Twin Deficits: Squaring Theory, Evidence and Common Sense

Abstract

In this paper we reconsider the twin deficit hypothesis (that fiscal shocks generating budget deficits also worsen external trade) both from a theoretical point of view and by analyzing data for Australia, Canada, the UK and the US. First, we assess the joint dynamics of budget and trade deficits along the business cycle, uncovering a strikingly recurrent S-shaped relation between the two. The correlation is actually negative, suggesting twin divergence. This observation however cannot rule out the possibility that government spending expansions and/or tax cuts may cause trade deficits, as the overall correlation is likely to be dominated by cyclical factors. Second, we reconsider the transmission of government spending in a standard two-country two-good model: we find that openness and the persistence of fiscal shocks are major determinants of the magnitude (or even sign) of the response of the trade balance to fiscal shocks. For a given persistence of the fiscal shock, the closer an economy, the larger the crowding out effect on investment, the lower the deterioration of the trade balance. Third, we take this insight to the data, investigating the transmission of fiscal shocks in a VAR framework in the four countries in our sample. Our empirical findings tend to support our view. In the US and Australia, which are relatively less open than Canada and the UK, and where government spending shocks are less persistent, we find that the external impact of fiscal policy is rather limited. Instead, private investment responds substantially. The reverse is true for Canada and the UK. These findings confirm and put into perspective earlier results, whereas fiscal expansions in the US are found to have on average a negligible effect on the country's trade balance. However, we emphasize that these results are consistent with a call for a US fiscal retrenchment to address global imbalances: the impact of budget cuts on the US external trade is muted by their positive effect on domestic investment, strengthening the US ability to generate resources against future interest and debt repayment.twin deficits, budget deficit, trade deficits, home-bias, openness, crowding out, international transmission of fiscal policy, current account adjustment, business cycle dynamics.