Introduction
A country's fiscal position is determined by the balance between government revenues and expenditures. Revenues come from taxes such as income tax, value-added tax, corporate tax and excise duties, along with non-tax revenues such as returns from sovereign investments. Expenditure covers public goods like national defence, merit goods like education and healthcare, transfer payments, infrastructure and public sector wages. When expenditure consistently exceeds revenue, the government runs a budget deficit, and if this persists it results in a fiscal imbalance. Such imbalances are common during economic distress, as in 2020, but if left unchecked over time they can have serious macroeconomic consequences.
Demand-pull inflation
A short-term effect of fiscal imbalances can be demand-pull inflation, particularly when driven by large-scale expansionary fiscal policy. Governments may implement stimulus during downturns through tax cuts, direct cash transfers or large public infrastructure projects. An increase in government spending shifts the aggregate demand curve rightward, leading to a multiplied increase in real national income through the Keynesian multiplier, raising growth and reducing cyclical unemployment as firms hire more.
However, if fiscal support is not carefully withdrawn once the economy nears full employment, further increases in AD result in overheating. As the output gap closes, any additional demand translates mostly into higher prices rather than output. This was observed in the United States in 2022, where continued fiscal support after the worst of the pandemic contributed to a surge in inflationary pressures. Expansionary fiscal policy is therefore effective against recession but can fuel inflation if poorly timed or scaled.
The crowding-out effect
Fiscal imbalances may also have unintended consequences for private investment, especially when financed through borrowing. When the government borrows heavily from domestic financial markets to fund its deficit, it competes with private firms for a limited pool of loanable funds, which can raise interest rates. Based on the marginal efficiency of investment, higher interest rates reduce the profitability of investment projects, particularly for firms sensitive to the cost of capital, causing a fall in private investment that partially or fully offsets the initial rise in aggregate demand. This crowding-out effect is more pronounced where capital markets are small or less open to foreign inflows. Singapore is less vulnerable given its open capital account and strong reserves, but other countries with high domestic borrowing needs may see slower long-term growth as private dynamism is suppressed.
Rising public debt and intergenerational burdens
Persistent fiscal imbalances financed by borrowing lead to a build-up of public debt. As debt rises, governments must allocate an increasing share of their budgets to interest repayments, an opportunity cost since those resources could fund healthcare, education or welfare. In the long run a heavily indebted government may be pressured to raise taxes, burdening future taxpayers and dampening consumption, or to cut social services, harming living standards for vulnerable groups. Excessive debt can also erode investor confidence; if markets doubt a government's ability to manage its debt, borrowing costs may spike, creating 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, with far-reaching implications domestically and globally. The Eurozone debt crisis of the early 2010s, triggered by the Greek government's inability to service its debt, spread across Europe, causing recessions and requiring large-scale bailouts from the European Central Bank and the International Monetary Fund. Investor confidence collapsed, bond yields surged and austerity caused social unrest. Default also damages a country's credit rating, making future borrowing more expensive, and can trigger capital flight, currency depreciation and a collapse of domestic institutions holding government bonds.
Conclusion
While fiscal imbalances may be necessary in the short run to cushion an economy during downturns, as during the pandemic, their prolonged persistence can cause significant challenges, including demand-pull inflation, crowding out of private investment, rising public debt burdens and, in extreme scenarios, the risk of sovereign default.