Twin Deficits: Does a Government Deficit Cause a Current Account Deficit? Essay Sample

Published: 2022-04-01
Twin Deficits: Does a Government Deficit Cause a Current Account Deficit? Essay Sample
Type of paper:  Essay
Categories:  Economics Government Budgeting
Pages: 7
Wordcount: 1689 words
15 min read

According to Obadic, Globan, and Nadoveza (2014), current account deficits have a significant impact on a nation's economic stability because of its implications on the present and future generations. Many studies conducted on the deficits attempt to establish an association between the current account and budget deficits through a phenomenon known as "twin deficits." The findings from these studies reveal mixed outcomes with a majority of researchers supporting the stance while others rebuffing the association between the deficits. The postulation suggests that a direct relationship exists between the two deficits since a rise in the government deficits leads to an escalation of the current deficit.

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Ramu (2017) describes the twin deficits theory as a proposition which exemplifies the existing positive association between trade account and budgetary deficits also known as fiscal deficits. The theory hypothesizes the association between account deficits and fiscal deficits (Kosteletou, 2013). In understanding the theory, Ramu (2017) outlines the major theoretical approaches associated with it. They include the Mundell Fleming Theory, the Ricardian Equivalence theory, the Risk Premium Theory and the Keynesian Absorption Theory. Ramu (2017, p.22) asserts that the Keynesian theory assumes that when budget deficits rise because of increased public spending or reduced taxation, it leads to the increase in national absorption. Subsequently, the intensification of importation activities results in deterioration of current account balances. Thus, the Keynesian principle posits that fiscal deficit causes a deficiency of current accounts.

Similarly, the Mundell-Fleming Theory uses exchange rates and interest rates in developing an association between a government's current account deficits and budgetary deficits. Ramu (2017) posits that the main argument of the theory suggests that changes in fiscal deficits pressurize the rates of domestic interests. Consequently, it leads to the increase of capital inflow which is also replicated in the local exchange rates. Ideally, the appreciation of local exchange rates leads to the reduced pricing of imports than exports. According to Ramu (2017, p.22), an increased importation compounded with the decline in exports causes the worsening of current account balances.

The Mundell Fleming view argues that there exist an indirect association between current account balances, exchange rate appreciation, local interest rates and fiscal balance (Ramu, 2017, p. 28). Likewise, the Ricardian Equivalence Theory established by Barro (1989) argues that fiscal deficits arise since the rise in fiscal expenditures receive reimbursements from either during the present or future economical periods. Similarly, Nadenichek (2016, p. 35) ascertains that the theory suggests a revenue increase from decreased taxation leads to a reduction in fiscal deficits which tend to exert an adverse effect on the current account balances. Thus, the theory shows the lack of association between the current account and budget deficits.

The last approach involves risk premium. According to Nickel and Tudyka (2014), the approach assumes that strengthening the local currency using foreign currency due to the growth of local interest rates and an increase in fiscal deficits results to increase of purchasing power. Subsequently, the situation leads to the increase of imported goods to satisfy the increased consumers' appetite. Nickel and Tudyka posit that the demand for imported goods results to a rise in asset values possessed by domestic residents that include assets from real estates and finance (Nickel & Tudyka, 2014; Bluedorn & Leigh, 2011). In return, federal savings decline because of pressure from the increase in demand for imported goods and the purchase of assets while consumption rates increase.

According to Sakyi and Opuku (2016), the debate concerning the relationship between the current account and fiscal deficits usually adhere to two principal doctrines. These are the twin divergence hypothesis and the Ricardian equivalence. Sakyi and Opuku assert that the former has been a subject of discussions particularly in both the developed and developing and developed nations (Sakyi & Opuku, 2016, p.4). A study conducted on one of the developing countries in Africa reveals that the fiscal deficits improve the state of current account deficit. Consequently, it indicates that the twin deficit hypothesis developed should not receive universal attention and acceptance owing to the twin divergence theory.

Tang (2015) conducted a study to explore the relationship between current account deficits and government deficits. In conducting the study, Tang uses the granger causality technique. Tang used the Johnson and Juselious technique that is grounded on a VAR model to investigate the integrational relationships (Tang, 2015, p.187). The observations made conclude that causality arises from government deficits thus leading to current account deficits as suggested through the application of Keynesian theory. Normalization of the co-integration coefficients proposes that the current account deficiencies have a positive relationship to the gross domestic product (GDP) and interest rates. Likewise, Tang concludes that the current account deficits are caused by two principal channels (Tang, 2015, p.197). One of the channels involves direct causality stemming from budget shortfalls and current account deficits. The other channel involves an indirect causal link which stems from budget deficits to increased interest rates.

Litsios and Pilbeam (2017) researched to investigate the association between the current account and fiscal balances. The study was conducted using three participating countries namely: Spain, Portugal, and Greece. The researchers applied the Autoregressive Distributed Lag (ARDL) method to investigate the association between the current account and fiscal balances which would imply that fiscal severity can aid failing economies to limit current account deficits and boost their competitive stature. Based on the findings from the study Litsios and Pilbeam assert that the deployment of fiscal austerity among the three nations provides an opportunity for their governments to fix the current account imbalances. The researchers also suggest that an increase in the local investment has negative implications on the capital used to finance investment in the three countries (Litsios & Pilbeam, 2017, p. 27). Therefore, the argument by the scholars suggests that financial investment is critical in the elimination of current account deficits among the participating economies.

Congruently, Kalou and Paleologou (2012) conducted an empirical study to investigate a causal link between both deficits for Greece using the nation's financial information for the period between 1960 and 2007. The results from the study established a positive correlation between the two deficits whereby the causality link's direction emerged from current account to budget deficit. Kalou and Paleologou ascertain that the domestic developments in Economic and Monetary Union (EMU) countries that are characterized high debt to GDP ratios are spearheaded by definite levels of foreign balance (Kalou & Paleologou, 2012, p.239). Consequently, it implies that the improvement of a government's budgetary and current account is dependent on quality improvement of its domestic goods.

A study conducted by Corsetti and Muller (2006) that the method which a government employs in responding to a macroeconomic variable of budgetary have severe consequences for twin deficits. In conducting the study, the scholars explored the transmission of fiscal shocks in a VAR model which suggested that the economization of finances has a limited impact on a country's external deficit. Corsetti and Muller posit that the increase in consumption rates has a direct relationship with reduced interest rates and a rise in local savings (Corsetti & Muller, p.635). The argument concurs with the one addressed by Bluedorn and Leigh (2011, p.591) which suggests that the deviation from the Ricardian equivalence take place and the magnitude of the consequent effects remain unknown. For instance, interest rates, investments, and consumption are endogenous. Thus, associations formed may result from the influence of other variables like the elements which affect the business cycle (Corsetti & Muller, 2006, p. 636).

In his examination of the fiscal and current account deficits of the United States, Chinn (2005) asserts that the country should withhold from increasing its debts since global investors will grow tired at some point because of the former's influence on current account deficit. Chinn posits that the size of the current account deficit would not sustain the country. He adds that the individuals and government agencies that are responsible for implementing policies should express concern regarding the current account deficits. In explaining his position, Chinn alludes to the Ricardian Equivalence theory which argues that prolonged borrowing affects the local currency and current account deficit (Chinn, 2005, p.3). According to Chinn, failure to adhere to such strategy would result in foreign governments influencing the country's fate. Consequently, it would contribute to an escalation of trade disagreements, slower economic growth and limited influence on the economic and political scene. (Chinn, 2005, p.3).

Similarly, Cavallo (2005, p.1) posits that the United Stated has witnessed the emergence of twin deficits owing to the increased levels of borrowing from other countries. The situation normally arises when the country's national saving decline lower than the domestic investment, a phenomenon which is caused by insufficient savings required for local ventures. Cavallo argues that government policies such as increase of tax revenues and a decrease in capital and labor taxes lead to an increase in budget deficits. The institution of these policies, which equate to about 1% of the nation's GDP, leading to the deterioration of the same by a margin of about 0.5%. Therefore, an escalation of the budget deficit increases the current account deficits (Cavallo, 2005, p.1).

Chen (2007) also studied the effect of federal fiscal policies on exchange rates as well as current account. The two variables were investigated during periods when the United States had flexible exchange rates. Chen implemented VAR techniques on the sample data and made several findings. According to the data, Chen established a regular pattern of twin divergence as opposed to twin deficits. The researcher concluded that fiscal policies negatively affect the current account balance and also contribute to the depreciation of real exchange rates (Chen, 2007, p.286). Although the outcome does not support the twin deficits theory, it hypothesized a twin divergence. Subsequently, it supports the arguments of Barro (1989) which suggest the lack of an association between current account deficits and fiscal deficits.

A study by Leachman and Francis (2002) investigate the concept of twin deficits in the US after the Second World War. The findings of the study assert that before 1974, the nation's financial sector exhibited a multi-cointegration of budget and current account deficits. Nonetheless, the outcome did not exclude the existence of a correlation between external and governmental deficits. In significance, the evidence of such relationship is existent between trade and fiscal deficits. Leachman and Francis establish the government expenditure, revenues, exports and imports all have a multi-cointegrated relationship. The researchers also argue...

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