Impact of the Twin Deficit Effect on the US Economy
Posted: August 25th, 2021
Impact of the Twin Deficit Effect on the US Economy
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ABSTRACT
This study strives to explore theinfluence of the Twin Deficit Effect on the US Economy.The hypothesis of twin deficit began in the U.S in 1980.Fiscal and current account deficits are of much concern for many U.Seconomists’. Higher budgetary and current account deficits can hinder foreign investors from investing in a country with deficits. Countless studies investigate the relationship between the budget deficit and the current account deficit for specific periods.Researchers argue that if spending exceeds revenue, there would be a budget deficit causing a decrease in national saving. The study employed model specification and estimation methodology to investigate the fiscal and current account deficit’s effects on the U.S. economy. The findings of the study show that the decrease in taxesraises the budgetary deficit, which eventually leads to an increase in the current account deficit with a reduction in government revenue and higher expenditures.The government should be prepared to mitigate these deficits by implementing reforms characterized by increased tax and reduced expenses. Through these reforms, the net export will improve, thus reducing the twin deficit and boost economic growth.This paper aims to investigate the correlation between fiscal and current account deficits and the effect on economic growth, with the US as a case study.
Table of Contents
Impact of the Twin Deficit Effect on the US Economy. 3
Empirical Results and Discussions. 11
Appendix B: Regression Results. 16
Impact of the Twin Deficit Effect on the US Economy
Introduction
The result of fiscal and current account deficits in economic growth and development cannot be ignored in contemporary society where countries are increasingly engaging in international trade. For this reason, the correlation between fiscal and current account deficits and their impacts on the economy has become a significant concern for most economists and policymakers. In recent years, the topic has received much global attention simply because rising fiscal and current account deficits can result in detrimental effects not only for a country but also for other foreign nations that engage with the former in international trade (Mendoza et al., 2007). Higher deficits can hinder prospective foreign investors from investing in a country due to the gloomy picture which such economic phenomena always create (Islam, 1998). The study targets at investigating the impact that the twin effect has on the United States economy. This is divided into four main sections, whereby, the first section looks at the literary works that have been done in the area, which is assessed and linked to the objectives of the paper, the second part examines on the appropriate methodologies that were applied in getting the main ideas that support the argument of the paper, and the final part examines the empirical studies over the same topic. Results and discussions are made in the fourth section of the paper, which reviews the research and concludes on the paper.
Purpose of the Study
The study aims at investigating the correlation between fiscal and current account deficits and the effect on economic growth, with the U.S. as a case study. The paper uses data on U.S current account deficits, the gross domestic product (GDP), and fiscal deficits to examine the objectives of the study.
Problem Statement
There is no doubt that the presence of a twin deficit effect can adversely hurt the performance of any economy, and the U.S. economy is not an exception. Therefore, the study seeks to expound on understanding its impact on the economy, which critically serves to provide a guide for the government to be ready to implement both fiscal and monetary reforms characterized by increased tax and interest rates coupled with reduced expenditure to mitigate the effect associated with the twin deficit on the economy. As such, the net export is likely to improve, thus reducing the current account deficit, and consequently enhancing economic growth and development.
Literature Review
This section of the study conducts a review of the existing literature related to the topic of discussion, that is, the relationship between fiscal and current account deficits and the impact on the economy.
The U.S. is one of the developed nations whose fiscal and current account deficits are of much concern not only to its citizens and policymakers but also to other countries across the globe due to its economic dominance in the global market (Mendoza, Quadrini and Rios-Rull, 2007). Since 2009, there have been numerous economic reforms that have been undertaken by the U.S. government to help stabilize and increase the country’s growth rate. Besides its growing service sector, the country is a significant player in the global manufacturing industry. According to history, the U.S is one of the best trading and investment destinations in the world (Bachman, 1992). However, this has not been the case after the 2008-2009 global recession, which had significant detrimental effects on the U.S. economy. Since 2002, the U.S. has experienced a resurgence of twin deficits, that is, a growing current deficit along with an increasing budget deficit, which explains the current increase in its national debt. According to De Castro and Garrote (2015), the impact of the twin deficit effect can be traced back to early 1980 during the reign of president Regan. During this period, the government significantly lowered the tax rate to spur economic growth, but these changes did not match the spending rates in the country. As a result, the budget deficit of the U.S. increased from 2.49% to 4.97% of GDP between 1981 and 1986. During the same period, the current account was slightly in the balance of 3.27% of the GDP.
Similarly, the government made the same economic move in 2001 by creating a tax rate cut that was not compatible with the country’s spending demand. Consequentially, the government’s budget experienced a deficit of 3.49% of GDP in 2004. The current account was also inflated from 3.76% in 2001 to 5.69% of the GDP in 2004. A situation where budget deficit affects the current account deficit is not surprising in standard economic theory.
De Castro and Garrote argue that budget deficit occurs when the spending exceeds revenue, thereby decreasing the national saving, which is the sum of private and public saving. By definition, when the domestic investments exceed the national saving, that is, when the country is deemed to be in a financial quagmire because of the availability of insufficient funds to finance its domestic investments, thus forcing the government to borrow money from abroad leading to a rise in the current account deficit.
A study by Blecker (2016) provides a good illustration of the relationship between the current account and the budget deficits. In his work, Blecker explores the economic consequences of two fiscal policies that can adversely affect the fiscal deficit. First, he investigates an increase in government expenditure that does not correspond to the rise in government tax revenues. Secondly, he examines a reduction in labor and the capital tax rate that is not compatible with a decrease in government expenditure. Blecker argues that in both policies, an increase in the budget deficit will always translate into about 1% of Gross Domestic Product (GDP) in the short-run, but the value decreases to zero in the long-run. Blecker’s investigation indicates that an increase in fiscal deficit deteriorates the current account balance by about 0.5% of Gross Domestic Product (GDP), hence showing a positive relationship between financial and current account deficits. Economically, there are several reasons for the deterioration in the current account balance in each fiscal policy the government undertakes. In the event of an increase in the budgetary deficit, there is anticipation by the citizens that the government will raise taxes in the future to reduce the financial gap and offset its foreign debts (Karras, 2019). To compensate for the expected future increase in taxes, the citizens tend to accumulate wealth by increasing their savings. They can accumulate wealth by spending less, increasing their working hours, or taking extra jobs. These adjustments made by the citizens create a productive capital stock that attracts domestic investments by private individuals or institutions. The increase in private investments partially offsets the increase in private savings (Abbas et al., 2011). Therefore, the current account balance depreciates in response to the depreciation of the fiscal balance.
Secondly, consider the policy based on persistent reduction in labor tax rates and capital. When the government cuts the tax rates, people tend to increase their working hours to take advantage of the low taxes levied on their salaries (Magazzino, 2017). Tax reduction also encourages private investment. With an increase in working hours among the citizens and an increase in private placements, the output and productivity of capital are likely to increase. As a result, therefore, the initial reduction in tax receipts is mitigated, and the current account deteriorates.
Although the theory shows that the current account and the deficit account should always move together, there are instances where they follow a divergent path. The reason for the divergence can be due to the impact of output fluctuation on budget and current account deficit. (Volcker, 1987). For example, if the economy increases its productivity, there will be an automatic expansion of its economic activities. Increase economic activities attract more private investors into the country. When investors invest in the country, their investment expenditures benefit the economy more than private savings, thereby causing the current balance to deteriorate.
Additionally, the output expansion not only increases the tax revenue but also helps in reducing government expenditure (Anoruo and Elike, 2008). However, when the government reduces its costs, budget balance in the country improves.
Empirical Review
Empirical studies that have been conducted to test the relationship between fiscal and current account deficit on economic growth (twin deficit effect) have produced different results. While some studies have proven that there is a positive correlation between fiscal and current account deficits, which results in a sluggish economic growth rate. Others have found unidirectional (one-way) casualty between the three variables, which run from fiscal to current account deficits or from current account deficits to budgetary deficits. However, these differences can be attributed to the difference in country specificity, methodology, and sample size used by researchers in their previous studies.
Methodology
In this section of the research, the paper describes the empirical method that was employed in analyzing the data. The division comprises of two main sub-sections: the model specification and estimation strategy.
Model Specification
The equation below was used to investigate the long-term effect of fiscal and current account deficits in the U.S. economy.
The 2.6 equation can be rewritten in the form:
CA= (Sp-1) +FD……………………………………………………………………… (3.1)
Where F.D. is the fiscal deficit which is expressed as T-G-R
However, economic theory stipulates that a country’s private saving Sp is a function of the household disposable income available for expenditure and the interest rate. Also, the domestic investment I am always influenced by the interest rate r. Based on these two theories, the previous equation 3.1 can be expressed as follows;
CA= [(Sp(y, r)-I(r)) +FD]………………………………………………………………….. (3.2)
The above equation can further be simplified as CA=f(y, r, F.D.)……………………..….. (3.3)
Hence, the estimable econometric model for this research can be expressed as CA=a1+a2y+a3r+a4FD+E…………………………………………………… (3.4)
Theoretical Framework
The twin effect hypothesis, also known as the twin deficit hypothesis (TDefH), was first developed in the 1980s to explain the current account in the U.S. (Abell, 1990). The development of the thesis came after a period of excessive fiscal expansion that was undertaken by the U.S. government during President Reagan. These monetary expansion reforms resulted in a series of negative economic implications such as dollar depreciation coupled with increased current account deficits. Theoretically, the analysis of the twin effect was derived from the understanding of the relationship between fiscal and current account deficits which were based on the national income identity (NII) given as follows:
Y=C+I+G+X-M…………………………………………………………………………. (2.1)
Where Y= Gross domestic product or output
C=Consumption expenditure
I= Investment expenditure
G=Government expenditure
X=Total export
M=Total import
On the other hand, the current account (C.A.) is expressed as:
CA=X-M+NF
Where NF is the net factor income from abroad, which is the difference between a country’s income receipts from abroad and the payments sent overseas. By introducing the national saving function as a dependent variable of the current account; then
S=I+CA…………………………………………………………………………………… (2.3)
However, S (saving) can be classified as either private saving (S.P.) or government saving (sg), where Sp becomes the part of consumers’ income left after paying taxes (T) and financing their expenditures.
Hence, Sp can be expressed as Sp=Y-T-C.
Sg refers to the difference between public revenue received from taxes, the amount used in financing public goods and services (G), and transfers (R). It can be expressed as Sg=T-G-R.
With Sp and Sg being the components of saving (S), the S function can be written as:
S=Sp+Sg=Y-T-C+ (T-G-R) =I+CA………………………………………………………. (2.4)
Equation (2.4) can also be illustrated as;
Sp+ (T-G-R) =I+CA………………………………………………………………………. (2.5)
By making C.A., the subject, the equation can be expressed as;
CA=Sp-I+ (T-GR)……………………………………………………………………… (2.6)
The above comparison shows that the current account depends on a country’s saving function, which is represented by the difference between private saving and investment and the fiscal deficit, which is represented by the difference between private saving and finance as well as the difference between government’s revenue.
From equation (2.6), two possible inferences can be derived; first, what can be the outcome of assuming that the difference between public saving and investment are constant or stable after some time. If this is the case, then it means that the fluctuations on the fiscal side represented by (T-G-R) of the equation above would cause variations on the current account side, thus reaffirming the assertion by Abell on twin deficit effect hypothesis. The second inference is that the relationship between Sp and I may not necessarily be stable over time. In the case of this scenario, then the changes in the fiscal side of the above equation, that is (T-G-R), could be offset by changes in the difference between private saving and investment (Sp and I). In this scenario, both the twin deficit effect hypothesis will not hold. Such an outcome shows that the fluctuations in both the fiscal and the current account deficit are unrelated; hence, their consequences cannot be assumed to have a direct effect on economic growth.
Empirical Results and Discussions
Like other previous researches that have shown on the existence of the twin deficit effect hypothesis (TDefh), the regression analysis of the above data reveals a significant positive relationship between fiscal and current account deficits. The high results lend support to TDefH and explain that an increase in budgetary deficit increases the current account deficit. The outcome conforms to other previous research studies, which have also shown that there is a direct correlation between fiscal deficit and current account deficit; hence, any increase in fiscal deficit triggers a corresponding increase in current account deficit. One probable reason for such occurrence was the decrease in taxes, which ultimately results in a decline in the number of revenues the government collects while its expenditure remains high.
With such a scenario, the economy will eventually experience a significant fiscal deficit because the revenues generated by the government from taxes cannot efficiently finance the proposed government expenditure, hence the budget deficit (Karras, 2019).). Even though the result showed the negative current account, showing a gap between export and import, such differences could be associated with overvaluation of the dollar currency, which resulted in the U.S. exports being expensive while the imports being cheap. Since price is a significant determinant of the quantities of goods and services demanded, the affordability of the imported products in comparison to the country’s exports means that most consumers in the country would show preference to the imported products, thus raising the amount sent abroad.
Higher prices of exports will mean that the demand for U.S. products in the global market will be low, and hence imports will be higher than exports translating into the current account deficit (Abbas et al., 2011). The result also shows the vital role of the interest rate on the existing account. The low-interest-rate in the country has a corresponding effect on the country’s current account deficit in two ways. First, the lower interest rates make it more attractive to borrow than to save. Heightened borrowing in the economy leads to increases in disposable income. Higher disposable earnings translate into higher consumer spending, thus leading to increased spending on imports, which further worsens the current account (Abell, 1990). Additionally, low interests increase the inflation rate in the country, making exports to be more expensive, thus increasing the current account.
Policy Implications
The findings of the study can provide valuable policy implications for the Federal Reserve and the US.There are several reasons for the deterioration in the current account balance in each fiscal policy the government undertakes. The government should, therefore, initiate reforms that can reduce the fiscal deficit. It should increase taxes as a way of limiting the amount of income its citizens spend on consumable products, including imports, while at the same time generating additional revenue to finance its expenditure, thus reducing the budget deficit.
Additionally, the government should increase the domestic interest rate to create a slight undervaluation of the local currency. This action will make imports a bit expensive while the exports will be more affordable. Hence, the net shipping will be positive, and the current account deficit will improve. An improvement in the existing account, coupled with a decrease in the fiscal deficit, will automatically propel the country’s economy to achieve a positive growth rate.
Conclusion
The paper aimed at investigating the correlation between fiscal and current account deficits to examine whether the twin deficit effect holds for the U.S. economy between the periods of 2008 – 2018. By employing the multiple regression analysis techniques, the findings of the study reveal that an increase in the country’s fiscal deficit worsens the current account deficits. Further evidence from the study shows that a decrease in the country’s domestic interest rate and real income of the years increased the current account deficit. To mitigate these effects, the government should initiate reforms that can reduce the twin deficit by raising taxes and lowering expenditures. Although the results of the study may support or contradict other previous studies on the above topic, its results should be applicable with some caution based on the fact that the sample data used.The twin deficit effect, therefore, has a corresponding impact on a country’s economic growth relatively small foran accurate and reliable result.
References
Abbas, S.M.A., Bouhga-Hagbe, J., Fatas, J., Mauro, P. and Velloso, R.C. (2011), “Fiscal Policy and Current Account,” IMF Economic Review, 59, 603-629.
Abell, J. D. (1990). Twin deficits during the 1980s: An empirical investigation. Journal of Macroeconomics, 12(1), 81–96. DOI: 10.1016/0164-0704(90)90057-h.
Anoruo, E. and Elike, U. (2008), “Asymmetric Dynamics in Current Account Interest rate Nexus: Evidence from Asian Countries,” Investment Management and Financial Innovations, 5(4):103-110
Bachman, D. D. (1992), “Why is the US Current Account Deficit so Large? Evidence from Vector Autoregressions”, Southern Economic Journal, 59:232-240.
Blecker, R. A. (2016). Beyond the Twin Deficits: A Trade Strategy for the 1990s: A Trade Strategy for the 1990s. Routledge.
De Castro, F., & Garrote, D. (2015). The effects of fiscal shocks on the exchange rate in the EMU and differences with the USA. Empirical Economics, 49(4), 1341-1365.
Islam, M. F. (1998). Brazils twin deficits: An empirical examination. Atlantic Economic Journal, 26(2), 121–128. DOI: 10.1007/bf02299354.
Karras, G. (2019). Are “twin deficits” asymmetric? Evidence on government budget and current account balances, 1870–2013. International Economics, 158, 12-24.
Magazzino, C. (2017). Twin Deficits or Ricardian Equivalence? Empirical Evidence in the APEC Countries. Asian Economic and Financial Review, 7(10), 959.
Mendoza, E. G., Quadrini, V. and Rios-Rull, J. V. (2007), “Financial Integration, Financial Deepness, and Global Imbalances,” National Bureau of Economic Research (NBER) Working Paper No. 12909.
Volcker, P. A. (1987). Facing up to the Twin Deficits. Challenge, 30(6), 31–36. DOI: 10.1080/05775132.1987.11471213.
Appendix
Appendix A: Data
| Year | Current Account deficit % change of the GDP | Real GDP growth rate % | Interest rate % | Fiscal deficit % change |
| 2008 | -4.1694 | -0.1365 | 2.17 | 185.3454 |
| 2009 | -45.3291 | -2.5367 | 0.50 | 208.0751 |
| 2010 | 15.7693 | 2.5637 | 0.73 | -8.3751 |
| 2011 | 3.3383 | 1.5508 | 0.75 | 0.4037 |
| 2012 | -4.2251 | 2.2495 | 0.75 | -17.1611 |
| 2013 | -18.2814 | 1.8420 | 0.75 | -36.8575 |
| 2014 | 4.7012 | 2.5259 | 0.75 | -28.6833 |
| 2015 | 11.6552 | 2.9080 | 0.77 | -8.8353 |
| 2016 | 5.0482 | 1.6378 | 1.02 | 32.2859 |
| 2017 | 2.6373 | 2.3698 | 1.63 | 13.8193 |
Table 1: US statistics (Federal Reserve Bank of St. Louis)
Appendix B: Regression Results
| Regression Statistics | ||||||||
| Multiple R | 0.935878 | |||||||
| R Square | 0.875867 | |||||||
| Adjusted R Square | 0.813801 | |||||||
| Standard Error | 7.598989 | |||||||
| Observations | 10 | |||||||
| ANOVA | ||||||||
| df | SS | MS | F | Significance F | ||||
| Regression | 3 | 2444.64 | 814.8801 | 14.11179 | 0.003984 | |||
| Residual | 6 | 346.4678 | 57.74463 | |||||
| Total | 9 | 2791.108 | ||||||
| Coefficients | Standard Error | t Stat | P-value | Lower 95% | Upper 95% | Lower 95.0% | ||
| Intercept | -38.431 | 8.571274 | -4.4837 | 0.004176 | -59.4042 | -17.4579 | -59.4042 | |
| X Variable 1 | 21.45547 | 5.795445 | 3.702127 | 0.010063 | 7.274527 | 35.63641 | 7.274527 | |
| X Variable 2 | -5.41869 | 8.022945 | -0.6754 | 0.524583 | -25.0501 | 14.21275 | -25.0501 | |
| X Variable 3 | 0.257003 | 0.116969 | 2.197186 | 0.070374 | -0.02921 | 0.543217 | -0.02921 |
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