The Twin-Deficit Illusion

Abstract

Despite employment and income gains in the 1980s, is the United States in trouble because it has become the world’s largest debtor? The common perception is that Americans havebecome spendthrifts, with private consumption and government deficits financed by loans from and sales ofassets to foreigners. The inference commonlydrawn is that futureconsumption will have to be cnt back in order to service the nation’s rapidly deteriorating net external wealth position. So much depends on the underlying measures that it is surprising how little attention has been paid to their quality. Thousands of regressions have been run to estimate the relationship between the budget and current-account deficits. But the data are suspect because official measures of these magnitudes typically have not been adjusted for either inflation or changes inmarket values. This paper’s main objective is toanalyze the twin-deficit phenomenon using data that have been adjusted for inflation and market values. The conventional wisdom is that there is a causal link between large U.S. fiscal deficits and current-account deficits. This observation seems confirmed by Figure 1. Such a relationship is theoretically possible if fiscal deficits raise real interest rates enough to induce a capital inflow. Nonetheless, there is considerable dispute about the historical relationship between current-account and fiscal balances. For example, the United States ran large fiscal deficits during both World Wars, but there was a current-account surplus during World War I and a current-account deficit during World War II.

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