ARE THE TWIN DEFICITS REALLY RELATED?

Abstract

The emergence of record current‐account and fiscal deficits in the United States during the 1980s draws increasing attention to what has become known as the “twin deficit” problem. Conventional wisdom is that a shift to larger government deficits entails a decline in government saving and results in larger trade deficits, Persistently large trade deficits are troublesome because they imply a transfer of wealth to foreigners and possibly a reduction in future generations' living standards.This paper examines whether post‐World War II data for the United States reveal a long‐run secular relationship between the trade deficit and the fiscal deficit. The focus is on the secular relationship since that is the one most relevant to long‐run policy concerns. The authors employ three different statistical techniques: (i) a deterministic technique for separating the secular components from the cyclical components to derive secular measures of the twin deficits, (ii) a stochastic procedure to isolate the secular components, (Hi) cointegration analysis to test for a long‐run equilibrium relationship.The authors conclude that, based on the first two approaches, evidence of a positive secular relationship between the twin deficits exists only under flexible exchange rates. This relationship appears quite strong–that is, a $1 change in the fiscal deficit eventually leads to roughly a $1 change in the trade deficit. On the other hand, findings based on cointegration analysis indicate no long‐run equilibrium relationship between the twin deficits. This latter finding, however, may reflect a low power of the relevant statistical tests stemming from the shortness of the sample period.