Twin Deficits

1

TwinDeficits

TwinDeficits

Fromtime to time, most economies are faced with a situation where theyhave a current account deficit as well as a fiscal deficit/budgetdeficit. This is what is commonly referred to as experiencing “twindeficits.” For many years especially after the year 2000, theUnited States has found itself in this cluster. Under normalcircumstances, a fiscal and current account surpluses are consideredideal. However, as some economists will agree the state of theeconomy, the cycle, rates of employment, and other major economicindicators should be the ones to determine whether a deficit orsurplus of the current account or budget is beneficial to theeconomy. For instance, if a certain economy is undergoing recession,running a fiscal and current account deficit might be the bestsolution to spearhead economic growth and productivity. China may beseen as a country that has a long history of twin surpluses. However,the net private savings, a crucial component of a country’sstability is very low. Thus, before appraising or criticizing asurplus or deficit it is important to look at other macroeconomicfactors that greatly affect the operations of the entire economy.

Understandingthe “Twin Deficit” concept

BudgetDeficit

Despitebeing described as twins, each part of the deficit is unique from theother. Concisely, a fiscal/budget deficit arises when the country’sexpenses exceed the revenues in a specific financial year. Thus, thisyear’s deficit is equal to the deficit accumulated from the lastyear plus the deficit realized in the current year. This can berepresented as Dt= (1+r) Dt-1+Gt-Tt, where Dt=current deficit, (1+r)Dt-1=last year’s deficit, Gt=this year’s government spending, andTt= this year’s tax revenue. From simple economics, it is wellknown that spending more than one can spend leads to financialtroubles, debts, and poverty. This should be no different if agovernment does the same. However, the government works differentlyand thus under certain conditions spending more than they do producemay cause the country to experience positive gains. Governments canissue bonds to finance their deficits and buy them back in times ofsurplus. In addition, government monopoly to levy taxes on householdsand businesses also gives them a predictable way of making moneymaking it easy for investors to loan money to governments whencompared to businesses and private citizens.

CurrentAccount Deficit

Acountry is said to run a current account deficit when its imports agreater number of goods and services then it exports within a certainfinancial year. This is represented as CA= (X-M) +NY + NCT, where CAis the current account balance, X represents exports, M denotesimports, NY represents net income from abroad, and NCT represents thenet current transfers. Just as is the case with budget deficits,running a current account deficit is not perceived to be good.Current account deficits leads to increase in interest rates asinterest must be paid for the loans acquired. Because exportingnations can apply political and financial pressure on the importingcountries, this can lead to adverse repercussions on nationalsecurity, politics, and financial position of a country. However,when a country imports more industrial goods rather than consumergoods, or if it is on a temporary basis, then the country can expectbetter returns in future. Additionally, if the imports are raw goodsor semi-processed goods that will be processed and later exportedthen there is no reason to worry. This is because finished ormanufactured goods usually attract higher prices in internationalmarkets than semi-processed and raw goods.

TwinDeficit Theory

Afew financial specialists trust that an extensive budget deficitcorresponds to a big current account deficit. This macroeconomichypothesis is known as the twin deficit theory. The rationale behindthe hypothesis is that tax reductions, which decrease revenueincreasing the deficit, result in expanded consumption as citizensspend the excess cash. This increased spending leads to a reductionof national savings and increased borrowing. On occasion, monetaryinformation underpins the twin deficit theory and at other times, itdoes not. Thus, let us look at the case of United States.

Casestudy: The case of United States

TheUnited States is not only the world’s most powerful economy butalso the world’s largest economy. United States citizens earn themost amount of money based on per capita income than any othereconomy in the world (US bureau of economic analysis). However, forsome time now since the early 2000s, the country has been faced withan increasing current account deficit as well as an increasing budgetdeficit.

Sincethe year 2002, the United States has seen the rise of twindeficits—meaning, a developing budget deficit alongside adeveloping current account deficit, which translates to expandingU.S. borrowings from overseas. To a few examiners, this circumstanceappears to be exceptionally to those of the mid 1980s. In theprevious version, there were huge tax cuts implemented by thegovernment but they were not matched with similar cuts in governmentexpenditure. This is also similar to what happened in the countrybetween 1981 and 1986, where the United States budget deficit rosefrom 2.5% of the gross GDP to around 5% of GDP. At the same time, thecurrent account went from being at par to a deficit of 3.3% of GDP(Soyoung &amp Roubini, 2004). Similarly, in 2001, the duty rate cutsthat were introduced were not met with similar spending cults causingthe deficit to rise to 3.5% of GDP while the current account deficitincreased from around 4% of GDP to around 6 % of GDP by 2004.

Standardmonetary hypothesis would not find either circumstance astounding.Ceteris paribus, a budget deficit suggests diminishing nationalsavings, which is the aggregate of private savings and fiscalbalances. Under normal circumstances, when savings fall below therate of domestic investment, then the current account is in deficit.Obviously, other factors are not always constant and thus a currentaccount deficit must not always emerge. Several factors determine howbudget deficits affect and to what degree do they influence currentaccount balances. However, this analysis will look at the otherfactors that may affect the relationship between budget deficit andcurrent account deficit.

TheUnited States maintained a surplus current account for many yearsuntil the 1980s while the country was still making significant fiscaldeficits. For the biggest part, the United States data does notindicate that the country’s fiscal deficit was a precursor tocurrent account deficits. Thus, it would be better to conclude thatin order for the fiscal budget to be a precursor to current accountdeficits, and then most probably there are other factors that must bein existence. The table below summarizes the current account deficitand the budget deficit from 1952 to 2014.

Table1: comparison of current account deficit and budget deficit balancesof the United States between 1952 and 2014.

(Seeattached excel)

Fromthe table above it is clear that before the 1980s the United Stateshad a relatively stable budget and current account balance. In fact,it was not until 1988 that the United States recorded its firstcurrent account deficit since 1952. Surprisingly it was not until1982 that the government fiscal deficit surpassed the 100 billionmark since 1982. This is an indication that current account deficitsare not necessarily correlated to budget deficits.

Evidence

Toproof this, a regression analysis was conducted for United Stateshistorical data between current account deficit as the dependentvariable and budget deficit, net private investments, and netgovernment savings as the independent variables for the years between1952 and 2014. The data used was annual non-seasonally adjusted forthe years mentioned above. The table below represents thisinformation.

Table showing current account deficit, budget deficit, net private savings, and net government savings in billions of dollars

year

CA surplus/deficit

budget surplus/deficit

net private savings

net government savings

1952

0.0

0

39.5

-0.3

1953

0.0

-5.3

40.4

-1.9

1954

0.0

-0.2

40.7

-6

1955

0.0

-2.7

45.9

1.6

1956

0.0

4.5

51.1

4.4

1957

0.0

2.1

52.9

0

1958

0.0

-1.6

52.2

-10.9

1959

0.2

-13.1

56.4

-1.7

1960

0.6

0.7

56.4

2.8

1961

0.9

-2.3

63.5

-2.5

1962

0.9

-5.8

71.3

-1.9

1963

0.8

-4

74.6

1.6

1964

0.7

-4.8

86.2

-2.6

1965

0.8

-2.7

96.3

-1.4

1966

1.0

-3.3

102.9

-1.8

1967

1.3

-1.5

111.7

-14.8

1968

1.2

-25.2

110.7

-9.5

1969

1.1

3.2

109.2

-1

1970

1.8

-2.8

123.2

-31.8

1971

2.7

-23

147.5

-50.2

1972

2.6

-23.2

157.2

-40.5

1973

2.7

-14.3

185.3

-28

1974

3.6

-3.5

181.4

-38.3

1975

3.8

-43.6

213.3

-102.5

1976

3.8

-65.6

217.3

-77.1

1977

3.3

-45

234.7

-63.5

1978

3.4

-48.8

269.5

-46.4

1979

2.4

-27.3

279

-36.3

1980

3.4

-59

285.5

-80.9

1981

3.3

-57.9

341.9

-81.7

1982

2.0

-110.7

363.3

-169.7

1983

1.9

-195.4

362.7

-203.7

1984

2.5

-178.2

461.6

-171.4

1985

2.2

-203.2

422.7

-175.4

1986

0.6

-221.1

377.9

-192.2

1987

0.4

-148.4

375.3

-151.1

1988

-0.4

-154.3

438.1

-140.4

1989

-1.8

-153.3

426.7

-149.2

1990

2.1

-220.5

438.1

-207.4

1991

-0.9

-269.5

498.1

-271.3

1992

-2.9

-290.3

563.1

-370.2

1993

-5.2

-254.6

513.3

-349

1994

-3.4

-203.2

524.2

-280.7

1995

-5.5

-164

579.2

-272.4

1996

-4.2

-107.4

596.3

-191

1997

-6.2

-21.9

633.1

-89.5

1998

-7.4

69.3

604

18.1

1999

-7.6

125.6

526.8

75.9

2000

-6.5

236.2

439.1

166.4

2001

-1.9

128.2

515.3

-50.8

2002

-5.8

-157.8

719.9

-391.4

2003

-6.8

-377.6

788.2

-524.3

2004

-6.2

-412.7

822.6

-507.6

2005

-0.8

-318.3

727.9

-371.3

2006

-1.4

-248.2

778.5

-266.4

2007

-2.5

-160.7

574.4

-338.4

2008

-1.0

-458.5

704.1

-799

2009

-1.1

-1412.7

1220.3

-1520.8

2010

1.6

-1294.4

1441.9

-1566

2011

7.1

-1299.6

1444

-1460.1

2012

7.8

-1087

1637.9

-1310.8

2013

11.8

-679.5

1234.4

-828

2014

9.8

-484.6

1319.2

-799.2

Asobserved above, the table shows that although in some years budgetdeficits have been accompanied by current account deficits, for mostof the years especially between 1952 and 1988 this was not true forthe United States. To prove this a regression analysis was done andthe results proved that historical data does not support the notionthat budget deficits are accompanied by current account deficits. Theexcel regression output is presented below.

SUMMARY OUTPUT

Regression Statistics

Multiple R

0.37751

R Square

0.142514

Adjusted R Square

0.098913

Standard Error

3.656368

Observations

63

ANOVA

&nbsp

df

SS

MS

F

Significance F

Regression

3

131.0934

43.6978

3.268585

0.027404

Residual

59

788.7726

13.36903

Total

62

919.866

&nbsp

&nbsp

&nbsp

&nbsp

Coefficients

Standard Error

t Stat

P-value

Lower 95%

Upper 95%

Lower 95.0%

Upper 95.0%

Intercept

0.733197

0.799233

0.917376

0.362681

-0.86606

2.332458

-0.86606

2.332458

budget surplus/deficit

-0.01058

0.008565

-1.23469

0.221839

-0.02771

0.006564

-0.02771

0.006564

net private savings

-0.00395

0.002895

-1.36617

0.177069

-0.00975

0.001838

-0.00975

0.001838

net government savings

0.002841

0.008684

0.327138

0.744722

-0.01454

0.020216

-0.01454

0.020216

Fromthe regression, output it is clear that R squared is 0.145. This isan indication that only 14.5% of the observations between 1952 and2014 support the claim that budget deficits cause current accountdeficits. The results cannot be ruled out at this time because it isclear that the Significance of F for this analysis is way below thethreshold of 0.05. In our case, it is 0.027. Thus if we were torepresent this information as an equation then we could have thefollowing:

CA=0.733-0.01budget deficit-0.04 net private savings +0.03 net government savings.To see the interrelationships between the dependent and independentvariables a correlation analysis was done.

Thecorrelation coefficients are presented below.

&nbsp

current account surplus/deficit

budget surplus/deficit

net private savings

net government savings

current account surplus/deficit

1

budget surplus/deficit

-0.28572

1

net private savings

0.112885

-0.847538709

1

net government savings

-0.24811

0.983769276

-0.893621733

1

Fromthe table above it is clear that the current account surplus/deficitis almost in no way related to the independent variables. Thus, otherfactors influence the relationship between current account deficitsand fiscal deficits. However, it is important to note that thegovernment deficit is highly negatively related to net privatesavings. At an index of -0.85, this is an indication that whenever agovernment is running a fiscal surplus net private savings plummets.One of the reasons this might be so is if the excess fiscal balancesis because of imposition of high taxes. Whenever households are taxedhighly, then their propensity to save diminishes.

Anotherobservation worth mentioning from the correlation is that the budgetsurplus/deficit is highly correlated to net government savings. At anindex of 0.98, this can be taken to mean that almost the entireamount that the government realizes as fiscal surpluses goes directlyinto savings. The last but not least observation that needs to bemade from this correlation analysis is that net private savings arealmost a hundred percent negatively correlated to net governmentsavings. This is an indication that the government and householdshave a negative relationship in that whenever governments make moremoney, it is probably the households that are being taxed and whenthe government runs losses it is probably because it is reducingtaxes. Thus, it is important to understand what relationship existsbetween current account deficits and budget deficits. From the datatable it was clear that for some years for instance between 2002 and2009, fiscal deficits were accompanied by current account deficits.

Thetruth behind double deficits

A1995 study by Marianne Baxter provides an excellent view of the caseof twin-ness of the current account and fiscal deficits. Using amodel economy with two fiscal policies, Baxter showed that this couldlead to worsening of the fiscal deficit (Baxter, 1995). In one case,Baxter takes a fiscal policy that increases government expenditurewithout increasing taxation and in the other a fiscal policy loweringcapital tax and labor rates without reducing government expenditure.Under both fiscal policies, Baxter found that the increase ingovernment deficit was equivalent to 1% but the resultingdeterioration in the current account deficit was around 0.5% of GDP(Baxter, 1995).

Aregression of the current account balance on the fiscal deficit failsto factor in other developments that affect investments, imports, andbalance of payments. For instance, supposing a fiscal policyinvolving increase in government spending. When this happens,households anticipate increases in interest rates and thus they willchoose to save and accumulate wealth.

Thiscan be done either by increasing the number of working hours or byreducing their spending activities. If households choose to work formore hours, then the capital stock becomes more productive leading tomore private investments. Increasing private investments leads to adecline in private savings. This in the long run leads to an increasein the current account deficit as households continue to spend more.

Inthe second case, if the government chooses to reduce labor andcapital tax rates, then people choose increase the number of workinghours to take advantage of these reduced rates. As a resultproductivity and output increases. This can also lead to adeterioration of the current account because of the increasedinvestment. Otherwise if the household sector chooses another paththen the current account balance will improve (Kim and Roubini,2008).

Whythe twins go in divergent ways most of the time

Whengovernment deficits increase, private investments and outputincreases. As this happens, the government realizes more revenuesfrom tax receipts form economic activities. In addition, theincreased growth creates more job opportunities meaning that thegovernment’s expenditure reduces because the transfer payments forunemployment benefits go down. This in effect causes the fiscalbalance to improve.

Anotherinteresting scenario is that as we saw in the correlation analysis,when government deficits increase, private savings also increase. Byincreasing private savings, households and businesses may choose toreduce their spending especially on imported goods, which tend tobecome more expensive as the currency deteriorates. This reduction inconsumption of imported goods will result in an improvement in thecurrent account balance, as businesses will become more productiveand export more goods as their exports become relatively cheaperoverseas. These two scenarios will work in an opposite direction tothe fiscal deficit. This is why sometimes-fiscal deficits are mostlyaccompanied by current account surpluses. However, it is important tonote that the current account is a part of the balance of paymentsaccount. Fortunately, it accounts for the largest share and thus hasmore potential to direct the movement of the entire balance ofpayments account.

Anotherdimension that theory failed to factor in is an increase in fiscaldeficit that is attributable to increases in nontradable laborservices. These may include health, national defense, education, andwage costs. When the deficit is attributable to such factors, it hasa less likelihood of affecting the current account balance as whenattributable to increase in expenditure on tradable goods (Cavallo,2005).

Conclusion

Thispaper explores the hypothesis that government deficits cause currentaccount deficits, to find out whether this hypothesis is true orfalse. However, as the study analysis has proved, fiscal deficits donot necessarily cause current account deficits. From our regressionanalysis we found out that fiscal deficits account for at least 14%of the current account deficit. Thus, as the paper has suggestedother factors such as exchange rates, productive capacity, balance oftrade, and business cycles have more weight in determining thecurrent account deficit.

Asthe paper suggests the relationship between the twin deficits isdifficult to comprehend. Although contemporary economic theory tendsto suggest that the two deficits happen together, the analysis donetends to suggest otherwise. However, we can agree that at times thetwo can run in parallel although this does not necessarily mean thatone causes the other. It could just be that other factors such as netprivate savings, and net government savings affect them in such a waythat they may seem to go in unison.

References

Baxter,M. (1995). International Trade and Business Cycles. In Handbookof International EconomicsVol. 3, eds. Gene M. Grossman and Kenneth Rogoff, pp. 1801-1864.Amsterdam: North-Holland.

Cavallo,M. (2005).GovernmentConsumption Expenditures and the Current Account. FRBSF Working Paper[PDF]

Soyoung,K &amp Roubini, N. (2004). or Twin Divergence? FiscalPolicy, Current Account, and Real Exchange Rate in the U.S. Mimeo,Korea University and New York University.