Deficit Budgets and Inflation Rate By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

Joe (Janakiraman) found sometime to meet up with Swami (Swaminathan) before he took off to the US. Their conversation, as usual, always served the purpose of understanding some macro-economic phenomenon. In true sense, it is a knowledge and information building dialogue.

Joe        : Swami, you have always kept abreast of all macro-economic events in the world. I want to pick up some ‘gyan’ before I leave for the US. Is it OK?

Swami: Certainly Joe. Free consultation for you.

Joe       : Thank you. Tell me something about balanced budget. Does such a thing exist?

Swami: Tough question. I will try to answer. A budget document of a country is the mother document which is presented to its parliament and if gets approved is implemented. In this document we can see both the sources and uses of funds. When the amount stated in the sources is the same as in the uses, we can say that this country has a balanced budget. Having said that, it never happens in real life. The budget will show mostly deficit and only on rare occasion we will see a surplus.

Joe          : Then let us talk about budget deficit. What does it mean?

Swami    : Put simply, the money available on hand with the government is not adequate to meet all its requirements. The government does not want to cut its expenditures as most of the expenses are either compulsory or promises made during the election.

Joe          : OK. First tell me about how the government finds money to function?

Swami    : The government collects income tax, corporate tax, customs duty, excise duty. Also from their investment interest and dividend income. The state government in India also collects money from its people by way of sales tax, liquor tax, stamp duty on property etc.

Joe          : Too many taxes. Is it like that everywhere?

Swami    : In some countries the types of taxes collected vary. For example in Canada they collect unemployment insurance, Canada pension plan etc. In your own country you have social security tax, medicare tax, medicaid tax, estate duty etc. Believe me. I am not totally familiar with all taxes. In India, for example, we have a surcharge on the income tax payable.

Joe          : Let us get back to the deficit. Tell me Swami. Is the budget deficit cause for inflation?

Swami    : This is the toughest question to answer. The answer could be yes, no or may be. But I will try. When the budget has a deficit component, the money must be found from somewhere to eliminate the deficit. This money normally finds its way into circulation and pushes up prices of commodities. Conversely, if the money is not found, the demand will slacken and this will push the prices down. Paul Krugman, the noble prized economist, kept supporting the idea that, when there is a general slowdown in the economy, the government should print money and circulate it. Recent experiences in the US show that inspite of quantitative easing QE1, QE2, QE3 when nearly 2.5 trillion dollars was pumped in, it did not cause inflation. On the other hand, it prevented the US from getting into a deflation. Yet another study in the US showed that when the debt level of a country reaches 90 percent of GDP, the economy starts slowing down and as usual another study showed that this need not be the case. In the last few years US budget deficit is hitting the roof and there seems to be no sign of inflation returning.

Joe          : After getting all these monies through taxes etc you are saying that countries do not have enough available to pay for all its activities.

Swami    : Joe, trust me. When a country needs money to spend, it will use all innovative ways to create it. For example,

(a) A country can borrow money from another country. Us borrows heavily from China and sells 1 trillion dollars worth of US government bonds to them.

(b) It can also print money and put it in to circulation. This is called monetization. It is also well known that the government debt is never retired completely and instead it is rolled over. Then the government only needs to pay the interest annually on the loans. The country can also increase taxes. Generally this is the least preferred option as the public don’t like paying more taxes. Of course a country can continue to issue more bonds. Thus there are so many ways by which they can meet their requirements.

Joe          : Are tax burdens equally shared by the public?

Swami    : Hell no. It never happens that way. For example if the income is derived as a long-term capital gain, it may be exempted from taxes. In fact most of the professionals like doctors; lawyers don’t declare their full income. Generally the salaried employee pays the correct taxes since it is deducted at source.

Joe          : How does capacity utilization affect the inflation?

Swami    : Capacity utilization does not necessarily mean that inflation is getting ready to come back. Look at Japan. Capacity utilization is increasing and there is no sign of inflation. Prime Minister Abe is pumping the prime to get the country out of deflation and to achieve a target of 2 percent inflation. It remains to be seen as to whether Japan will ever get out of deflation in which it has been there for the last 15 years.

Joe          : I am getting confused. You don’t seem to have readymade theory for me?

Swami    : I don’t blame you. Yesterday, Mario Draghi, ECB President lowered the interest rate by 15 basis points to prevent deflation in the euro zone. Their inflation rate is 0.5 percent. There is also a penalty to keep money in the bank. Funny isn’t it?

Joe          : Can we say that inflation arises because of the highly irresponsible monetary policy with M3 aggregate moving higher and higher.

Swami    : Far from truth. All countries facing deflation are adding more and more money into circulation to get it out of deflation. It appears initially as though it is working. Experiences of Japan, Euro zone and the US show that monetary policy is not the reason for inflation to occur.

Joe          : Tell me how does increased productivity affect inflation?

Swami    : Increased productivity increases output as well its quality and so reduces cost of manufacture. Look at the computer hardware industry. Price of a Laptop keeps dropping while its capability increases multifold.

Joe          : Finally, tell me how do I spot the inflation tendencies?

Swami    : Yes. For example, you have accepted a job like a contractor who is engaged in the construction of an apartment but you are not able to find the qualified labor. To attract them you need to increase the wages. This is a sign of inflation. Again, the construction material costs are going up like sand, cement, steel etc. This is a sign of inflation. Look at the commodity prices in the future market. If they start to move up then eventually, it will hit the retail price. To tell the truth, the longer the supply chain greater will be the inflation rate. For example, a farm output like onion, when it reached the retail market the price topped 100 Rs a kilo. The main reason was that there were many intermediaries who cost had to be added on thus taking the consumer to the cleaners.

Joe          : Thank you for this informative dialogue. I will catch up with you when I make the next trip.

Swami    : Thank you and good luck. Have a safe journey.

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