Academic journal article Journal of Australian Political Economy

Rethinking the Twin Deficits

Academic journal article Journal of Australian Political Economy

Rethinking the Twin Deficits

Article excerpt

The twin deficits debate that emerged in the late 1970s has regained traction in recent times since the Eurozone crisis and the debt ceiling debates in the USA. The neoclassical economic contention is that imprudent government spending causes trade deficits: thus, public deficits and debt are the offenders responsible for the Eurozone trade imbalances, the USA's trade deficits and global imbalances generally.

Empirical tests are inconclusive. Some (Abell 1990:81-96; and Volcker 1984:4-9) show that fiscal deficits cause trade deficits, while others (Summers 1988:349-375; and Reisen 1998) indicate the reverse causality. Yet, austerity policies are advanced as if they rest on an uncontested theoretical and empirical foundation. This article challenges the orthodoxy and uses a simple model and a Eurozone case study to show that international differences in competitiveness (based on real unit labor costs and the complexity of exports) lead to unbalanced trade. This crucial insight overturns the neoclassical reasoning, since the latter explanation of a twin-deficit relationship rests firmly on the free trade-balanced trade theory. The popular story is that, because trade balances naturally, any imbalances can only be explained by fiscal imprudence. But when imbalances are the natural outcome of trade among differently abled countries, fiscal deficits cannot adequately explain these imbalances. Therefore, this article contradicts the neoclassical view. It contends that public deficits and household debt are unfortunate consequences of trade deficits because government outlays tend to increase, stabilizing income and employment, as trade deficits increase.

This debate around these issues is important because of the impact its policy implications could have on the global economy and how it is managed in the future. Overturning the free trade theory and the mainstream economists' explanation of the twin deficits contradicts the claim that austerity is necessary. Using a simple model, this article demonstrates how austerity measures can reduce cyclical trade deficits but at the cost of higher unemployment and indebtedness. Knowing the difference between cyclical and structural trade balances is crucial in understanding why austerity gives a false sense of adjustment. Structural balances are underpinned by competitiveness, while the cyclical trade balances adjust with income. But suppressing income to shrink trade deficits is neither the solution when trade deficits are structural, nor is it humane. Austerity is not the appropriate policy to adjust structural trade deficits.

Some previous studies, such as Nikiforos et al (2013:17), support the line of causation proposed here, but there are important differences. For instance, Nikiforos et al (2013:2) explain that the source of imbalances in Greece is the Euro, unlike the contention in this article that differences in competitiveness are the key problem. Similarly, Krugman (2013) claims that imbalances in Europe could be eliminated if the Eurozone countries had independent currencies: but this article explains that this adjustment mechanism is dependent on the assumptions of Say's Law and high price and income elasticities of demand for exports and imports respectively. When these latter assumptions are relaxed, the adjustment mechanism fails to operate and trade imbalances persist.

So how can global imbalances be prevented? Keynes suggested an International Clearing Union but this would not prevent imbalances where the source of the imbalances is differences in competitiveness. Rather, industrial policies are necessary to acquire the tacit knowledge and technology needed to improve competitiveness. Nations with highly ubiquitous export portfolios and/or relatively high real unit labor cost need space to elevate their productivity and the technology content of their exports. Trade arrangements that fail to compensate for competitive differences create future crises of debt, trade imbalances and high unemployment. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.