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FURTHER ANALYSIS OF THE TWIN DEFICITS BASUDEB BISWAS, GOPAL TRIBEDY, and PETER SAUNDERS* In a 1989 Contemporary Policy Issues article Miller and Russek publislzedfind- ings of a causal relation between thefiscal deficit and the trade kficit. Hmever, they found no ovemhelming support for reverse causation between the twin deficits. The authors of the analysis here gathered annual data on U.S. federal budget dejicits and net exports for 1950-1988 and deflated the nominal values by the GDP deflators to examine the causal relation based on real values. They made a distinction between structural and actual budget deficits. Instead of an arbitray choice of lag structure, they used Hsiao (1979, 1981) minimum final prediction error criterion to determine the optimum lag lengths of the explanato y variables. The analysis reveals a unidi- rectional causal relation running from structural budget deficits to net exports, con- firming some of Miller and Russek’s findings. Contra y to Miller and Russek’s con- clusions, however, findings here indicate a bi-directional causal relation between actual budget deficits and net exports. Thesefindings suggest important policy implications. 1. INTRODUCTION A 1989 Contemporary Policy Issues article published results of a study in which Miller and Russek conducted standard Granger causality tests to check the direc- tion of temporal causality between fiscal deficits and crowding out of net exports for the U.S. economy. Miller and Russek found no overwhelming support for re- verse causation, thereby justifying the Bernheim (1988) approach of regressing the trade deficit on current and lagged fis- cal deficits. Further, in their cointegration tests, they concluded that the twin deficits have no long-run equilibrium relationship during the flexible exchange rate regime. Consequently, Miller and Russek sug- *Professor, Department of Economics, Utah State University, Logan, Utah; Professor, Asutosh College, Calcutta; Professor, Central Washington University, Ellensburg, Washington; respectively. This is a revised version of a paper presented at the Western Economic Association International 65th Annual Conference, San Diego, Calif., June 30,1990. Contemporary Policy Issues Vol. X, January 1992 gested that the absence of cointegration may signal only omitted variables from the cointegration regression. The analysis here uses annual data on U.S. federal budget deficits and net ex- ports 1950-1988 and deflates the nominal values by the GDP deflators to examine the causal relation based on real values. This study distinguishes between struc- tural and actual budget deficits. Instead of an arbitrary choice of the lag structure, it uses the minimum final prediction error criterion of Hsiao (1979, 1981) to deter- mine the optimum lag lengths of the ex- planatory variables. The analysis here finds a unidirectional causal relation run- ning from structural budget deficits to net exports, confirming some of Miller and Russek’s findings. Contrary to Miller and Russek’s conclusions, however, this study reveals a bi-directional causal relation be- tween actual budget deficits and net ex- ports. The concluding part of this com- ment notes the interesting implications of these findings. 104 @Western Economic Association International

FURTHER ANALYSIS OF THE TWIN DEFICITS

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Page 1: FURTHER ANALYSIS OF THE TWIN DEFICITS

FURTHER ANALYSIS OF THE TWIN DEFICITS BASUDEB BISWAS, GOPAL TRIBEDY, and PETER SAUNDERS*

In a 1989 Contemporary Policy Issues article Miller and Russek publislzedfind- ings of a causal relation between thefiscal deficit and the trade kficit. Hmever, they found no ovemhelming support for reverse causation between the twin deficits. The authors of the analysis here gathered annual data on U.S. federal budget dejicits and net exports for 1950-1988 and deflated the nominal values by the GDP deflators to examine the causal relation based on real values. They made a distinction between structural and actual budget deficits. Instead of an arbitray choice of lag structure, they used Hsiao (1979, 1981) minimum final prediction error criterion to determine the optimum lag lengths of the explanato y variables. The analysis reveals a unidi- rectional causal relation running from structural budget deficits to net exports, con- firming some of Miller and Russek’s findings. Contra y to Miller and Russek’s con- clusions, however, findings here indicate a bi-directional causal relation between actual budget deficits and net exports. These findings suggest important policy implications.

1. INTRODUCTION

A 1989 Contemporary Policy Issues article published results of a study in which Miller and Russek conducted standard Granger causality tests to check the direc- tion of temporal causality between fiscal deficits and crowding out of net exports for the U.S. economy. Miller and Russek found no overwhelming support for re- verse causation, thereby justifying the Bernheim (1988) approach of regressing the trade deficit on current and lagged fis- cal deficits. Further, in their cointegration tests, they concluded that the twin deficits have no long-run equilibrium relationship during the flexible exchange rate regime. Consequently, Miller and Russek sug-

*Professor, Department of Economics, Utah State University, Logan, Utah; Professor, Asutosh College, Calcutta; Professor, Central Washington University, Ellensburg, Washington; respectively. This is a revised version of a paper presented at the Western Economic Association International 65th Annual Conference, San Diego, Calif., June 30,1990.

Contemporary Policy Issues Vol. X, January 1992

gested that the absence of cointegration may signal only omitted variables from the cointegration regression.

The analysis here uses annual data on U.S. federal budget deficits and net ex- ports 1950-1988 and deflates the nominal values by the GDP deflators to examine the causal relation based on real values. This study distinguishes between struc- tural and actual budget deficits. Instead of an arbitrary choice of the lag structure, it uses the minimum final prediction error criterion of Hsiao (1979, 1981) to deter- mine the optimum lag lengths of the ex- planatory variables. The analysis here finds a unidirectional causal relation run- ning from structural budget deficits to net exports, confirming some of Miller and Russek’s findings. Contrary to Miller and Russek’s conclusions, however, this study reveals a bi-directional causal relation be- tween actual budget deficits and net ex- ports. The concluding part of this com- ment notes the interesting implications of these findings.

104

@Western Economic Association International

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BISWAS et al.: FURTHER ANALYSIS OF THE l" DEFICIT 105

II. EMPIRICAL RESULTS

The following presentation of empirical results represents net exports Y,, the actual federal budget deficits by X, and the structural budget deficits by X;.

The equations for the test of the order of integration are as foliows:

(1) X; * -0.0784 - 0.0606&1+ 0.085&-1, (0.0499) (0.0721) (0.1909)

(2) X t - -0.1121 - 0.1283Xt-1- 0.0983LYct-1, (0.0714) (0.0912) (0.1685)

and

(3) Yt = 0.0263 + 0.0829Yt-1 - 0.231aYt-I, (0.0704) (0.0353) (0.1895)

where the numbers in parentheses are standard errors of the regression coeffi- cients. In equation (Z), the coefficient of X,-l is negative in sign, but the Dickey and Fuller (1979) statistic suggests that it is not significantly different from zero at any reasonable level of significance. However, in equations (1) and (3), the coefficients of Xt,, and Y,-l are positive in sign. So, both net exports and federal budget deficits, structural and actual, in their real values integrate of order one.

To test cointegration between the real values of the federal budget deficits and net exports estimates of the residuals came from the following regression equations:

(4) Yt = 0.6803 - 2.746lX; + G I (0.1577) (0.2112)

and

(5) Yt = 0.6641 - 2.264lXf + Ut . (0.1756) (0.2146)

The cointegration tests based on the fol- lowing equations:

A

(6) 2 = -0.5201q-1 + 0.1034$-1, (0.1899) (0.1897)

and

A A A

(7) ~t 3 0.812711,-1+ 0.2827 Ut-1 I

(0.2341) (0.1956)

where

and

A A

suggest that coefficients of L& and U,, are negative in sign and significantly different

from zero. So, both l& and U, integrate of order zero. This means that cointegration holds both between X; and Y, and between XI and Y,. Clearly, then Granger causal relations exist both between structural budget deficits and net exports and between actual budget deficits and net exports in at least one direction.

The standard procedure for Granger causality tests requires estimating the fol- lowing equations:

A A

I I

(8) xt = b, + C bj xt-j + C-C+J~-~, j-1 i-1

and 1 1

and testing the null hypotheses ci = 0 and c; = 0 for i = 1,2 ,..., I. In this method, the choice of lag structure of the explanatory variables in equations (5) and (6) is arbitrary. A better method is to apply the

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106 CONTEMPORARY POLICY ISSUE

Hsiao (1979, 1981) minimum final prediction error criterion, in which determines optimum lag lengths by minimizing the final prEdiction errors defined as F P E , = E(x,-x,)~ and FPE, =

E(y, - yt)* where xt and yt are estimated values of the respective variables in equations (8) and (9).

With equation (8) the procedure deter- mines the optimum lag length of x in the absence of lagged values of y as explana- tory variables. Then retaining this opti- mum lag of x, the procedure introduces lagged values of y one by one to minimize the FPE,. The procedure follows the same steps using Equation (9). Once the FPEs are obtained, the causality tests are straightforward. If the minimum FPE, without lagged values of y is greater than that with the lagged values of y, causality supposedly runs from Y to X. Otherwise, one rejects the null hypothesis. Similarly, if the minimum FPE, without lagged val- ues of x is greater than that with the lagged values of x causality supposedly runs from X to Y. A bi-directional causality exists when causality runs both from Y to X and from X to Y.

To detect the direction Granger causal- ity between federal budget deficits and net exports, table 1 presents the optimum lag lengths and the corresponding F P E s in equations (8 ) and (9). The last column notes the causality implications of the F P E procedure.

The table shows that the structural bud- get deficits (X') have the minimum FPE of 0.0434 when one lagged value of the vari- able is introduced. The minimum FPE goes up to 0.0461 with the inclusion one lagged value of net exports (Y). So as Y+X indicates, causality does not run from net exports to structural budget def- icits. Net exports have the minimum FPE of 0.0875 with one lagged value of itself, including one lagged value of the struc- tural budget deficit in the equation brings the FPE down to 0.0832. This means that causality runs from structural budget def-

A A A

icits to net exports, as X*+Y indicates. Thus, a unidirectional causal relation from structural budget deficits to net exports exists.

Similar tests show existence of bi-direc- tional causality between actual budget deficits ( X ) and net exports (Y). The actual budget deficits have the minimum F P E of 0.1113 when two lags of the variable are introduced. But the minimum F P E goes down to 0.1082 when nine lagged values of net exports are included in the equa- tion. This result indicates that causality runs from net exports to actual budget def- icits, as Y+X shows. Including six lagged values of actual budget deficits in the equation also brings the minimum FPE of net exports down from 0.0875 to 0.06. So, causality also runs from actual budget def- icits to net exports, as X+Y indicates. Thus, the minimum F P E criterion applied to the U.S. data suggests that a bi-direc- tional causality exists between actual bud- get deficits and net exports of the country.

111. CONCLUSIONS

The unidirectional causal relation run- ning from structural budget deficits to net exports and the two-way relation between actual budget deficits and trade deficits, revealed by U.S. data for the period 1950- 1988, have a number of policy implica- tions. First, one cannot treat the federal budget as a fully controlled policy vari- able. Although discretionary fiscal policy has an important macroeconomic func- tion, one cannot ignore the budgetary im- plications of exogenous changes in foreign trade variables. The trade balance, which result from exogenous factors, affects the budget balance.

Second, the slowing of the overall pro- ductivity growth in the U.S. economy compared to the productivity improve- ments in the European Common Market countries and Japan plays a significant role in the loss of competitive power of U.S. goods in domestic and international

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BEWAS et al.: FURTHER ANALYSIS OF THE TWIN DEFICIT 107

TABLE 1 Causality Implications of the FPE Procedure for Federal Budget Deficits and Net

Exports of the USA, 1950-1988

Controlled Manipulated Minimum Variable Variable FPE Implication

0.0434

0.0461 0.0875 0.0832

0.1113 0.1082 0.0600

0.0434 < 0.0461

Y t, x* 0.0875 > 0.0832 x* -., Y

0.1113 > 0.1082 Y-x 0.0875 > 0.0600

x-Y

Note: Numbers in the parentheses are the lags of the variable for the minimum FPE.

markets. If policy measures do not specif- ically focus on productivity growth, cut- ting the budget deficit alone will be insuf- ficient to improve the country's trade bal- ance. On the contrary, the deteriorating trade balance caused by the loss of com- petitive power in the world might aggra- vate the contractionary effects of a budget cut. Moreover, the budget cut policy itself might be self-defeating because of the re- verse causality from trade deficits to bud- get deficits.

Third, in the flexible exchange rate re- gime, exogenous changes in the budget deficit and the foreign trade component of the aggregate demand affect each other in a way in which the equilibrating forces aggravate the situation. On the one hand, the slowing of productivity growth alone would have caused a sufficient deprecia- tion of the U.S. dollar; and then an appro- priate adjustment of the real exchange rate could have restored the U.S. competitive position in the world market. However, increasing budget deficits did not allow the U.S. dollar to depreciate. Rather, com- petitive power suffered a further loss through dollar appreciation. On the other

hand, the effects of trade deficits on the endogenous part of the budget might frus- trate congressional efforts to cut the bud- get deficits. A real solution of the problem of fiscal deficits and trade imbalances lies in a simultaneous attack on both fronts. Policy measures focusing on productivity improvement will complement budget-cut policy.

REFERENCES

Bernheim, B. D., "Budget Deficits and the Balance of Trade" in Tax Policy and the Economy 2, L. H . Sum- mers, ed., National Bureau of Economic Research, The MIT Press, Cambridge, Mass., 1988,l-31.

Dickey, D. A,, and W. A. Fuller, "Distributions of the Estimators for Autoregressive Time Series with a Unit Root," ]oiirnal o/ the American Statistical As- sociation, June 1979, 427-431.

Hsiao, C., " Autoregressive Modeling of Canadian Money and Income Data," journal ofthe American Statistical Association, September 1979, 553-560.

, "Autoregressive Modeling and Money-In- come Causality Detection," journal of Monetary Economics, January 1981, 85-106.

Miller, S. M., and F. S. Russek, "Are the Twin Deficits Really Related?" Contempora y Policy Issues, Oc- tober 1989,91-114.