Twin Deficits and Twin Decades

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Twin Deficits and Twin Decades

• Jeffrey Frankel
• Harpel Professor of Capital Formation and Growth
• Kennedy School of Government
• Harvard University
• conference on the Macroeconomics of Fiscal Policy
• sponsored by the Federal Reserve Bank of Boston,
• at Wequasett, June 14-16, 2004

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Three propositions were put to the test by fiscal
expansion of 1980s
Proposition Prediction Outcome in 1980s
Barros debt neutrality BD would be offset by increased private saving, so National Saving would not fall. Private National Saving rates fell
Mundell-Fleming high capital mobility floating rates The fall in national saving rate would crowd out TB, more than crowding out investment (via rise in real interest rate and ) As predicted. The Twin Deficits are born.
Feldstein-Horioka finding Fall in NS gt fall in investment, lt rise in current account deficit (Capital mobility is not that high.) Saving-retention coefficient fell some. Both kinds of crowding out occur.
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Remarkably close parallels between fiscal
expansion of the 1980s and the current decade

• tax cuts gt big deficits (despite claims to
  long-run fiscal probity) (Figure 1)
• part of the problem overly optimistic forecasts
  (Figure 4)
• incl. the Laffer hypothesis US tax rate cuts
  gt growth up gt tax receipts up
• optimistic forecasts soon shattered, although
  Administration still blames deficits on
  recession and claims they will go away soon
  (Figure 5)
• failure of budget outcomes to follow script gt
  switch to Starve the Beast claim

• Starve the Beast claim rings hollow lt WH
  increases spending (Figure 6)
• Private saving does not offset deficits gt
  national saving falls. (Figure 2 or 2b)
• Economists debate if deficits affect interest
  rates
• Fall in national saving reflected in current
  account deficit. (Figure 3) Twin deficits.
• (Admittedly, cyclical factors responsible for
  exaggerating decline in budget, NS, I at
  the beginning of decade, but not for overall
  pattern.)

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Fig.1 US Federal Deficit as Share of GDP by
Presidential Term
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Fig. 4 Three years of budget forecasts that
soon proved too optimistic
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Fig. 5 As of 2004, official budget forecasts
are still too optimistic

• Source
• Alice Rivlin Isabel Sawhill, Brookings,
  1/13/2004

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Fig. 6 US Federal Spending as a Share of GDP,
by Presidential Term
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Fig. 2b Private Saving Fails to Rise to Offset
Budget Deficits Rather National Saving Falls
(shares of GDP 1980-2002)
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Fig. 2 Budget Balances, Private Saving,
National Saving, as Shares of GDP
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Fig. 3 National Saving, Investment, Current
Account, as Shares of GDP
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Table 2 Feldstein-Horioka Regressions for US --
1964-2003

• Dependent Variable
• Current Account / GDP, Cyclically Adjusted
• Coefficient is about 1/2
• Some evidence of upward trend in capital mobility

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Differences between the two decades

• Differences between early 00s and early 80s
• Interest rates have been low, 2001-2004
• The dollar began to depreciate in 2003
• Not surprising
• The Fed has been very accommodating, so far
• Asian central banks, too, have bought US Treasury
  securities
• People are apparently not yet fully aware of the
  likely magnitude of coming deficits.
• Likely to change i trend will be up

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Interest Rates Expected Budget DeficitsSource
Menzie Chinn and Jeffrey Frankel, October 15,
2003OLS regression using annual data, in levels
(Newey-West robust standard errors in
parentheses). variables defined in decimal
form. () denotes significance at the
10(5)1 level.