Academic journal article Business and Economics Research Journal

Assessing the Twin Deficits Hypothesis in Selected OECD Countries: An Empirical Investigation

Academic journal article Business and Economics Research Journal

Assessing the Twin Deficits Hypothesis in Selected OECD Countries: An Empirical Investigation

Article excerpt

Abstract: The improvement of budget deficits and current account deficits has renewed the debate over the twin deficits hypothesis. This paper examines the validity of the twin deficits hypothesis in nine members of the Organizations for Economic Co-operation and Development (OECD) over the period 1990-2007. We use recently developed panel cointegration tests with structural breaks to assess the relationship between budget deficits and current account deficits. The empirical findings in this paper are as follows: (1) There is a long-run relationship between budget deficits and current account deficits for these countries; (2) The empirical result is consistent with the Keynesian proposition.

Keywords: Twin deficits, panel unit root, structural breaks, panel cointegration

JEL Classification: C23, E6, F4

(ProQuest: ... denotes formulae omitted.)

1. Introduction

In recent years, many scholars have studied the relationship between budget deficits and current account deficits in both developed and developing countries. In the past decade, the twin deficits phenomenon has reemerged in many countries. The importance of twin deficits stems from the "harmful" effects of deficits on an economy and the threats to macroeconomic stability. The two deficits are depending on the underlying tax system, trade patterns and barriers, the exchange rate and a complex host of internal and international forces that shape a country's economic status in the global setting. The twin deficit hypothesis first emerged during the Reagan period of the 1980s in U.S., the budget deficit rose from 0.5% of full employment GDP in 1981 to 4.2% in 1985. The trade deficit rose over this period from 0.1% of GDP to 2.6% of GDP. The recession in 2001 mirrored the 1980s experience both in terms of the budget deficit and the trade deficit (Labonte, 2003). During the middle of the 2000s, some argued that a larger fiscal deficit, through its effect on national savings, would rekindle the current account deficit (Bartolini and Lahiri, 2006). During the 1980s and 2000s, the main cause of the U.S. current account deficit was the federal government budget deficit. The lack of savings in the government and private sectors must be complemented by foreign savings, resulting in capital inflow (Ito, 2009).

The United States is not a unique country from the point of view of twin deficits. Although the existing literature mostly focuses on the U.S., similar problems exist in both developed countries, such as Germany, England and Sweden, and in developing countries, such as Malaysia, Philippines and Turkey. These country currencies are dependent on the U.S. dollar. With the appreciation of the dollar, the increase in their budget deficits during the early 1990s led to current account imbalances, which resulted in an economic crisis (Baharumshah et al., 2006). The outbreak of the current global financial crisis has not wiped away the twin deficits issue. Indeed, many international economists blame it on the global crisis (Ito, 2009).

The aim of this article is to explore the validity of the twin deficits hypothesis in nine OECD countries using panel cointegration tests with structural breaks from 1990 to 2007. This article differs from existing related studies in three ways. First, although some studies have used trade deficits in the twin deficits hypothesis, this paper includes the current account of the balance of payments. The current account deficit, more comprehensive than the trade deficit, is the sum of the balance of trade (the export of goods and services minus the import goods and services) and net current transfers (interests, dividends, and foreign aid). Second, although there is now significant evidence to support the twin deficits hypothesis (Piersanti, 2000; Normandin, 1999; Chinn and Ito, 2005), none of these previous studies is based on panel cointegration with structural breaks. Most studies use time series data (Holmes, 2009; Grier and Ye, 2009) or classical panel data in their modeling (Saleh et al. …

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