Explain the impact of “fiscal imbalances” on an economy.
The year 2020 was marked by extreme events. International travel came to a near standstill, oil prices experienced dramatic swings, and trade in medical supplies surged. Consumer spending shifted away from services towards goods, while household savings soared as people remained at home during the global lockdown. However, many of the factors behind persistent external imbalances existed even before the pandemic—such as fiscal imbalances, structural issues, and competitiveness-related distortions.
a. Explain the impact of “fiscal imbalances” on an economy. [10]
Introduction
A country’s fiscal position is determined by the balance between government revenues and government expenditures. Government revenues are typically sourced from tax collections such as income tax, value-added tax (VAT), corporate tax, and excise duties, as well as non-tax revenues like returns from sovereign investments and government-linked entities. Government expenditure, on the other hand, includes the provision of public goods (e.g., national defence), merit goods (e.g., education and healthcare), transfer payments (e.g., pensions, unemployment benefits), infrastructure projects, and the wages of public sector employees.
When a government’s expenditures consistently exceed its revenues, it runs a budget deficit, and if this persists over time, it results in what economists refer to as a fiscal imbalance. Such imbalances are not uncommon during periods of economic distress—such as the global pandemic in 2020—when governments engage in aggressive fiscal expansion. However, if such imbalances are left unchecked over an extended period, they can have serious macroeconomic consequences.
Explain any 2-3 points
Demand-pull inflation
One of the short-term effects of fiscal imbalances can be demand-pull inflation, particularly if the imbalance is driven by large-scale expansionary fiscal policy. Governments may implement stimulus packages during economic downturns to boost aggregate demand (AD). This can take the form of tax cuts to encourage consumption, direct cash transfers to households, or large public infrastructure projects to create jobs and stimulate investment.
An increase in government spending (G) shifts the aggregate demand curve rightward. This leads to a multiplied increase in real national income (NY) through the Keynesian multiplier effect, resulting in higher economic growth and a reduction in cyclical unemployment, as firms hire more labour and capital to meet rising demand.
However, if such fiscal support is not carefully withdrawn once the economy nears or reaches full employment, further increases in AD can result in overheating. In this scenario, the output gap closes, and any further increase in demand translates mostly into price increases rather than output gains. This was observed in the United States in 2022, where continued fiscal support, even after the worst of the pandemic had passed, contributed to a surge in inflationary pressures.
Thus, while expansionary fiscal policy is effective in countering recessionary pressures, it can contribute to inflation if not timed or scaled appropriately, especially in an already recovering economy.
The crowding-out effect
Fiscal imbalances may also have unintended consequences on private sector investment, especially if government spending is financed through borrowing.
When the government borrows heavily from the domestic financial markets to finance its deficit, it competes with private firms for a limited pool of loanable funds. This competition can lead to an increase in interest rates. Based on the Marginal Efficiency of Investment (MEI) theory, higher interest rates reduce the profitability of investment projects, particularly for firms that are sensitive to the cost of capital. This results in a fall in private investment, which partially or even fully offsets the initial increase in aggregate demand caused by higher government spending.
This phenomenon is referred to as the crowding-out effect, and it is more pronounced in economies where capital markets are relatively small or less open to foreign capital inflows. Although Singapore is less vulnerable to this due to its open capital account and strong fiscal reserves, other countries with high domestic borrowing needs may experience slower long-term growth as private sector dynamism is suppressed by public sector expansion.
Rising public debt and intergenerational burdens
Persistent fiscal imbalances, when financed by borrowing, naturally lead to a build-up of public debt. As debt levels rise, governments must allocate an increasing portion of their annual budgets to interest repayments on existing debt. This results in opportunity costs—resources used to service debt could have otherwise been spent on essential services such as healthcare, education, or social welfare.
In the long run, a heavily indebted government may face pressure to raise taxes or cut spending in vital areas. Raising taxes imposes a financial burden on future taxpayers, potentially reducing disposable income and dampening consumption. Alternatively, cutting social services can adversely affect the standard of living, especially for vulnerable groups who rely on government support.
Moreover, excessive public debt can lead to loss of investor confidence. Should markets perceive that a government is unable or unwilling to manage its debt burden, borrowing costs may spike as investors demand higher yields to compensate for rising risk. This can create a vicious cycle of worsening debt sustainability.
Risk of sovereign default and financial contagion
In extreme cases, prolonged fiscal imbalances can push a country into sovereign default—where the government fails to meet its debt obligations. This has far-reaching implications not only for the domestic economy but also for global financial markets, especially if the country in question is highly integrated into the international financial system.
A clear example of this was the Eurozone debt crisis in the early 2010s. Triggered by the Greek government’s inability to service its debt, the crisis spread across Europe, causing recessions in multiple economies and requiring large-scale bailouts from the European Central Bank and the International Monetary Fund. Investor confidence was shattered, bond yields surged, and austerity measures led to deep social unrest.
Defaulting on debt also damages a country’s credit rating and reputation, making future borrowing more expensive or even impossible without external assistance. It can also trigger capital flight, currency depreciation, and a collapse in domestic financial institutions holding large quantities of government bonds.
Conclusion
In summary, while fiscal imbalances may be necessary in the short run to cushion an economy during downturns—as seen during the COVID-19 pandemic—their prolonged persistence can cause significant macroeconomic challenges. These include demand-pull inflation, crowding out of private investment, rising public debt burdens, and in extreme scenarios, the risk of sovereign default.
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