Study rationale
Continuous imbalances within the current financial account of several advanced as well as up coming economies has resulted to raised concern from the domestic as well as international financial markets as well as policymakers. Makin (2004) realized that in the deficit nations, including U.S, where current financial account deficits recently have reached 5 % of GDP, having trends towards protectionist measures like import restrictions as well as export subsidies.
Twin Deficit concept
Economic theory is conflicted regarding the true effects that the fiscal deficits have across an economy. One of the branches of the economic debate opposed to the growing deficits argues that the fiscal deficits might stimulate a trade deficit. Such a relationship is called twin deficit phenomenon. The theory of twin deficit postulates that the continued fiscal deficits lead to current financial account deficits. The claim has widely been debated in literature with many researches having a focus on its effects in developed economies.
Having had been 7 % of the disposable income, current account deficit that had shrunk with more than a half during President Clinton leadership exploded. The current account deficit refers to a country’s excess of the imports plus other available current expenses over exports plus other available current receipts. Now it is twice as huge, relative to the disposable income, as it used to be at its previous peak throughout the 1980s. During this time, the discussion nears hysterical level, with dire predictions regarding not only unbearable burdens for the future American generation, but also possible bankruptcy of the federal American government as well as the nation as a whole (Altman 2006). Additionally, Americans’ unquenchable appetite towards the world’s saving does not only endanger their personal well-being entirely, but it also depresses economic growth in the developing countries. The Council of Economic Advisers recommendation was that US ought to raise the domestic rate of saving to decrease its current financial account deficit as well as decrease reliance on the foreign saving (2006, p. 127). However, a widespread agreement is there in that both the deficits are indeed unsustainable.
Historical perspective of twin deficits
Discussion in the 1980s aimed on necessity of decreasing budget deficit as well as increasing private saving so as to raise the loan-able funds supply for investment as well as encourage the economic growth. In fact, as private sector decreased spending and raised its surplus, there was economy stagnation. Despite generating a better economic development, the high level for the private sector saving actually was connected to greater government deficits, increased unemployment (touching nearly 8 %), a recession, as well as lower financial current account deficit.
However, after a long but weak recovery in the early 1990s—associated with continued but falling private sector surpluses— the economy finally started to grow at a robust rate in the middle of the decade. By the end of 1995, private sector balance already had come back to normal surplus for about 2 % of the DI; a faster growth reduced also budget deficit—to approximately 3.5 5—as the current financial account deficit increased to 1.5 %.
Over the 1990s remainder, as it has been discussed above, a private sector surplus constantly deteriorated and turned to be negative in the year 1997. The unemployment dropped to its ever lowest since 1960s. A strong growth of economic moved the total government budget into historically huge surpluses, as well as the current financial account to a record deficit. There is important to remember that a budget surplus projection during that time was to move on continuously for at least 15 yrs, as well as retirement of a federal government debt ought to be also adding in the country’s net wealth. Actually, the total sum for the current financial account deficit as well as government surplus was equal to private sector deficit; provided the current financial account, every additional dollar for the government surplus, in identity, it meant an extra dollar of the private division deficit. In fact, retirement of the federal government debt is equal to a net decrease of the private sector possessions. The leakage for the private sector wealth and income to budget the surpluses as well as current financial account deficits finally contributed towards recessionary forces which brought the historical boom to a stop by 2000.
The recession that was under younger Bush experienced a very sharp turnaround for the private sector as well as government balances. Government surplus morphed to deficit of beyond than 5 % of the DI, a swing of 6.7 % of the DI—the greatest turnaround from the 1974–75 recession. Likewise, the private division balance moved, with about 6 % of the DI, to a tiny surplus. While initially there was a small decrease of current financial account deficit, the recovery quickly twisted that trend downward. At the end, unemployment rate increased quickly during the recession, though has just slowly fallen at time of recovery—with a pace which is slower than which was experienced during the “jobless” recovery of 1990s.
Make note how close the rate of unemployment tracks the trends of private sector financial balance figure—rising at times when saving rises as well as falling when the saving falls. The time period after the year 1995, to right of heavy vertical line, does stands out due to the private sector financial surplus fell more rapidly than the rate of unemployment. This rapid decrease in private sector financial balance is an end result for the current financial account balance acting differently after the year 1995: as current financial account deficit widely opened up, demand injection formed by the low private sector financial balance was dissolute through imports. A huge increase of the private sector expenditure that is relative to the income was hence required to move the rate of unemployment even lowered. The needed boost depends with the fiscal stance of the government. If a budget is indeed biased to be running surpluses at times when growth is vigorous—as it was the case during the 1990s—then bigger private sector financial deficits are required to fuel the growth.
Provided with how huge the external outflow has become, during even the current moderate growth rates, private sector itself cannot achieve a balance between the income and the spending unless there is budget deficit that is above 6 % of the DI. The dilemma is that there appears unlikely political will for deliberately allowing the budget financial deficit to increase to, about, 8 % or 9 % of the DI, should that private sector at last decide to go back to the normal financial surplus balance which is of 2 % or 3 % of the DI. Somewhat, the adjustment certainly would almost have to emanate from growth rates which are slow sufficiently to allow some combination for a decreased current financial account deficit as well as budget deficit distant beyond what is thought as desirable.
Past studies
(Darrat, 1988) considered the U.S. 1960-1984quarterly data, as well as the results emanating from multivariate Granger-causality tests having additional variables for monetary base, inflation, real output, exchange rate, short-run interest rate, labour cost, long-run interest rates, as well as foreign real financial income support which budget deficit do Granger-cause the current financial account deficit. This study finds also causality from the current financial account to a budget balance, thus the 4th hypothesis is then held. The current financial account balance also is caused by the monetary base, exchange rate, short-run interest rates, long-run interest rates, foreign real financial income and inflation. All the other variables considerably cause a budget balance. Making use of a similar empirical methodology, (Abell, 1990)’s research study supports the hypothesis of twin deficits, though their relationship indirectly is connected via transmission mechanisms for the interest rates as well as exchange rates of the sample duration of 1979-1985. Others that included variables such as money supply (M1), real money exchange rate, interest rates (Moody’s AAA rated bonds), real disposable individual income, as well as consumer index price. (Ibrahim & Kumah, 1996) indentified that budget financial deficit does rise the rate of interest differential, as well as worsen the balance of the current account for Germany, Sweden, Japan, and U.K during the time of 1974-1992 (the quarterly data). (Bartolini & Labiri, 2006) looked into the fiscal as well as current financial account balances within the OECD nations for the time period of 1990-2005, realizes that many of changes within the fiscal as well as the current financial account balances agreement with the twin deficit predictions view. However, actually it is very interesting to finding clearly from them the improvement of U.S. financial accounts from the year 1992 to the year 2000 were all associated with worsening of the U.S. current financial account. (Vamvoukas, 1999)’s research study applied the co-integration analysis, the error-correction modeling as well as causality of Granger trivariate, and supports the twin deficits theory in Greece. (Lau, Abu Mansor, & Puah, 2010) find also that causality does run from the budget deficit towards the current financial account deficit of Malaysia, Philippines (pre-crisis) as well as Thailand, that fits very well with Keynesian view.
The other groups of studies likes (Lau, Abu Mansor, & Puah, 2010) found that causality runs at the opposite way which is from the current financial account deficit towards the budget deficit, in regards to Indonesia, as well as South Korea. Furthermore, other works like (Kearney & Monadjemi, 1990), (Argimon & Roldan, 1994), as well as (Alkswani, 2000) have offered empirical support of reverse causation. For instance, (Alkswani, 2000) did study the hypothesis of twin deficits by making use of Saudi Arabia’s 1970 to 1999data, and the outcome suggests trade financial deficit do Granger-cause the budget deficit. Nevertheless, some researches supports the view which claims that both financial deficits are jointly dependent. (Darrat, 1988) found that both financial deficits accounts are actually mutually causal finalishing the current financial account as well as budget deficits also are mutually dependent. (Ibrahim & Kumah, 1996)’s research study finds bilateral causality that is between the trade deficits as well as budget deficits of Brazil from the year 1973 through to the year 1991. Also, (Lau, Abu Mansor, & Puah, 2010) did reexamine the hypothesis of twin deficits argument at Asian disaster-affected nations, and their end empirical results did suggest causality of bi-directional exists for Philippines within the post-crisis period. It is very interesting to realize that, hypothesis such as this is vulnerable as well as their finding generally was artificially determined from Granger’s causation view. Impressionistically, this is to mean that interpretation for two patterns (the bi-direction causality) happened simultaneously during the same period, is difficult. For instance, provided a fixed period sample, once causal relation empirical is identified from say X to Y (or even Y to X), a reversed feedback causal relation actually is impossible. Economically, this reinforces intuition that the temporally based relationships of causality may not show the right structural relationship which exists between budget financial balance as well as the current financial account balance. Past studies fall short to put attention on such a concern. Therefore, the present research study focuses towards the first hypothesis – the hypothesis of twin deficits.
Some studies examine also the co-moving that is between budget financial deficit and the fiscal financial deficit with the application of co-integration approach. For instance, (Miller & Russek, 1989)’s research study shows there is no co-integration (a long-term equilibrium relationship) between both deficits. Such a negative finding, may be explained using low power for the significant statistical experiments and trials stemming from shortness of sample period. This very “common factor”, though, can be carried out with some care by using a sample period that is longer and the appropriateness for the co-integration methods (inclusive of their vital values, see (Narayan, 2005)). The other reason for negative (-) twin deficits theory may be explained through bias of the bivariate structure for the twin deficits theory that ignores influential of the other significant variables to multivariate or trivariate framework. (Daly & Siddiki, 2009) have found empirical evidence of long-term relationship between the budget deficits, current financial account deficit and real financial interest rate in 13 nations out of 23 nations. The other research study is for (Ibrahim & Kumah, 1996). From literature survey, many of the studies put to this category, model is anticipated to represent ad hoc decreased form relatively than behavioural relationship(s) which are systematically derived from relevant theoretical hypothesis.
Current account deficit and budget deficit
The Economic research recently has started to raise questions on what is a true impact for deficit spending as well as debt is within an economy. One primary concerns regards the sustainability of current financial account and the capital financial account positions. As per the twin deficit hypothesis, huge budget deficits may have negative (-) implications for stability of current financial account.
Twin deficit existence
Currently, the literature of economy remains conflicted concerning validity of the twin deficits, having researchers showing the empirical evidence as both stands against the theory.
CA deficit and budget deficit
The Fiscal Budget Constraint budget or Fiscal deficits happens when the government spends beyond what it receives as revenues through taxation. These are calculated through subtracting the amount of the national government spending from the amount of the tax receipts. The funding for the current deficits typically are generated via the debt issuance. Government budget control is shown as:
Gt + (1 + i)*Bdt-1 = Rt + Bdt (1)
Where Gt = the government expenditure on goods as well as services and transfers, i =Sovereign rate of interest, Bdt = the government bonds of a single period maturity while R =the total revenues received as taxes. The rearranging of equation (1) yields:
(Gt + i*Bdt-1) – Rt = Bdt – Bdt-1 = _Bd (1_)
This equation demonstrates the truth that whenever the government spending on goods, services, debt servicing and transfers, exceed the current era revenues, a positive change is there in government debt.
Government budget deficit vs. Trade Deficit
Data
Plot
The data on the budget deficit and the trade deficit is presented in a chart as follows
Twin deficit always existence: Correlation
In terms of whether the two deficit always occurs together, the following correlation table summarizes their relationship
In view of the correlation, it is clear that there is a slight strong relation between the budget deficit and the trade deficit. That is given that they have a positive correlation coefficient of 0.60 that indicates a rise in budget deficit is most likely to be associated with a rise in trade deficit. However, the fact that the correlation is less than one is an indication that the two do not always occur together.
Statistical relationship
As a means of understanding the statistical relationship between the two deficit, a regression analysis is done with the budget deficit as the dependent variable and the trade deficit as the independent variable and the results presented as follows.
With a coefficient of 0.75023743 for the trade deficit, it means that a unit change in the trade deficit results in 0.75 units change in the budget deficit in same direction. However, the adjusted R-squared value of 0.3576 shows that the trade deficit only explains 35.76% variation in the budget deficit.
Regarding the estimated model’s p-value of 1.08032E-06 is relatively lower than the significant value of 0.05 meaning that the trade deficit variable is significant in determining the budget deficit.
Current account balance vs. other aggregate data
For the relationship between the current account deficit and the other aggregate data variables, the following is the data used, a plot and the estimated statistical relationship among the variables in consideration.
Data
The table presents the US data for the Current account balance, budget balance and the Net private savings for the period beginning the year 1960.
Plot
The data for the three variables is summarized in the following chart showing the trend over time.
The chart and the data show that as the net private savings increases, the budget and the current account deficit increases.
Statistical relationship
Using the data for the three variables, the following is an estimated model and regression results summarizing the statistical relationship between the variables.
The above model and parameters shows that an increase in a unit of the budget balance decreases the current account balance by 0.30365 units given the coefficient for the budget balance variable. Further, the model shows that an increase in a unit of the net private savings results in 0.86 decrease in the current account balance.
The adjusted R-Squared value of 0.6975 indicates that the independent variables explain 69.75% variation in the current account balance. Further, the estimated model’s p-value of 2.15E-14 , which is less than that significant value of 0.05 shows that the two variables are significant determiners of the current account balance.
Correlation table
The following correlation table summarizes the relationship between the three variables considered in the regression analysis.
In view of the above correlation table, there is a slight strong positive correlation between the current account balance and the budget balance shown by the 0.06 correlation coefficient. On the other hand, there is a strong negative relationship between the current account balance and the net savings given the correlation coefficient of -0.82. That indicates that increase in net savings is associated with substantial decrease in the current account balance. Finally, there is a strong positive correlation between the current account balance and the budget balance shown by the correlation coefficient 0.86.
Works cited
Makin, Anthony (2004). The Current Account, Fiscal Policy, and Medium-Run Income Determination. Contemporary Economic Policy, 22 (3), 309-316.
Abell, J. D. (1990). Twin deficits during the 1980s: an empirical investigation. Journal of Macroeconomics , 12 (1), 81-96.
Alkswani, M. A. (2000). The twin deficits phenomenon in petroleum economy: evidence from Saudi Arabia. Economic Research Forum 26-29 October. Amman, Jordan.
Darrat, A. F. (1988). Have large budget deficits caused rising trade deficits. Southern Economic Journal , 54 (4), 879-887.
Darrat, A. F. (1990). Structural federal deficits and interest rates: some causality and co-integration tests. Southern Economic Journal , 56 (3), 752-759.
Ibrahim, S. B., & Kumah, F. Y. (1996). Comovements in budget deficits, money, interest rates, exchange rates and the current account balance: some empirical evidence. Applied Economics , 28 (1), 117-130. 17
Kearney, C., & Monadjemi, M. (1990). Fiscal policy and current account performance: international evidence on the twin deficits. Journal of Macroeconomics , 12 (2), 197-219.
Lau, E., Abu Mansor, S., & Puah, C.-H. (2010). Revival of the twin deficits in Asian crisis affected countries. Economic Issues , 15 (1), 29-53.
Miller, S. M., & Russek, F. S. (1989). Are the twin deficits really related? Contemporary Policy Issues , 7 (4), 91-115.
Narayan, P. K. (2005). The saving and investment nexus for China: Evidence from cointegration tests. Applied Economics , 37 (17), 1979-1990.
Blecker, Robert A. 1992. Beyond the Twin Deficits: A Trade Strategy for the 1990s. Armonk, New York: M. E. Sharpe.
Council of Economic Advisers. 2006. Economic Report of the President. www.whitehouse.gov/cea/pubs.html
Rock, James M., ed. 1991. Debt and the Twin Deficits Debate. Mountain View, California: Mayfield Publishing.
