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Is a Fiscal Deficit Inherently Bad?

Answer: In the late twenties the British Treasury (because of which this view came to be known as the "Treasury View") that in all circumstances the government's balancing its expenditure with its income, i.e. not resorting to any fiscal deficit, is the most desirable policy for an economy. The British colonial government in India, it may be recalled, had used precisely this argument for pursuing deflationary policies even during the years of the Great Depression because of the fall in its tax revenue. This had succeeded in worsening the impact of the Depression on our economy, had thwarted the industrialisation prospects which the policy of protection of the inter-war period had opened up, and had resulted in a wholesale running down of the economy's infrastructure. This view in short was pervasive in the pre-Keynesian era. A slight variation of this view is that the fiscal deficit must under all circumstances never be allowed to exceed a certain small limit.
 
The theoretical articulation of the Treasury view was contained in a White Paper of the British Treasury in 1929, called "Memorandum On Certain Proposals Relating to Unemployment", and written in response to Lloyd George's suggestion that Britain should undertake public works for reducing unemployment which at that time stood at 10 percent (it was to reach 20 percent later). The White Paper argued that in any economy there is at any time only a certain pool of savings, and that if more of it is used for home investment then less becomes available for foreign investment, or if more of it is used for public works financed by government borrowing, then less is left over for private investment and foreign investment. It follows then that public works can never increase total employment in an economy since the increase in employment brought about by public works would be exactly counterbalanced by the reduction in employment arising from reduced private and foreign investment.
 
The fallacy of this argument was exposed by a young Cambridge economist and pupil of Keynes, Richard Kahn, in a classic paper published in 1931. The argument was simple: total savings in an economy depend, among other things, on its total income. There is therefore no fixed pool of savings, unless we assume that income cannot be augmented, i.e. the economy is already at full employment, in which case the need for public works does not arise. The Treasury View in other words was arguing against proposals for reducing unemployment on the basis of a theory that implicitly assumed that unemployment did not exist at all. In an economy in which there is unemployment, in the sense of resources lying idle owing to lack of aggregate demand, if investment increases then these resources start getting used up directly and indirectly, through various rounds of the "multiplier". As a result, income rises and so do savings. Indeed, Kahn showed, the whole process of increase in income and employment would go on and on, until an amount of savings had been generated which exactly equalled the increase in home and foreign investment. Far from there being a predetermined pool of savings above which investment cannot increase, it is the total investment that determines the total savings: the direction of causation in other words is precisely the opposite of what pre-Keynesian theory believed. A corollary of Kahn's theorem was that if the government expanded public works for generating employment and financed these by borrowing, i.e. by enlarging the fiscal deficit, then an exactly equivalent amount of savings would accrue in private hands. A fiscal deficit in other words finances itself.
 
The argument advanced by Kahn in 1931 was central to Keynes' opus The General Theory of Employment, Interest and Money published in 1936. Keynes argued in a similar manner that in a situation of "involuntary unemployment", or "demand constraint", the government can enlarge employment and output by increasing its fiscal deficit; far from there being any adverse effects of this on any other stream of expenditure, such government action in fact would stimulate the total expenditure from these other streams via the "multiplier", and not even generate any significant inflationary pressures. Moreover, since the government can successfully pursue such a policy, it must do so, because, as Keynes put it, "it is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated -- and, in my opinion, inevitably associated -- with present day capitalistic individualism." Even if the government used the fiscal deficit for no worthier purpose than "to dig holes in the ground", that is still preferable to letting unemployment persist, since "'to dig holes in the ground' paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services" (again because of the "multiplier"). To argue against the mitigation to human suffering that an increased fiscal deficit can provide is therefore bad theory, the sheer "humbug of finance".