Journal of Policy Modeling 28 (2006) 595602
Twin deficits and financial integrationin EU member-states
Theodore Papadogonas a,, Yannis Stournaras ba Bank of Greece, Greece
b University of Athens, GreeceReceived 1 September 2005; received in revised form 1 January 2006; accepted 1 February 2006
In this paper, we find that changes in general government balances in the EU-15 member-states arematched to a large extent by opposite changes in the private savingsinvestment gap, implying that changesin public sector deficits have a rather small relationship with current account deficits. Also, using an empiricalframework implied by a well-known, intertemporal model of the current account, we find that current accountdevelopments in Greece are explained by factors which are related to financial and economic integration,such as interest rate spreads and growth differentials, as well as to the general government balance. 2006 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.
JEL classication: F15; F32; F41Keywords: Financial integration; Public sector and current account balances
One of the central issues in both economic policy and open-economy macroeconomics is therelationship between public sector (general government) deficits and current account deficits. Itis often argued that the two deficits are related strongly and positively (twin deficits) and this isthe way that this relationship is usually presented in the financial press. If this is true, national orworld current account imbalances can be (easily?) tackled to the extent that public sector deficitsare, more or less, under government control.
However, the relationship between public sector and current account deficits is more com-plicated, depending on the behavior of the private sector savings/investment gap, since the
Corresponding author at: 10 Kivelis street, 111 46 Athens, Greece. Tel.: +30 2103203601.E-mail address: email@example.com (T. Papadogonas).
0161-8938/$ see front matter 2006 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.doi:10.1016/j.jpolmod.2006.02.002
596 T. Papadogonas, Y. Stournaras / Journal of Policy Modeling 28 (2006) 595602
well-known national account identity states that the current account deficit is equal to the sum ofthe public sector deficit (that is, the difference between government investment and governmentsaving) and the private sector deficit (that is, the difference between private sector investment andsaving).
Almost every contribution to the literature on open-economy macroeconomics examines themacroeconomic implications of a higher public sector deficit and, in particular, its effects onthe real exchange rate, output, private savings, private investment and the current account. TheMundellFlemingDornbusch model might be said to remain the standard paradigm althoughmany authors are also using the new, open-economy macroeconomics framework (for differencesand similarities between the different models see, among others, Lane (2001), Obstfeld and Rogoff(1996), Vines (2003)).
According to the standard paradigm, the effects of a higher public sector deficit are transmittedthrough two channels of influence, namely the goods market (via the real exchange rate) and thecapital account (via the real interest rate). A higher public sector deficit is associated with anappreciation of the real exchange rate and higher output (as aggregate demand increases). As aconsequence, it is also associated with a deterioration of the current account. In addition, a currentaccount deficit results in net asset decumulation and higher foreign debt. The impact of this onexpenditure, as well as long-term considerations regarding the need to raise taxes to repay thepublic sector debt, are additional transmission mechanisms through which public deficits mightaffect external deficits.
Two particular cases deserve special attention for being at the two opposite extremes. Firstly, thedebt neutrality (Ricardian) hypothesis: according to one version this hypothesis suggests that in aworld with no imperfections and infinite horizons, changes in budget deficits cause offsetting, one-to-one changes in private savings through anticipations of changes in future taxation. Therefore,national savings and the current account remain unaffected (Barro, 1988).
Secondly, complete crowding out of net exports: in a small open-economy where all goods areperfect substitutes and freely traded (that is, the law of one price holds) while domestic productionis either at the full employment level or is fixed due to a rigid real product wage, a higher budgetdeficit causes a one-to-one increase in the current account deficit. It may be noted that this resultremains valid in two other cases: (a) in the conventional MundellFlemingDornbusch model withperfect capital mobility and a floating nominal exchange rate, and (b) under the New Cambridgeassumption (Fetherston & Godley, 1978) that the private sectors (households and corporations)net acquisition of financial assets is zero (that is, under the assumption that private disposableincome is equal to private consumption and investment).
In an interesting contribution, Blanchard and Giavazzi (2002) attempt to explain current accountdevelopments in certain European Union (EU) member-states emphasizing factors related toeconomic and financial integration. First, the reduction in interest rate spreads and in currency riskdue to nominal convergence, which, for net borrowing countries, increase private investment andreduce national savings. Unless government net lending (that is, the general government surplus)moves sufficiently in the opposite direction, this channel implies an increase in the current accountdeficit to GDP ratio. Second, the increase in competition through economic integration, whichis expected to increase total factor productivity, improving the home countrys growth prospects.Unless the growth rate of trade partners exceeds the home countrys growth rate, this channel alsoimplies an increase in the current account deficit to GDP ratio.
Blanchard and Giavazzi (2002) use an explicit utilitarian approach with households living fortwo periods and maximizing a logarithmic utility function under a two-period budget constraint.Their model is thus different than the more traditional MundellFlemingDornbusch models of
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the current account, which emphasize competitiveness and national incomes of the home andforeign country as the main determinants of the current account. However, differences are moreapparent than real: as we will explain later, competitiveness in the Blanchard and Giavazzi (2002)model does not appear in their current account equation because it is an endogenous variable, whichdepends on relative output. Actually, models with aggregate demandaggregate supply equationsof the MundellFlemingDornbusch tradition emphasize variables (as determinants of the currentaccount), which are closer to those of Blanchard and Giavazzi (2002), see Stournaras (2004).
The present paper addresses the following two empirical questions: (a) What is the empiricalrelationship between changes in the net lending of general government (that is, in the surplus of thepublic sector) and changes in the private sector savingsinvestment gap and, therefore, betweenchanges in the net lending of general government and the current account balance in EU member-states? (b) Can the Greek current account balance be explained by factors related to economic andfinancial integration a la Blanchard and Giavazzi (2002) as well as the general government deficit?
2. Government savings and investment and the private sector savingsinvestment gap
It is well known that we can express the difference between national savings and nationalinvestment (that is, the current account surplus) as the sum of the net lending of general government(NLG)1 and the private sector savingsinvestment gap (SpIp). To the extent that NLG can beconsidered, more or less, as an exogenous variable under government control, it is important toexamine the contribution of the net lending of general government to the overall balance betweennational savings and national investment and, thus, to the evolution of the current account balance.Incidentally it is interesting that many authors (see among others, Gourinchas (2002)) have stressedthat the widening of current account deficits due to financial integration might cause internationalfinancial markets to take fright over the sustainability of the net foreign asset position of countrieswith widening current account deficits. This might require some insurance, or buffer. Smallergovernment deficits (or larger government surpluses) provide such an insurance. Hence it mightbe argued that the limits imposed by the Stability and Growth Pact on government deficits arejustified not only on the grounds of fiscal and monetary stability, but also on grounds related tocurrent account adjustment as a result of financial integration.
In any case, general government net lending cannot be ignored in models analyzing the effectsof financial integration. Since financial integration and, in particular, the convergence of interestrates, affect the balance between private savings and private investment, general government netlending could either reinforce this effect or move the balance between national saving and nationalinvestment (and, therefore, the current account balance) to the opposite direction.
An important question that is usually asked in this context is the following: To what extent isa change in the net lending of general government matched by an opposite change in the privatesavingsinvestment gap (and through which transmission mechanisms) and, therefore, to whatextent does a change in the net lending of general government affect the current account balance?
This leads us to test the following equation:
]= a0 + a1
+ ui (1)
1 NLG is equal to government savings minus government investment. Government savings is equal to current governmentrevenue minus current expenditure.
598 T. Papadogonas, Y. Stournaras / Journal of Policy Modeling 28 (2006) 595602
Table 1Estimation results for Eq. (1)
a0 a1 Adj. R2 a1 = 1a
Austria 0.04 (0.88) 1.19*** (4.73) 0.45 0.76Belgium 0.02 (0.09) 0.71*** (6.87) 0.59 2.81**Denmark 0.16 (0.09) 0.12 (0.44) 0.02 5.82***Finland 0.53 (1.40) 0.82*** (5.31) 0.50 1.15France 0.08 (0.41) 1.01*** (5.04) 0.52 0.07Greece 0.08 (0.26) 0.75*** (4.95) 0.42 1.66Ireland 0.11 (0.24) 0.74** (2.87) 0.31 1.02Italy 0.10 (0.42) 0.89*** (5.72) 0.59 0.73Netherlands 0.08 (0.31) 0.41*** (3.26) 0.24 4.64***Portugal 0.03 (0.06) 0.93*** (3.44) 0.31 0.28United Kingdom 0.08 (0.38) 1.01*** (6.94) 0.60 0.05t ratios are in parentheses. ** Significant at the 5% level, *** significant at the 1% level (two-tailed tests). Results forGermany, Luxembourg, Spain and Sweden are not reliable due to insufficient observations.
a t-tests for the hypothesis H0: a1 = 1. ** Denotes rejection at the 5% level, and *** denotes rejection at the 1% level.
Table 1 presents results for 11 EU member-states for this equation.2 These imply a negative andstatistically significant coefficient a1 for all member-states except Denmark with a value close to1. Actually the hypothesis a1 = 1 cannot be rejected for most of these 11 member-states. Also,the constant a0 appears to be statistically insignificant in all member-states. These results implythat changes in the net lending of general government are matched to a large extent by oppositechanges in the private sector savings/investment gap implying a negligible association betweenpublic sector and current accounts balances.
This surprisingly strong result might be explained in many ways and has strong policy impli-cations. We will not attempt to present all relevant theories here, since this is outside the scope ofthe present study, nor the full transmission mechanism. However, we will indicate certain possibleexplanations:
(A) It might be argued very strongly that these results are consistent with the debt neutralityor Ricardian hypothesis presented earlier, since a stylized fact that would emerge from aRicardian model is precisely the fact that the coefficient a1 in the above equation would be1. An objection to this explanation could be the following: The precise Ricardian positiondoes not refer to the relationship between government net lending and the private sectorsavingsinvestment gap. It refers to the relationship between private savings and governmentsavings in a frictionless and fully rational world, where the private sector, in full anticipationof the future implications of increases in government current expenditure, increases its currentsavings. Moreover, earlier tests by McCallum (1993) for OECD countries reject this Ricardianrelationship between private savings and government savings.
(B) MundellFlemingDornbusch models suggest that a reduction in government net lending(that is, an increase in general government deficit) leads to higher output, an increase inreal interest rates and an appreciation of the real exchange rate. These imply higher pri-vate savings and, perhaps, lower private investment (depending on interest rate and income
2 All data used in this study come from OECD, National Accounts and cover the period 19702003.
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elasticities). Therefore, they imply a higher private savingsinvestment gap. However, thecorrelation between the increase in general government deficit and the increase in the pri-vate savingsinvestment gap is generally less than unity. A correlation coefficient equal tounity might be derived in models with product real wage rigidity, capital controls and creditrationing (see among others, Gibson, Stournaras, & Tsakalotos, 1992, 1994).
(C) The result might be due to a combination of conjunctural factors and financial integration:Maastricht Treaty fiscal criteria promoted fiscal contraction (an increase in government netlending) for member-states with large government deficits and, at the same time, financialintegration affected the private savingsinvestment gap: for borrowing countries the privatesavingsinvestment gap shrank as a result of interest rate convergence, which reduced privatesavings and increased private investment.
Although we do not examine empirically the transmission mechanism and the full implications ofthis surprisingly strong result (which definitely requires further investigation), we can draw threeconclusions. Firstly, we should expect a rather small association between changes in the currentaccount deficit and changes in the public sector deficit, as there is strong evidence that changes inthe public sector deficit are matched by opposite changes in the private sector savingsinvestmentgap.3 Secondly, empirical efforts to analyz...