Question

In the 1980s, some economists in the US wrote about the so-called “twin deficits.” That is, the US experienced both a government budget deficit and a trade deficit. Suppose that gross investment exceeds private saving. Explain why a country with a budget deficit must also show a trade deficit. After that, in the late 1990s, the US experienced a trade deficit and a budget surplus. In other words, the “twin deficits” got separated. Explain how this is possible. (Hint: what can you say about private saving and investment?)

Answer 1

Since, Y=C+I+G+NX

And, Y-C-T=S, then

S=G-T+NX+I, which simplifies to the sectoral balances identity

(S-I)+(T-G)-NX, then

If (T-G) is negative, we have a budget deficit.

Now, suppose that gross investment exceeds private savings then assume an economy already at potential output, meaning Y is fixed. In this case, if the budget deficit increases, and saving remains the same, then this last equation implies that either investment (I) must fall (see crowding out), or net exports (NX) must fall, causing a trade deficit. Hence, a budget deficit can also lead to a trade deficit, causing a twin deficit.

Though the economics behind which of the two is used to finance the government deficit can get more complicated than what is shown above, the essence of it is that if foreigners' savings pay for the budget deficit, the current account deficit grows. If the country's own citizens' savings finance the borrowing, it may cause a crowding out effect (in an economy at or near potential output, or full employment).

In the 1980s expansion, the trade deficit and budget deficit moved together. This pattern re-emerged in the recession and subsequent expansion beginning in 2001. This is the opposite of what happened in the last half of the 1990s, when the budget deficit fell as a fraction of gross domestic product (GDP) and the trade deficit rose sharply as a fraction of GDP. From this experience it is clear that international capital flows, which drive the net balance of trade, do not depend solely on movements in the budget deficit. During the last half of the 1990s, real gross domestic investment rose as a fraction of real GDP. This resulted from the rise in U.S. productivity and the related rise in the real yield on U.S. assets. This drew in additional private capital from abroad. If the twin deficits theory is correct, it has an adverse implication for the efficacy of fiscal policy as a stimulus tool. It suggests that in an environment of highly mobile international capital, the effect of policy induced increases in the structural budget deficit (e.g., tax cuts) on short-run economic growth would be largely offset by increases in the trade deficit. The experience during both the 1980s and 1990s demonstrates that a large and growing trade deficit need not be an impediment to overall job creation even though it may have had an effect on the type of jobs that were created since it affected the composition of U.S. output.

In the late 1990s, the US experienced a trade deficit and a budget surplus. In other words, the “twin deficits” got separated in the late 1990s, the government budget balance turned from deficit to surplus, but the trade deficit remained large and growing. During this time, the inflow of foreign financial investment was supporting a surge of physical capital investment by U.S. firms. The United States last had a budget surplus during fiscal year 2001. From fiscal years 2001 to 2009, spending increased by 6.5% of gross domestic product (from 18.2% to 24.7%) while taxes declined by 4.7% of GDP (from 19.5% to 14.8%). Spending increases (expressed as percentage of GDP) were in the following areas: Medicare and Medicaid (1.7%), defense (1.6%), income security such as unemployment benefits and food stamps (1.4%), Social Security (0.6%) and all other categories (1.2%). Revenue reductions were individual income taxes (−3.3%), payroll taxes (−0.5%), corporate income taxes (−0.5%) and other (−0.4%).

The 2009 spending level was the highest relative to GDP in 40 years, while the tax receipts were the lowest relative to GDP in 40 years. The next highest spending year was 1985 (22.8%), while the next lowest tax year was 2004 (16.1%)

It was possible for the following reason, in 1990, with the projected deficit spiraling out of control, the warring branches replaced GRH with the Budget Enforcement Act (BEA), a law that focuses on revenue and spending rather than the size of the deficit. Almost a decade later, BEA remains in effect, and although it has not always been strictly enforced, it has helped improve the budget condition. It has two principal rules: (i) a limit on annual appropriations and a requirement that any revenue or spending legislation that would increase the deficit (or decrease the surplus) must be offset. In sharp contrast to GRH, it does not regulate changes in the budget caused by fluctuations in economic conditions or in the cost of existing entitlement programs. It controls only the parts of the budget that the president and Congress directly influence (ii)and thus holds politicians accountable only for the things they control.