WHAT IS Fiscal Imbalance

Fiscal imbalance refers to a situation where all of the future debt obligations of a government are different from the future income streams. The obligations and the income streams are measured at their respective present values and will be discounted at the risk free rate plus a certain spread. Fiscal imbalances can occur for a government at any given time. If there is a sustained positive fiscal imbalance, then tax revenues will likely increase in the future, causing current and future household consumption to fall.

BREAKING DOWN Fiscal Imbalance

There are two main types of fiscal imbalance. A vertical fiscal imbalance describes a situation where revenues do not match expenditures for different levels of government. A horizontal imbalance describes a situation where revenues do not match expenditures for different regions of the country. Horizontal fiscal imbalances require equalization transfers, or payments to a state or province from the federal government to offset monetary imbalances between different parts of the country. A vertical fiscal imbalance is a structural issue and requires revenue and expenditure responsibilities to be reassigned.

A horizontal fiscal imbalance occurs when sub-national governments do not have the same capabilities in terms of raising funds from their tax bases and to provide certain services. This type of fiscal imbalance creates differences in net fiscal benefits, which are a combination of levels of taxation and public services. These benefits are also the root cause of horizontal fiscal differences that eventually require equalization payments.

Consequences of Fiscal Imbalance 

The Greek debt crisis had its origins in the fiscal profligacy, or wasteful and excessive expenditure, of previous governments. After Greece joined the European Community in 1981, its economy and finances were in good shape, but its financial situation deteriorated dramatically over the next 30 years. The populist Panhellenic Socialist Movement (PASOK) alternated in power with the New Democracy Party. In a continuing bid to keep their voters happy, both parties enacted liberal welfare policies that created an inefficient economy. As a result of low productivity, eroding competitiveness and rampant tax evasion, the government resorted to a massive debt binge to keep the party going. 

Greece's admission into the Eurozone in 2001 and its adoption of the euro made it much more easier for the government to borrow. Greek bond yields and interest rates declined sharply as they converged with those of strong European Union members like Germany. As a result, the Greek economy boomed, with real GDP growth averaged 3.9 percent per year between 2001 and 2008. 

However, the financial crisis of 2008-2009 caused investors and creditors to focus on the massive sovereign debt loads of the U.S. and Europe. With default a real possibility investors began demanding much higher yields for sovereign debt issued by Greece as compensation for this added risk. As Greece's economy contracted in the aftermath of the crisis, its debt-to-GDP ratio skyrocketed.