Twin deficits redux

On the current account deficit, “We have met the enemy, and he is us”.

As The Economist’s View observes, the issue of global imbalances — really the United States’ outsize current account deficit — is never far away from policy-makers minds. There are two major camps in the debate. First, there is the Bernanke “global saving glut” view, and the closely related but intellectually distinct “Bretton Woods Revived” force. The U.S. current account deficit, according to adherents of this view, is made abroad or at least made anywhere but in America. Second, there is the “Twin Deficits View”. This perspective has taken a lot of lumps in recent years, partly because the current account deficit kept on rising even as the budget balance moved toward surplus over the latter part of the 1990′s. Of course, since budget surplus was achieved in 2000, the Administration’s policies have re-established the positive correlation between budget deficits and current account deficits by driving both to new nominal heights (and percent of GDP records, for the current account).

But what of the 1990′s experience? Doesn’t Don’t the divergent trends in the two deficits necessarily invalidate the twin deficits hypothesis? Certainly, this talking point has been taken as a way to absolve fiscal policy of any responsibility in the current account imbalance. Well, my response to this bivariate view of the world is that questions like this led man to create “multiple regression analysis”. Taking this perspective, Hiro Ito and I have updated the results [PDF] discussed in this post.

Specifically, we have “rigorously interrogated” the data to see what the range of effects that one can obtain from the data sample. We find the following (for the industrial countries, as defined by the IMF), over the 1975-2004 period:

  • The pooled OLS estimate of the response of the current account balance to the budget balance, using 5-year-averaged data and time fixed effects, is 0.15 to 0.16. This means a one percentage point (ppt) change in the budget balance to GDP ratio induces a 0.15 to 0.16 ppt improvement in the current account to GDP ratio (statistically significantly different from zero, using robust standard errors, and the 10% marginal significance level). The pooled OLS estimator imposes the assumptions that (i) all the errors are drawn from the same distribution, and (ii) the slope coefficients are the same irrespective of whether one is looking across countries or over time within in a country.
  • The two stage least squares estimate (i.e., accounting for endogeneity) estimate of the response is 0.325, statistically significantly different from zero at the 10% level.
  • The estimate using Hodrick-Prescott (HP) trends (to identify the medium term values) is 0.095, statistically significantly different from zero at the 10% level.
  • The OLS estimate using HP trend data and fixed effects is 0.485, statistically significantly different from zero at the 10% level. This result means that a 1 ppt. increase in the budget balance to GDP ratio purged of business cycle frequency effects induces an approximately 0.5 ppt. improvement in the the current account balance purged of business cycle frequency movements, after conditioning for country specific effects.
  • In general, the point estimates range from a minimum of 0.095 (HP trends and OLS) to a maximum of 0.485 (HP trends, fixed effects), with a median of the estimates reported in the paper of 0.325.

In other words, in an exhaustive study that has addressed issues of specification (pooled OLS versus fixed effects), extraction of medium term variation (five year averages versus Hodrick-Prescott filtering), endogeneity (OLS versus 2SLS), the importance of institutions (w/ and w/o institutional variables), we find that fiscal policy has important economic and statistically significant effects on the current account imbalance. (By the way, as pointed out by Calculated Risk in this post, don’t hold your breath for actual progress on the “on-budget” budget deficit).

This shouldn’t deny the fact that international factors may have an impact on our current account imbalance. But those who hold blameless U.S. fiscal policy should reconsider the empirical evidence.

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3 thoughts on “Twin deficits redux

  1. Asymmetrical Information

    I think I’m doing the math wrong

    Joseph Stiglitz wrote an op-ed in the New York Times urging America to fix the current account deficit by (and I know that this will surprise you) raising taxes on the wealthy while cutting them for lower-income households. This will be hard to do, bec…

  2. Anonymous

    The budget deficit is falling faster than expeceted … I will credit nether the President or the congress … American’s are cutting the deficit with their tremendous payment of taxes … the current account deficit appears to be more stubborn … it is driven by American’s hunger for imports … The fix is not in the congress or executie branch … let’s allow the market to solve the problem …

  3. menzie chinn

    Anonymous: The model pertains to medium term movements in the budget balance, not cyclically-induced ones. I have not seen a revision to the CBO’s standardized / cyclically adjusted budget balance. Hence, I don’t think letting the magic of the marketplace will solve the problem.

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