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INTRODUCTION TO DEFICIT FINANCING THEORY

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INTRODUCTION TO DEFICIT FINANCING THEORY

Introduction to the chapter

This chapter describes the nature and specific features of deficit
financing. By the end of the chapter you will be able to:
 use basic terminology;
 identify the types of budget deficit;
 identify debt financing instruments;
 identify governmental debt factors.

The chapter includes two subtopics:

1. The general characteristics of deficit financing;
2. Classical concepts of deficit financing.

1. The general characteristics of deficit

financing
In order to define issues associated with deficit financing we must
first consider the issues related to:
 governmental debt;
 the budget deficit;
 debt structure;
 the budgeting process;
 budget discipline;
 the effects of deficit financing.

The issues associated with debt financing are among the main
discussion points in the organizational process of every budget, and
therefore one of the central issues in the field of finance. In its broad sense,
the term “deficit” can be defined as an excess of budget expenditures
compared with the incomes for a specified period. Its application in both
specialized financial theory and practice requires the meaning to be defined
with regards to the following three main areas:

Zahariev, A. (2012). Debt Management, Veliko Tarnovo: ABAGAR Publishing

House. ISBN: ISBN 978-954-427-981-3. DOI: 10.13140/RG.2.1.4872.3607
12 Debt management

 budget deficit structure;

 planned and actual deficit;
 deficit scope.

The structure of the budget deficit is classified by four levels of

consequent inclusion of the main debt-related expenditures, and includes
the following basic categories:1
A. Budget imbalance – the mismatch between revenues and
expenditures within the budget period. It is the basis for the determination of
the budgetary situation having particular importance. Often, its value is
positive, i.e. there is a budget surplus, while a deficit is reported after
considering the subsequent elements. Examples abound in our budgetary
law, which is indicative of the structure of debt accumulated in previous
periods.
B. Internal budget deficit – calculated by reducing the budget by
the amounts due in order to service the internal debt throughout the period
(budget year).
C. Current budget deficit – calculated by increasing the amount of
the internal budget deficit by the expenditures for servicing the external debt
over the period.
D. Total budget deficit - calculated by increasing the amount of the
current budget deficit with all outstanding payments from previous periods.2

Another point of view to consider is when the budget deficit is related

to the processes of its adoption and implementation. In this context, the
deficit forecasted, planned and approved via State Budget Law is defined as
planned deficit. However, the practical implementation of a budget using
planned deficit is often particularly difficult because the actual deficit is, more
often than not, different from the planned one. The actual result at the end
of the budget period is the actual budget deficit. The latter can be larger or
smaller, or (for we should not ignore this theoretical possibility, although this
is practically very hard to achieve) equal to the planned deficit.3

1The Annual budgetary procedures and the introduction of budget classifications

used by the EU lead to some changes in basic terminology. For comparability between the
basic research, we use the budget categories introduced and applied by national statistics
and the Ministry of Finance, after the reforms in 1989.
2For more detailed information see: ADAMOV V., Lilova, R., Zahariev, V. Byudzhet

i byudzhetna politika. V. Tarnovo, ABAGAR, 1997; SIMEONOV, S., Zaharieva., G.Defitsitno

finansirane na byudzheta v: BROWN, C. & Jackson., P. Public Sector Economics (Bulg.
transl. ed.). Sofia, FSSA, 1998.
3 LILOVA, R., Politicheski i ikonomicheski ramki na byudzheta. Svishtov 1992.

According to preliminary data from the Ministry of Finance, the budget in 2011 is an exception
to the general rule, as the deficit is less than 0.4% of GDP compared to the planned amount.
Zahariev, A. (2012). Debt Management, Veliko Tarnovo: ABAGAR Publishing
House. ISBN: ISBN 978-954-427-981-3. DOI: 10.13140/RG.2.1.4872.3607
 Chapter I. Introduction to Deficit Financing Theory 13

It should be borne in mind that governments do not include all

activities in the official budget, which is often based on current regulations,
such as the redistribution of income and expenses related to social activities
that are generally off-budget. However, the official distinction and correct
measurement of a government's obligation requires the reporting of all
revenues and expenses. According to the U.S. financial practice, the deficit
structure is represented through the differentiation of the elements by
considering first the amount of the on-budget deficit (which represents only
the activities included in the budget), and then the off-budget deficit (which
represents only the off-budget activities). The sum of these two elements
gives us the aggregate (net) deficit.4
In order to provide more accurate definitions of deficit and debt, we
should also consider the following facts:
 At a certain point, debt is the sum of the deficits from previous
years, reduced by the amount of settled debt;
 Debt is the aggregate amount of the excess of expenses over the
revenues from previous periods;
 Debt is the value of a dynamic variable at a specific moment,
while the deficit covers a defined budget period;
 Debt resulting from credit transactions has certain obligations for
the issuer, expressed mostly in the payment of remuneration in terms of
interest and/or discounts on the face value of the debt security.

Despite the popular belief that debt is a governmental "problem", we

should point out that not only the central government, but also local
governments take out loans.5 This generally leads to an overall increase in
indebtedness.
Of course, the real inflationary effects of the actual reduction of the
debt burden to creditors cannot be ignored, and there are certain sufficiently
reliable tools for their alleviation. A popular method is debt indexation,
without which, lending to the government would be unthinkable during
periods of high and varying inflation levels. We should also point out that
investors tend to shorten the time span and index, even of the most short-
term capital market instruments.
The basis for debt indexation is of particular importance for the
success of a bond issue. Debt management is thus directly related to the
actual profitability and burden of the debt respectively, and we must find a

4ROSEN, H. Public Finance. New York, 3 ed. 1993.

5
As a result of the process of fiscal decentralization, and with technical assistance
from USAID, Bulgaria has adopted and enforced the specialized Municipal Debt Act,
promulgated in SG, No. 34 of 19 April 2005.
Zahariev, A. (2012). Debt Management, Veliko Tarnovo: ABAGAR Publishing
House. ISBN: ISBN 978-954-427-981-3. DOI: 10.13140/RG.2.1.4872.3607
14 Debt management

reasonable balance between sufficient and essential stimulation of investors

on the one hand, and an acceptable burden upon the budget on the other.
When we consider public debt, we should take into account both its
absolute value and its relation to governmental assets such as administrative
buildings, equipment, gold, rights regarding natural resources and other
factors. It is believed that the exclusion of tangible assets can be highly
misleading when considering debt.
In general, the formation of government debt is based on the
emergence of budget deficits. Therefore, the size of the budget deficit
defines the size and scope of the debt. Debt financing involves the use of
various debt instruments. On a global scale, the most common are:6
a) issues of short-, medium- and long-term securities;
b) direct loans from Central Banks;
c) loans taken through tenders from commercial banks and other
banking institutions;
d) credit from international financial institutions.

The use of any of these instruments is in direct relation to the policy

of deficit financing and debt management.

2. Classical concepts of deficit financing

Deficit financing is a problem as old as the problems related to the
structure and finance of state government. This problem was addressed in
Adam Smith’s “The Wealth of Nations”. Smith believes that national debt
owes it’s origins to three main factors:7
 the willingness of government authorities to spend budgetary
funds;
 the unpopularity of tax increases as a method for collecting
additional state revenue;
 the willingness of capitalists to extend loans.
Smith is explicitly against the use of loans as a method of financing
budget deficit. He predicts that, “The progress of the enormous debts which
at present oppress, and will in the long-run probably ruin, all the great nations
of Europe…” (The Wealth of Nations, p. 753). Based on empirical evidence
of deficit financing, he believes that there is a direct relation between the
ability of governments to borrow money and their willingness to fight wars.

6 SIMEONOV, S., Zaharieva, G. Op. cit., p. 565.

7FINK, R. and J. High. A Nation in Debt: Economists Debate the Federal Budget
Deficit. Maryland. 1997 p. xiv.
Zahariev, A. (2012). Debt Management, Veliko Tarnovo: ABAGAR Publishing
House. ISBN: ISBN 978-954-427-981-3. DOI: 10.13140/RG.2.1.4872.3607
 Chapter I. Introduction to Deficit Financing Theory 15

In other words, a budget deficit should be avoided except in situations of war

or other extraordinary events. Smith recommends that the main principle of
public finance management should be the "prudent owner" principle. The
government should be responsible for its financial affairs with the
same prudence as the individual regarding their personal financial
affairs.8
At a later stage in the development of economics, Karl Marx
conjectured that government debt is a derivative of capitalist societies. This
derivative is designed to facilitate the exploitation of labour. According to
Marx, government loans are an easy and convenient way to raise capital
which does not expose the government to the problems and risks that are
inevitable if the capital is used for industrial purposes. The use of deficit
financing and the formation of government debt leads to four major
consequences: first, it creates a class of "lazy annuity holders"; second, it
increases the benefits for central bankers in exchange for their agreement
to extend loans to the state; third, it stimulates an increase in the tax burden
and the collection of taxes for the repayment of government debt; fourth, it
motivates industrialists to find new ways of escalating employee
exploitation.9
In conclusion, we should point out that the two representatives of the
classical school (Smith and Marx) highlight the harmful effects of debt
financing – effects which must be limited, and which must not be accepted
by governments.

Recommended additional sources:

1. ADAMOV, V. Teoriya na finansite (Darzhavni finansi). // Biblioteka
„Obrazovanie i nauka”, Svishtov, Tsenov, 2012.
2. LILOVA, R., V. Adamov, Zahariev, V. Byudzhet i byudzhetna
politika. V. Tarnovo, ABAGAR, 1997.
3. STIGLITZ, J. Economics of the Public Sector. (Russ. Transl. ed)
Moscow, 1997.
4. Municipal Law Act, prom. SG, № 34 of 19 April 2005.
Keywords
1. Budget deficit structure
2. Budget balance
3. Internal budget deficit

8SMITH, A. Of Public Debts. in: A Notion in Debt: Economists Debate the Federal

Budget Deficit, Maryland, 1987, p. 1.

9 FINK, R., High, J. Op.cit., p. xiv.

Zahariev, A. (2012). Debt Management, Veliko Tarnovo: ABAGAR Publishing

House. ISBN: ISBN 978-954-427-981-3. DOI: 10.13140/RG.2.1.4872.3607
16 Debt management

4. Current budget deficit

5. Total budget deficit
6. Deficit scope
7. Planned deficit
8. Actual deficit
9. On-budget deficit
10. Off-budget deficit
11. Net (aggregate) deficit
12. Government debt
13. Debt indexing
14. Debt financing

Questions for self-evaluation and discussion

1. Provide the common definition of the term “deficit”.
2. Which are the elements of the budget deficit structure and how are they
defined?
3. What is the difference between planned and actual deficit?
4. What is the difference between the terms “debt” and “deficit?
5. What is the U.S. practice in terms of calculating the aggregate deficit?
6. Which debt financing instruments are you familiar with?
7. Which are the main causes for government debt?
8. What arguments did Smith and Marx express, opposing deficit financing?

Zahariev, A. (2012). Debt Management, Veliko Tarnovo: ABAGAR Publishing

House. ISBN: ISBN 978-954-427-981-3. DOI: 10.13140/RG.2.1.4872.3607
 Chapter I. Introduction to Deficit Financing Theory 17

Chapter summary
The issues related to debt financing are among the main discussion
points in the organizational process of every budget, and therefore one of the
central issues in the field of finance. In its broad sense, the term deficit means
an excess of budget expenditures compared to the incomes for a specified
period. The successful management of a budget deficit requires knowledge
of its structure - the four levels of consequent inclusion of the main debt-
related expenditures - and includes the following basic categories: budget
balance, internal budget deficit, current budget deficit and total budget deficit.
In terms of the processes of the acceptance and implementation of
the budget, we can distinguish between planned and actual deficits. The
methods used by governments to finance their activities through their official
budgets are also important. The U.S government first considers the on-
budget deficit (which represents only activities included in the budget), then
the off-budget deficit (which represents only off-budget activities) and then
defines the amount of the total budget deficit as the sum of these deficits.
Various debt financing instruments are used in financial practice: issues of
short-, medium- and long-term securities; direct loans from Central Banks;
loans taken through tenders from commercial banks and other banking
institutions; and credits from international financial institutions.
The success of debt management also depends on knowledge of the
main factors which influence debt. Smith defined three main factors for
growth of government debt. He, himself (and later, other economists as well),
was explicitly against loans as a means of financing the budget deficit. Smith
recommends that the main principle of public finance management should
be the "prudent owner" principle, i.e. that the government should be
responsible for its financial affairs using the same prudence as individuals
regarding their personal financial affairs.
At a later stage, Marx defined government loans as an easy and
convenient way of raising capital which does not expose governments to the
problems and risks that are inevitable if the capital is used for industrial
purposes.

Zahariev, A. (2012). Debt Management, Veliko Tarnovo: ABAGAR Publishing

House. ISBN: ISBN 978-954-427-981-3. DOI: 10.13140/RG.2.1.4872.3607

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