Are "Twin deficits" an illusion? International evidence on fiscal policy and the current account

Abstract

The “Twin Deficits” hypothesis predicts that the current account responds to changes in the budget deficit, whether these are coming from changes in government spending or taxes. On the contrary, the “Fundamental Current Account Equation” of the intertemporal approach predicts that the current account responds only to (temporary) changes in government spending but not to taxes. Using annual data from 1870 to 2013 for a panel of seven OECD economies, the paper finds that (i) budget and current account deficits move together, which is necessary but not sufficient for the Twin Deficits hypothesis to hold; (ii) temporary increases in government spending deteriorate the current account balance, as predicted by the Fundamental Equation hypothesis; and (iii) changes in the budget deficit, other than temporary changes in government spending, also reduce the current account balance, suggesting that Twin Deficits are not an illusion. Quantitatively, an increase in temporary government spending by 1% of GDP deteriorates the current account by a maximum of 0.20% of GDP, whereas an increase in temporary taxes by 1% of GDP improves the current account by a maximum of 0.50% of GDP.