Twin Deficits: Squaring Theory, Evidence and Common Sense

Appealing to the twin deficit hypothesis, according to which shocks to the government budget move the current account in the same direction, many observers call for fiscal consolidation in the US as a necessary measure to reduce the large external imbalance of this country. We reconsider the international transmission mechanism in a standard two-country two-good business cycle model, and find that fiscal expansions have no effect on the trade balance and thus on the current account i) if the economy is not very open to trade and ii) if fiscal shocks are not too persistent. Under these conditions, the crowding out effect of fiscal shocks on private investment is stronger than conventionally believed. We take this insight to the data and investigate the transmission of fiscal shocks in a VAR model estimated for Australia, Canada, the UK and the US. For the US and Australia, which are less open to trade than Canada and the UK, we find that the external impact of shocks to either government spending or budget deficits is limited, while private investment responds significantly – in line with our theoretical prediction. The reverse is true for Canada and the UK. These results suggest that a fiscal retrenchment in the US may have a limited impact on its current external deficit. However, our results do not weaken the case for fiscal consolidation: by crowding in investment, a fiscal correction will strengthen the ability of the US to generate resources required to service future external liabilities.