RDP 8813: The Fiscal Deficit and the Current Account: Twins or Distant Relatives? 3. Twins or Distant Relatives: A Conclusion.

The preceding analysis has emphasized that the relationship between the current account and the government's budget balance is unlikely to be as direct and strong as the twin deficit hypothesis predicts. The savings-investment balance of the private sector may fully, partially, or more than offset the effects of budget consolidation efforts depending on the way in which fiscal policy is altered to achieve a reduction in the public sector's borrowing requirement. In this respect one might expect reductions on the expenditure side to have the most reliable influence on the current account. Changes in taxes frequently modify incentives to save and invest in ways that could significantly influence the final outcome as far as the current account is concerned. In addition, current-period tax increases that are used to reduce the public debt imply lower taxes in the future as debt service payments fall. As a result private sector consumption may increase enough to offset higher public sector savings and leave the current account essentially unchanged.

These considerations suggest that it is not a simple matter to interpret correlations (or the lack thereof) between the current account and the fiscal balance in specific historical episodes. Similarly, predictions of the effects of reductions in government deficits on external balance should take into account the induced effects on private sector savings and investment decisions. This implies that careful empirical analyses of these effects is essential for a complete understanding of the influence of fiscal policy on external balance. The implementation of such empirical work must incorporate the various transmission mechanisms that have been illustrated in the theoretical analysis of the previous section.

First of all, the fact that the current account may respond quite strongly to other factors than policy-induced disturbances must be kept in mind lest a too strong or too weak influence is attributed to fiscal policy. Imagine, for instance a situation in which fiscal policy is contractionary leading to a substantial reduction in the fiscal deficit. This should, according to theory, translate into an improved external balance assuming that no other changes are taking place. But this is rarely the case. Suppose that for reasons other than policy, domestic private sector autonomous demand is particularly strong at the same time.^[23] The current account may fail to improve even if fiscal policy taken by itself would have had the predicted influence. Clearly any empirical investigation must be designed so as to capture the effects of major non-policy shocks.

The budget deficit itself may also change endogenously. Government receipts and expenditures both have strong cyclical components that do not reflect changes in basic policy stance. Does this imply that one should carry out empirical analysis using cyclically adjusted budged figures? Not necessarily. Since fiscal policy has indirect effects on both the budget itself and the current account through changes in the economy's cyclical position, a quantitavely misleading estimate might be obtained if cyclically adjusted data were used. On the other hand one would perhaps want to purge the data on both the current account and the fiscal deficit from cyclical influences due to all non-policy shocks. This is clearly not feasible, but the same effect may be achieved by appropriate multivariate regression analysis with which one can “correct” for movements in crucial exogenous variables.

Simple correlations between fiscal deficits and the current account may be misleading not only due to the presence of other shocks but also because the way in which the deficit is changed matters. Recall for instance the substantially different effects of a tax cut that affects savings behaviour and one that affects investment. This type of consideration may be of particular importance in cross-country comparisons since the operation of fiscal policy may vary quite significantly across countries. But major changes in the direction and philosophy of fiscal policy within a country could also lead to similar instability over time in the relationship between the “twin deficits”.

The fact that debt service payments depend to a large extent on past cumulated deficits suggests that policy changes will be felt most strongly and rapidly on the balance of trade rather than on the overall current account. Similarly, the debt service component of government outlays may reflect valuation effects rather than discretionary changes in policy. For this reason it might be important to separate out the interest components of both variables and explain these separately. In this context the currency composition of both the internal and the external debt should be kept in mind.

Footnote

Perhaps due to an investment boom based on expectations of high future profits. [23]