Twin deficits in the US: How sustainable is it?

Authors: Ace Chua, Bernie Tan

Region Head: Ace Chua

Editor: Akshat Daga

Abstract

A twin deficit occurs when the country has both a current account (CA) deficit and a fiscal deficit. The CA is part of the nation’s balance of payments (BOP) and is representative of its trade balance (exports minus imports). A CA deficit occurs when imports exceed exports, thus the country is a net borrower from abroad. A government’s deficit happens when the government is spending more than its tax revenues. The name “Twin Deficits” arose as CA balance and federal debt were seen to move in tandem. This article will go into detail on the evidence, impact and sustainability of the twin deficits in the US.

Hypothesis

A fiscal expansion will lead to an increase in demand for loanable funds and increase interest rates, making the US attractive to investors, resulting in a capital influx, putting pressure on the USD to appreciate, which will worsen the trade and CA balance, resulting in short run output fluctuations (Institute for International Economics, n.d.). Alternatively, one can argue that a reduction in tax will fuel domestic consumption and discourage private savings, thus worsening national savings. Workers will also want to maximize their after-tax labour income, fostering a higher rate of domestic capital investment. This fall in national saving and increase in domestic investment will worsen the CA balance, as the country needs to borrow internationally to finance its expenditures. (Cavallo, 2005).

Causes of the Twin Deficits in the US

The twin deficit economic phenomenon was first seen in the 1980s, when the United States’ (US) budget deficit increased from 2.7% to 5% of GDP and its CA deficit rose to 3.5% of GDP. Two major contributors to this event were the Federal Reserve’s decision to raise interest rates amidst high inflation that originated in the 1970s & the 1981 Reagan tax cuts. Moreover, the US also increased its military expenditure fund for the 1991 Gulf War (Institute for International Economics, n.d.).

However, the twin deficits briefly diverged in the 1990s due to the fiscal tightening by the Clinton administration and tax revenue collected during the 1990 stock market bubble crisis that improved its government deficit. This divergence did not last long as following the 1997 Asian Financial Crisis, investors started to see the US as a safe haven and this thus puts appreciation on the USD. Speculations against the Yuan also pressured the US to appreciate, resulting in the CA deficit peaking at -5.5% of GDP in 2005. Moreover, the US also increased its military spending to fund for the 2003 Iraq War. The 2008 financial crisis had led to an increase in private savings from 4.7% to 8.5% and a fall in domestic investment from 7% to 1.4%, also implies a deteriorating CA balance (Zulauf & Orden, 2019).

Fig 1 shows that there is a negative correlation between the federal debt and the CA balance in the US from 1980 to 2020, which explains the presence of the twin deficits in the US. The higher the federal debt, the worse the CA deficit becomes. Fig 2 also shows a whipsaw-like fluctuation in the US GDP growth, hence supporting the twin deficit hypothesis in the US.

Fig 1: Negative correlation between US federal debt and US CA balance (CEIC Data)

Fig 2: US GDP YoY (%) (CEIC Data)

How is the US still able to finance itself?

Despite the twin deficit scenario present in the US (as discussed above), the US still remains to be strongly funded by other countries all over the world, especially China (Seth, 2020). This is because the US is the leading import country in the world, evidenced by an import value of approximately 2.57 trillion dollars in 2019, ahead of China (2nd place) by 25% of China’s imports (Plecher, 2020). This would mean that the US spending is largely on other countries’ export sectors, which would in turn attribute to their GDP growth. Therefore, in order to further economic growth, overseas banks will be willing to lend to the US, especially the unique position of the greenback currency being the world’s reserve currency.

Impact on Investor Confidence

In order to break down this scenario, the US can be thought of as a rich person who uses up all his finances and continues borrowing money in order to expand his business further. In this scenario, there are primarily two types of investors: The Bears (Inherently pessimistic Investors), and The Bulls (Inherently optimistic investors). For the Bears, they are investors who are primarily concerned with the rising federal debt and do not wish to be entangled in the potential crisis which may devalue their portfolio. As such, these investors will be keen to pull out from direct US debt-related financial instruments.

In terms of the proportion of investors, there will generally be more Bulls than Bears where the US market is concerned. This is because the US is still currently leading in terms of technological innovation - the highlight of economic growth in the past century (Cher, 2020). Furthermore, the USD, or what we deem as the greenback, has also been the unofficial reserve currency of the world, and the most commonly used currency in transactions all around the world (Weizhen, 2020). However, the twin deficit may be one of the major factors for the Bull investors to switch sides as markets begin to explore other profit-making opportunities. In recent times, points of contentions between China and the US opens up possibilities for growth in the East, as China supercharges in a bid to surpass the US. One example of this would be in the evolving AI industry, where China is deemed to be leading in the field, with USD 150bn to be injected into the budget as at 2030 (Srivastaya, 2019).

Policy Recommendations

Since the US is a highly developed country, it should not hold twin deficits similar to developing countries that are looking for leverage to expand, since due to the law of diminishing returns, it is harder for them to expedite growth in comparison to a third-world country. Thus, it may not be feasible to consistently holding onto twin deficits in the long run. As such, several policy recommendations to alleviate the US from the situation would include fiscal structural reforms, to improve the Fiscal Budget position by increasing tax and cutting government spending, and increasing domestic production and consumption - This is meant to improve the CA balance by increasing private savings through increasing net exports (Faruqee, 2013).

Conclusion

To conclude, the twin deficits would be inconsequential only as long as the US remains as the world leader in terms of areas in economic growth, such as science and technology, and education. However, as with all policies, there is the trade-off with economic output, or GDP, and thus should be balanced with a healthy and sustainable economic output growth whenever possible.

Appendix: Twin Deficit Hypothesis

Y=C + I + G + (EX - IM) (Investment-Savings (IS) function)

M/P = eY - fi (Liquidity Preference-Money Supply (LM) function)

i = i* + ∆Ee/E (Domestic return (DR) = Foreign Return (FR), Forex market (FX) functions)

Sprivate=Y - C - T → private savings

Sgov=T - G → public savings (<0 since its a fiscal deficit)

CA Identity: Snational = (Sgov + Sprivate ) = I + CA

Consumption C= (Y - T) - Sprivate

Net exports function: NX = NX(0) + ae - mY

Real exchange rate: e = EP*/P where E is the nominal exchange rate quoted in terms of the home currency, P and P* are goods prices home and abroad, respectively.

Note that any terms denoted in asterisk are for foreign/rest of the world. Salient equations are bolded.

The twin deficit hypothesis can be illustrated in Fig 3 where a fiscal expansion (G increases) or in the case of a tax cut (C increases) shifts the IS curve rightwards, increasing output and domestic interest rate (DR shifts upwards), and in the FX diagram, this will lead to a nominal exchange rate appreciation (E decreases). Since the IS-LM-FX is a short run analysis, prices are assumed to be sticky and a nominal appreciation will lead to a real appreciation. Together with an increase in output from the initial IS curve rightward shift, this will deteriorate net exports and thus deteriorate the CA balance.

This worsening of the net exports will shift back the IS curve back towards its initial point at (y1, i1), resulting in short run fluctuations on the output between y1 and y2.

Fig 3: IS-LM-FX analysis of the twin deficit hypothesis

References

1.Cavallo, M. (2005, July 22). Understanding the Twin Deficits: New Approaches, New Results. Federal Reserve Bank of San Francisco. https://www.frbsf.org/economic-research/publications/economic-letter/2005/july/understanding-the-twin-deficits-new-approaches-new-results/

2.Cher, A. (2020, May 17). ‘Superpower marathon’: U.S. may lead China in tech right now — but Beijing has the strength to catch up. CNBC. https://www.cnbc.com/2020/05/18/us-china-tech-race-beijing-has-strength-to-catch-up-with-us-lead.html

3.Faruqee, H. (2013, August). Chapter 3. The United States: Resolving “Twin” Deficits. IMF. https://www.elibrary.imf.org/view/IMF071/20068-9781475573664/20068-9781475573664/ch03.xml?language=en&redirect=true

4.Institute for International Economics. (n.d.). What Forces Drive International Trade, Finance, and the external deficit? https://www.piie.com/publications/chapters_preview/47/2iie2644.pdf

5.Plecher, H. (2020, August 25). Leading Import Countries Worldwide 2019. Statista. https://www.statista.com/statistics/268184/leading-import-countries-worldwide/#:~:text=In%202019%2C%20the%20U.S.%20were,about%202.57%20trillion%20US%20dollars.&text=Import%20and%20export%20are%20generally,a%20country's%20imports%20and%20exports

6.Seth, S. (2020, April 14). Why China Buys U.S. Debt With Treasury Bonds. Investopedia. https://www.investopedia.com/articles/investing/040115/reasons-why-china-buys-us-treasury-bonds.asp#:~:text=Effectively%2C%20owing%20to%20the%20acceptance,safest%20investment%E2%80%94U.S.%20Treasury%20securities.&text=Buying%20U.S.%20Treasurys%20enhances%2

7.Srivastaya, S. (2019, June 27). Top 10 Countries Leading the Artificial Intelligence Race. https://www.analyticsinsight.net/top-10-countries-leading-the-artificial-intelligence-race/

Weizhen, T. (2020, August 23). The dollar may slide further, but analysts say its demise is ‘greatly exaggerated’. CNBC. https://www.cnbc.com/2020/08/24/us-dollar-still-unrivaled-as-global-reserve-currency-versus-yuan-euro.html

8.Zulauf, C., & Orden, D. (2019, January 25). America's Twin deficits since 1980. farmdoc daily. https://farmdocdaily.illinois.edu/2019/01/americas-twin-deficits-since-1980.html