Govt. makes roads, dams, bridges, ports, schools, etc.
·      such work is productive. It will lead to further economic Development.
·      So, if Govt. spends money here & runs into deficit / takes debt to finance it = its not bad. because it'll be recovered later on.
·      e.g. kids learn in school, they grow up - do some job / business = ultimately pay taxes directly / indirectly thus money is recovered. and so on...
·      Another example, Govt. gives free meal via Mid-day meal schemes. Now you might think, all those kids are poor, and they’ll never earn enough money to be in the ‘income-tax slabs’ group. So what’s the point in giving them free food?
·      but no matter how rich / poor those kids are when they grow up- they’ll still have to buy things like petrol, matchsticks, cinema tickets, milk, food oil, soap etc.
·      and on all such things, Govt. takes taxes (Vat, entertainment tax etc.) . So even if the poor people are not paying direct income tax- they still end up paying money to Govt. this is called ‘indirect Tax’
in short, if Govt. runs into deficit, while paying for the capital formation spending = good for nation.

3 types of Deficit?

#1- Total or Budgetary deficit (BD)

= spending – income
=Total Expenditure - total receipts ; (the income of Govt. is written as ‘reciepts’)
= [Total (Revenue + Capital) Expenditure] –MINUS- [Total (Revenue + Capital) receipts]

#2- Fiscal Deficit (FD)

BD + Market borrowing + other liabilities
This Measures total borrowing requirement of govt from
1.   internal
2.   external sources
#3- Primary Deficit / Non Interest Deficit

=FD – Interest paid
What is Monetized Deficit?

Ans. That is When RBI prints more currency notes to fill up Govt.’s deficit. (Technically its RBI selling Govt. treasury bills in market & giving money to Govt.)

To  finance the Deficit, where does Govt. get money from?

1.   Govt Savings
2.   PSU Surplus
3.   Budget surplus
4.   Public Borrowing (if Govt. has low cash on above 3 items) ->> this is public DEBT. (via treasure bills etc)
5.   External Assistance (borrow from World Bank , IMF etc.)

Can’t we just print more currency notes to pay-off the debts?

·      We’ve lot poor people in India, how about RBI printing 1LaKh rupee notes, & giving that to each poor family, then all our poverty problems will solve isn’t it?
·      Nope, it’s not that easy.
·      When each poor has 1 Lakh rs. In his pocket, he’ll go to market & buy 1 kg potato.
·      Ultimately there will be shortage of potato because every poor will have more money.
·      So then, some poor will offer the veggie vendor- 30,000 Rs. Just for one kg potato
·      Then some other will offer 40,000 Rs. And so on.
·      At the end, they won’t be able to buy much potato even with 1 Lakh rs. In their pocket. This is  inflation
·      So printing more money to solve problems doesn’t help=  you’ve to produce more products as well so that people can buy it using their money.

Ok so in short, Govt. borrows money from somewhere to finance its gaps (deficit) – that’s called Deficit Financing.

What’re the uses of Deficit Financing?

Use #1 Fighting Depression / Recession ( Keynesian Theory)

In 1930, an Economist named JM Keynes gave this concept.
·      during recession – there is low demand in market because people don’t have enough money to buy things.
·      So, if Govt. starts some project, people get employment= they’ve money = they’ll buy something = boost in production = boost in economy.
·      Like Hoover Dam was made during 1930s recession in America.
·      This is “dig wells and fill wells”

Use #2 Economic Development

·      Suppose you want  to start a canteen, but don’t have enough money. So you can do two things
o      Work as a waiter in someone else’s canteen until you save enough money to buy your own canteen (but this will take a long time)
o      Or, borrow loan from bank to start a canteen (quick solution) … same way
·      Developing countries (3rd world) Don’t have enough money, so this way fast capital formation can be done. (borrow money to make Dams, roads)
·      Thus Deficit financing Breaks bottlenecks, structural rigidities.

Negative effect of Deficit Financing

·      Increase inflation [like I told ago- poors & potato]
·      Changes pattern of investment
·      Forced savings (since everything Is so costly, you can’t buy it, so you’ll park your money in the Bank account as savings.)

Use #3 in War

·      During war we need lot money to buy oil, missiles, food /medicines for army etc.
·      Nations print more money to finance it. (because its hard for a nation to get loans during war.)
·      For Example, Germany printed more money during World war 1 (1914-18)
·      But then Inflation destroyed German money’s value.
·      That’s why there will be steep inflation after war. (poor potato.)
·      USSR did the reverse of it- it refused to pay loans in 1917 – that’s called ‘repudiation


·      TO PREVENT INFLATION   deficit financing should be made so that it leads to capital formation
o      Means Govt. must not use the money to pay interest / subsidy / salary.
·      surplus money must be sucked away from market by higher tax- loan interest
·      Newly created (printed) money used in capital formation Which have short gestation period*
o      Means you print more money to build a dam but it takes long years to build dams. Thus you won’t be able to recover the costs quickly  = during this time, it spoils market with inflation.
o      If you use newly printed money to build a superfast highway (which takes quite less time compared to Dams) then you’ll recover the money quickly.
o      Again you might think how can Govt. recover money used in building roads?
o      Ans- more roads = more transport & business = more Sales / Excise / GST / VAT etc taxes.
·      Import of luxury items must be discouraged
o      Suppose you’re a road contractor, and Govt. gave you payment for building a highway.
o      But you use that money to buy expensive imported perfumes / gold watches/ i-pods!
o      that doesn’t help the Indian Economy. That’s why.

Now moving to another part-

Public Debt

When does Govt. borrow from public?

1.   When Govt. doesn’t have enough surplus money.
2.   When Taxes can’t be increased beyond a level (not like you can ask every middle-class man to pay 1 Lakh rs. To help build the dams/highways)
3.   When printing more money is making inflation (after safe limit)

How does Govt. borrow from public?
 One example is By issuing
o      Kisan Vikas Patra,
o      Indira vikas patra
o      Narmada Vikas patra
o      The money gathered from such certificates is used for building dams & other things.
o      And the advantage is, Govt. will double your money after some 10-15-20 years. So Govt. doesn’t have to repay you interest every month / year.
·                   So its in a way- loan taken from you (the public) by the Govt.
Via Treasury bills

-        here RBI (have to) buy Govt. treasury bills- gives money to Govt. & sells these bills in Capital market*.
-        When you buy a Govt. security- you can be sure: its safe and give you good profit- that’s why its called ‘Gild Edged market’
-        It deals with Govt. & semi Govt. securities
-        Generally commercial banks (have to)  purchase Govt. securities (remember the SLR: statutory liquidity ratio)
-        SLR = banks to invest a certain percentage of their liabilities in government securities – the rate was
o      38.5 per cent in 1990
o      25 per cent in 1997
*{will write in detail about capital market, in another article}

What’s the Treasury bill?

-        When Govt. has small temporary gap/deficit in the Revenue part, it’ll sell the treasury bills to RBI.
-        RBI has to buy it. (because there is some law / deal)
-        Then RBI sells it to Commercial Banks (thus recovers money)
-        But here as you can see money is just printed / given without actual creation of any direct ‘physical product’ so this is bad for economy in long run.

Debt trap

When you borrow just to pay your previous debts.
That is the act of borrowing money just to keep up with debt servicing*
*Debt servicing = interest + installment payment

(FRBM) Fiscal Responsibility + Budget Management Bill (2000)

-        It was made to eliminate fiscal deficit
-        It put limits on central government’s   borrowings,  debt,  deficits
-        It said that total liabilities of central government should not exceed 50 per cent of GDP. (it was 76% in 2002.)
-        However its provisions are diluted now, because Govt. had to pay lot money due to 6th pay Commission / debt waiver & recession.

Separate Public debt Management office

-        Currently RBI is responsible for managing Govt.’s debt.
-        But as you know- RBI is also responsible for monetary policy (control money supply + inflation via CRR, SLR, Repo etc.)
-        Both tasks are conflicting with each other.
-        On one hand, RBI has to print more money / sell Govt.’s treasury bills in market to fill Govt.’s deficit
-        On the other hand same RBI also has to control money supply in market in such a way that there is no inflation.
-        That’s why there are talks of separate debt Management office other than RBI.
-        From now on when you read editorials, keep this in mind. And you’ll learn new things to write in Essay / GS.

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