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Revisiting the Twin Deficits Hypothesis: The Effect of Fiscal Consolidation on the Current Account

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Abstract

This paper investigates the effect of fiscal consolidation on the current account. We examine contemporaneous policy documents, including Budget Speeches, Budgets, and IMF and OECD reports, to identify changes in fiscal policy motivated primarily by the desire to reduce the budget deficit, and not by a response to the short-term economic outlook or the current account. Estimation results based on this measure of fiscal policy changes suggest that a 1 percent of GDP fiscal consolidation raises the current account balance-to-GDP ratio by about 0.6 percentage point, supporting the twin deficits hypothesis. This effect is substantially larger than that obtained using standard measures of the fiscal policy stance, such as the change in the cyclically adjusted primary balance.

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Notes

  1. See, for example, Bernheim (1988), Alesina, Gruen, and Jones (1991), Chinn and Prasad (2003), Chinn and Ito (2005), Gruber and Kamin (2007), Lee and others (2008), Abbas and others (2010), Bussière, Fratzscher, and Müller (2010), and Summers (1986). Gagnon (2011) obtains a coefficient of 0.2 for industrialized economies, and 0.3 for a broader sample of 112 countries.

  2. For example, Alesina and Perotti (1995) and Alesina and Ardagna (2010) correct the primary balance for year-to-year changes in the unemployment rate.

  3. For a discussion of how cyclically adjusted fiscal data contain nonpolicy movements correlated with economic activity, see, for example, Morris and Schuknecht (2007), Milesi-Ferretti (2009), Romer and Romer (2010), Guajardo, Leigh, and Pescatori (2011), and Wolswijk (2007).

  4. An exception would be the case of an economy for which domestic activity is primarily driven by external demand for its exports, in which case the current account may also improve when activity rises. For example, a rise in the global demand for oil may be associated with strong domestic income and exports in a country such as Norway (which is not in our sample).

  5. In a robustness check, we investigate whether the omission of anticipated policy changes may be biasing the estimated effect of fiscal policy. If agents are in fact responding to anticipated future policy changes that happen to be correlated with current policy changes, then we should find that the estimated effect of fiscal policy on the current account changes noticeably when leads of the policy measure are included.

  6. Alternative approaches to identifying exogenous changes in fiscal policy include, for example, that of Shoag (2010), who focuses on changes in U.S. state government spending associated with windfalls from pension fund returns. Another example is the approach of Ramey (2011), who estimates the effect of changes in U.S. military spending. Future research could investigate the feasibility of applying these approaches to a broad panel of countries.

  7. The finding that our fiscal policy changes tend to be permanent raises a theoretical question: can permanent fiscal policy changes affect the current account? In models with non-Ricardian features, such as households with finite lifetimes, a permanent reduction in the budget deficit induces a permanent (steady-state) improvement in the current account balance, as explained by Kumhof and Laxton (2009). For example, with finitely lived households, an increase in government saving due to tax hikes (or government spending cuts) is not fully offset by a reduction in private saving, implying a rise in national saving, and a fall in net foreign liabilities. The lower interest payments on the reduced stock of net foreign liabilities in turn imply a permanent improvement in the (interest-inclusive) current account balance. Thus, allowing for non-Ricardian behavior can overturn the prediction of some basic models in which permanent fiscal consolidation measures have no effect on the current account.

  8. The cyclically adjusted data come from Alesina and Ardagna (2010).

  9. The current account balance data are taken from the World Economic Outlook (WEO) database of the IMF. To compute the current account-to-GDP ratio, the current account in U.S. dollars (code BCA) is divided by nominal GDP in U.S. dollars (also taken from the WEO database, code NGDPD).

  10. The estimated coefficients on the contemporaneous and lagged fiscal consolidation terms––the γs in Equation (2)––are statistically significant with a joint F-statistic of 6.34 (p-value=0.0003). The estimated equation has an overall R-squared of 0.15, a between R-squared of 0.10, and a within R-squared of 0.15.

  11. Observations with Cook's distance greater than 4/N, where N is the sample size, are discarded.

  12. As Kilian and Vigfusson (2009) point out in the context of estimating the effects of energy price increases, setting one side of the distribution of the independent variable to zero can lead to estimates that are greater in absolute value than the true effects.

  13. For example, to investigate the impact of fiscal contraction on the investment-to-GDP ratio, we estimate the following equation:

    where I is the investment-to-GDP ratio. The investment-to-GDP ratio is computed based on data from the IMF’s WEO database (series NI divided by series NGDP). The saving-to-GDP ratio is constructed as the sum of the current account-to-GDP ratio and the investment-to-GDP ratio.

  14. The price differential relative to trading partners is defined as the ratio of the real effective (trade-weighted) exchange rate to the nominal effective exchange rate. The real and nominal effective exchange rate data come from the IMF Information Notice System (IMF-INS) database.

  15. The ULC measures the average cost of labor per unit of output and is calculated as the ratio of total labor costs to real output. The ULC data come from the OECD Economic Outlook database.

  16. Similarly, comparing the effect of fiscal consolidation following euro adoption with the effect in all economies with a pegged exchange rate, as defined by the Ilzetzki, Reinhart, and Rogoff (2008) exchange rate regime classification, suggests that the current account improves more in the euro area than in economies with pegs in general. However, for the countries in our sample, this comparison is very similar to that of comparing the effect of fiscal consolidation before and after euro adoption, since most of the countries with a pegged exchange rate in our sample were those that eventually adopted the euro.

  17. Real domestic demand is defined as the sum of real final consumption expenditure and real gross fixed capital formation (series CV and ITV from the OECD Economic Outlook database, respectively). The short-term policy rate series come from Datastream.

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Additional information

*John Bluedorn and Daniel Leigh are economists at the IMF's Research Department. This paper was presented at the European University Institute/IMF Conference on Fiscal Policy, Stabilization, and Sustainability Conference in Florence, Italy, on June 7, 2011. The authors thank Roel Beetsma, Olivier Blanchard, Pierre Olivier Gourinchas, the referees, and numerous seminar participants for valuable feedback. The views expressed in this paper are those of the authors and do not necessarily represent those of the IMF or IMF policy.

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Bluedorn, J., Leigh, D. Revisiting the Twin Deficits Hypothesis: The Effect of Fiscal Consolidation on the Current Account. IMF Econ Rev 59, 582–602 (2011). https://doi.org/10.1057/imfer.2011.21

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