fiscal crisis

fiscal crisis, inability of the state to bridge a deficit between its expenditures and its tax revenues. Fiscal crises are characterized by a financial, economic, and technical dimension on the one hand and a political and social dimension on the other. The latter dimension tends to have the more important implication for governance, especially when a fiscal crisis necessitates painful and frequently simultaneous cuts in government expenditures and increases in taxes on individuals, households, and companies. A financial and economic crisis will tend to arise from a fiscal deficit if government debt levels contribute to a loss of market confidence in a national economy, reflected in turn in instability in currency and financial markets and stagnation in domestic output. A political and social crisis will tend to arise if both the fiscal deficit itself and the necessary corrective measure implemented to eliminate that deficit result in further losses of employment and output, falling living standards, and rising poverty.

The concept of a fiscal crisis first came to prominence in both developed and developing economies during the early 1970s, largely as a consequence of the breakdown of the Bretton Woods international economic order, the October 1973 Arab-Israeli war, and the resulting oil crisis. Those events combined to produce inflationary world energy and commodity prices, resulting in declining output and employment, and a simultaneous demand for higher government expenditure at a time of falling government revenues. The concept of a fiscal crisis of the state arose in relation to this fall in government revenues.

James O’Connor, a political economist influenced by Karl Marx, argued that the capitalist state was in crisis because of its need to fulfill two fundamental but contradictory functions, namely accumulation and legitimization. To promote profitable private capital accumulation, the state was required to finance expenditure on social capital—that is, investment in projects and services to enhance labour productivity, lower the reproduction costs of labour, and thereby increase the rate of profit. To promote legitimization, the state was required to finance expenditure on social expenses, notably on the welfare state, and thereby maintain social harmony among the workers and the unemployed. However, because of the private appropriation of profits, the capitalist state would experience a growing structural gap, or fiscal crisis, between its expenditures and revenues, which would lead in turn to an economic, social, and political crisis.

O’Connor asserted that the fiscal crisis of the state was actually a crisis of capitalism, for which the only lasting solution was socialism. Although the inflation and recession of the mid-1970s failed to deliver the downfall of capitalism, it did lead to a political crisis for the Keynesian social democratic welfare state. The increasing incidence of budget deficits became associated with the idea that government had become overloaded, that full employment was not a legitimate objective of macroeconomic policy, that the state had become unduly influenced by powerful interest groups, notably trade unions in the public sector, and that society had become ungovernable. The corrective action proposed was that the role of the public domain of the state should be rolled back, to thereby reduce the popular expectations on government, and the role of the private domain rolled forward, to enhance economic freedom and unleash the creative energy of the entrepreneur.

This ideological assault on big government was led by Margaret Thatcher in the United Kingdom and Ronald Reagan in the United States. Such thinking was given powerful credence by the fiscal crises and growing economic and political instability experienced in several major industrialized economies. This was most evident in the United Kingdom when, in September 1976, Chancellor of the Exchequer Denis Healey announced his application to the International Monetary Fund (IMF) for $3.9 billion, the largest credit that had been extended by the IMF. The conditionality that accompanied the IMF loan demanded cuts in government spending of £1 billion in 1977–78 and £1.5 billion in 1978–79 and the sale of £500 million of state assets to redress the fiscal crisis that had arisen largely as a consequence of the 12.5 percent real terms increase in government spending that had occurred in 1974–75.

In the subsequent era of increasingly liberalized financial markets, the consequences of fiscal crises for national economies, and their investors and creditors, including the IMF, have been even more severe, especially when government debt has been denominated in foreign currency and held by overseas investors, who in turn operate in volatile market conditions. When a fiscal crisis has combined with a currency crisis to create a systemic financial crisis, the consequences have been devastating. In Argentina, for example, weaknesses in fiscal policy and three years of recession led to the ratio of government debt to gross domestic product (GDP) increasing from 37.7 percent at the end of 1997 to 62 percent at the end of 2001. Despite the provision of no fewer than five successive IMF financing arrangements totaling $22 billion, and $39 billion of additional official and private finance, the loss of market confidence in the Argentine peso in January 2002 was so severe that, having been pegged at parity against the dollar since 1991, the peso’s convertibility regime collapsed. Argentina defaulted on its sovereign debt, the economy contracted by 11 percent in 2002, unemployment rose higher than 20 percent, and the incidence of poverty increased dramatically. To avoid the risk of further expensive and destabilizing fiscal crises, the World Bank and IMF have built an extensive framework of best practice and transparency in fiscal policy into their frameworks for good governance in general and public-sector governance in particular.