Debt and deficit
"Wants always exceed the means of finance. Invariably some desires are foregone. Necessities, however, cannot be compromised on. When means of finance are inadequate to cover the necessities, then an individual resorts to borrowing a sum adequate enough to cover the gap between the available finance and required finance. This gap in finance is the deficit, and the borrowing is the prospective debt that plugs the deficit.
Deficit financing / borrowing / debt has both positive and negative aspects. Borrowing for purchasing an asset such as a house is a wise decision. Borrowing for an expensive holiday is not. The borrower will never be able to save adequately to buy the house because of mismatch between the rate of saving and the rate at which the prices of property rise. Because the property prices rise faster than the savings and interest rates, a house will always go beyond a persons reach with time, unless the person chooses to borrow. Expensive holiday is not as much of a necessity as a house. Though a break from work is essential for good mental health, it is not synonymous with a costly vacation plans.
Deficit financing is effectively borrowing from future earnings. In other words, it is deferred payment, and not some gift from Santa Claus. After the expensive vacation, the reality sinks in that monthly installments have to be paid to the lender. The thought itself is often enough to create stress and fatigue. On the other hand, when a house is bought with loans, there is something more permanent to show for it.
But it is not individuals alone who resort to borrowing or deficit financing. Companies do it, and so do countries. In fact, the great American economic depression in 1930s was aggravated due to people becoming over thrifty. In those days, few dared to be brave enough to borrow, when the survival was in question, and 40 percent of the value of money was wiped out. According to some economists, borrowing would have been the right remedy.
Many business enterprises borrow funds for their business operations. Generally, investors do not have adequate personal funds to start a business on large scale, or they are averse to the associated risk. Therefore, borrowing is almost a norm for businesses. Borrowings from bankers, financial institutions, individual lenders etc., cover the deficit or the gap between the investors funds and the business requirement. If the earnings from business operations exceed the interest paid out on borrowed funds, the owners (investors) are rewarded more than what they would have earned on their investments, had they not borrowed. If, however, the earnings were less than the interest paid out, then these investors would have to absorb losses. The phenomenon is termed as financial gearing. If the business borrows more than the investors funds, then it is referred to as highly geared. It does not mean that low gearing is advisable.
On the contrary, when a business enterprise does not borrow, it is unable to set up large-scale operations, and therefore, unable to achieve economies of scale. The cost of production in such cases is naturally higher. At the other end, to capture some permanent market share, the low-geared business cannot even afford to set high price for its produce. This means profits are likely to be very low. Low profits in turn mean inadequate reserves to absorb any new technology. Inability to buy and implement new technologies eventually makes the product redundant. Or the business may not remain in position to set the price of the product competitively, and steadily lose the market share.
Though deficit financing is a type of borrowing, not all borrowings are deficit financing. The financial gearing in businesses is a striking example. The investors may have adequate funds but may be unwilling to take the risk. Alternatively, the investors may have other investment options that can fetch them better returns. In such cases, the owners or investors may choose to borrow from a source that carries lesser interest rate.
Debts may or may not be manageable. All borrowings essentially create indebtedness. The term deficit is often confused with unmanageable debts. This is not true. When debts become unmanageable, what really happens is that sources of finances are inadequate to repay the debts. And therefore, there is a gap between the amount required and amount available, and this is the deficit.
Major differences between debt and deficit
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