Twin Deficits: Apparition or Reality?

Abstract

This paper uses cointegration and multicointegration analysis to explore the issue of twin deficits for the USA in the post-World War II period. The results suggest that prior to 1974 the systems of fiscal and foreign sector variables exhibit multicointegration. These results do not rule out short-run correlations between government deficits and external deficits. However, they do preclude the possibility that the twin deficit phenomenon describes a long-run structural relationship in the post-World War II, Bretton Woods era. In the more recent period, 1974 forward, neither system exhibits evidence of multi/cointegration. But, weak evidence of cointegration is present between fiscal deficits and trade deficits. Error correction models suggest that causality runs from internal to external deficits in the dynamic adjustment process. This evidence provides some support for the notion that more recently fiscal deficits may have contributed to external deficits. In combination with the results from the early sub-period, the evidence indicates that to the extent the twin deficit relationship exists, it is time specific and weak.

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