What are the consequences of fiscal imbalances?

If public sector finances are not well managed, public programmes are disrupted or could be terminated, and the economy suffers because of a misallocation of resources and misguided use of incentives. We would call this a fiscal imbalance and the consequences can be quite detrimental. If, for example, a public sector entity cannot repay its debts because of lack of cash, then its managers will have to make hard choices, such as cutting costs or selling assets. But these measures only help in the short term. In the long term, they undermine the capacity of the entity to deliver public programmes.

It depends on particular circumstances. One option might be to substitute short-term debts with long-term debts, possibly with some negotiation with the creditors. If short-term debts are just repaid while making new short-term debts, managers are just kicking the can down the road, but they will have to come to a point when they repay their creditors sooner or later.

The consequences of fiscal imbalances are no less serious for countries than they are for public sector organisations. When public debt is high, governments need to raise cash from tax revenues and other income sources to fulfil their payments. Taxation, however, may reduce private spending for consumption and investments, with a depressing effect on the economy. This is especially the case if foreign investors own public debt, because money flows outside of the country. Sometimes, increased taxation may even result in a reduction of tax revenues, because taxes are levied on a shrinking economy.

It is possible that a government could go bankrupt if it defaults on its debt. In the 16th century, Philip II of Spain defaulted on debt four times in the face of rising military costs and the declining value of gold. In recent decades financial crises and defaults have occurred in countries such as Mexico in 1982, Thailand in 1997, Russia in 1998, Argentina in 2001, and more recently, Greece. So how do you define exactly when a country defaults? In practical terms, this is what happens when a country government that cannot repay its debts and seeks an agreement with the creditors to convert short-term debts into longer term ones, and possibly to cancel part of the outstanding debts.