Twin deficits – implications of current account and fiscal imbalances for the accession countries

Abstract

Growing fiscal and current account imbalances in a relatively large number of countries have motivated increasing research on so-called twin deficits. Taylor (2002) discusses the development of current account deficits over a period of about 120 years. He shows that external imbalances have been an important feature of the world economy, although their role has changed several times. Similarly, McCoskey and Kao (1999) look for panel cointegration in the OECD countries. Several authors address twin deficits from the point of view of macroeconomic stability (see Edwards, 2001). In this vein, Halpern (1998) and Megarbane (2002) underline the negative implications of a combination of adverse factors (e.g. twin deficits, high interest rates and exchange rate depreciation), which may increase the vulnerability of transition countries. Megarbane (2002) also points out a possible interrelationship between the mentioned variables: an adverse fiscal development has to be counteracted by a more prudent monetary policy, implying higher interest rates. He concludes that fiscal instruments are crucial for sound macroeconomic policy in transition countries. Therefore, twin deficits should be avoided. Finally, Milesi-Ferretti and Razin (1998a, 1998b) discuss the relation between current account deficits and currency crises in emerging markets. They also stress the importance of further research regarding the role of macroeconomic policies during periods of high current account deficits and their reversals. In line with McCoskey and Kao (1999), we define twin deficits as a long-run (positive) relationship (cointegrating relationship) between the current account and the fiscal balance, including some other factors. Thus, this paper contributes to the discussion of current account and fiscal policy in the following ways. First, we analyze the determinants of the long-run current account position in a broad set of countries including OECD countries as well as emerging economies between 1970 and 2001. Second, we use quarterly data, while comparative studies (see Edwards, 2001, and Ventura, 2002) are based on annual data. 3 ) Thus, we can address the issue of structural breaks and nonstationarity in our analysis, an issue most authors of comparative studies (except for McCoskey and Kao, 1999), have omitted. By contrast, several country studies 4 )h ave focused strongly on the properties of analyzed time series. Third, we consider both investment and the fiscal balance determinants of the current account in the long run, while the majority of the previous studies concentrated on only one of these factors. Finally, we focus on the development of the current account and the fiscal balance in transition economies in the past decade, while also presenting evidence for selected countries for comparison. With few exceptions, this group of countries has been omitted from the analysis so far.