JOHN D. ABELL Unioersity of North Carolina

Charlotte, North Carolina

Twin Deficits during the 7980s: An Empirical investigation *

This study uses multivariate time series analysis to examine the linkages between federal budget deficits and merchandise trade deficits. Using a vectorautoregressive model, support is found for the notion that budget deficits influence trade deficits indirectly rather than directly. Evidence is obtained through causality testing and impulse response functions that the “twin deficits” are connected through the trans- mission mechanisms of interest rates and exchange rates. The model indicates that reducing the size of the budget deficit may prove to be at least as effective as exchange rate intervention for the purpose of reducing the size of the merchandise trade deficit.

1. Introduction This paper examines the period from 1979 to 1985 when the

federal government budget deficit grew from $16 billion to over $200 billion, while the U.S. merchandise trade deficit grew from $27 billion to $125 billion. The connection between these twin def- icits has been made by a number of observers such as Volcker (1984), Hakkio and Higgins (1985), Kvasnicka (1985), Laney (1986), Cheng (1987), and Darrat (1988).

Volcker, for example, suggests that the two deficits are linked in the following way. Given the relatively low domestic savings rate in the U.S., large federal budget deficits put upward pressure on real interest rates. Those high rates made the U.S. a relatively at- tractive place in which to invest and thus led to an inflow of foreign capital. While easing some of the strain on domestic credit markets and helping to finance the budget deficit, the foreign capital flows increased the value of the U.S. dollar relative to the currencies of our trading partners. This, in turn, diminished the U.S. worldwide trading position, or in other words, led to an increasing merchan- dise trade deficit.

*This work was supported in part by funds from the Foundation of the Uni- versity of North Carolina at Charlotte and from the state of North Carolina. I wish to thank two anonymous referees for their insightful comments on earlier versions of this paper. I also wish to thank Djohan Hahma for valuable research assistance.

Journal of Macroeconomics, Winter 1990, Vol. 12, No. 1, pp. 81-96 81 Copyright 0 1999 by Louisiana State University Press 0164-0794/99/$1.59

John D. Abel1

However, as important as this issue is, there has been little empirical attention devoted to it. A number of studies have ex- amined a portion, but not all, of the individual linkages in the causal flow from budget deficits to trade deficits. For example, Plosser (1982) and Hoelscher (1986) find support for the theory that larger deficits cause interest rates to rise, while Evans (1987) and Hoelscher (1983) do not.’ Needless to say, the discussion surrounding deficits and interest rates has been controversial. The connection between interest rates and exchange rates has been examined by Batten and Thornton (1985), who found that an increase in U.S. interest rates relative to foreign rates led to an appreciation of the U. S. dollar. Belongia (1986) found a negative response of our agriculture trade position to an increase in the U.S. dollar.

Evans (1986) undertook a broader analysis in which he found that larger deficits were not responsible for the rise in the value of the U.S. dollar. Unfortunately, his analysis did not reveal any of the underlying linkages because he merely regressed an exchange rate on budget deficits and a number of other macro variables theo- rized to have an influence on exchange rates.

Lastly, Darrat (1988) examined the issue of causality between budget deficits and trade deficits in a multivariate setting and found evidence of bi-directional (Granger) causality. This finding provides support for Volcker’s contention that budget deficits indeed have a causal relationship with trade deficits. Unfortunately, the method- ology does not allow for an analysis of the channels by which this causality exists. The result that trade deficits were found to cause budget deficits indicates that U.S. policy makers may have re- sponded with additional government spending in response to do- mestic hardships caused by the trade imbalance.

This article seeks to empirically verify the set of macro link- ages connecting domestic budget deficits and merchandise trade deficits. Specifically, the causal ordering of the variables within the linkages is tested in a vector autoregressive model (VAR). In ad- dition, the moving average representation of the VAR is used to generate variance decompositions and impulse response functions.

The following section discusses in more detail the theory of an open economy, thus providing intuition for the particular choice

‘Hoelscher found that deficits affected long-term interest rates, but not short- term rates, respectively, in his 1987 and 1983 studies.

82

Twin Deficits during the 1980s: An Empirical Inoestigation

of VAR design. The next sections provide details of the VAR meth- odology and empirical results respectively. The article concludes with a discussion of the policy implications of the model.

2. Open Economy Macroeconomic Linkages The following national income accounting identity is useful for

analyzing the relationship between budget deficits and trade defi- cits :

NCF = CA = (G - T) + (I - S) , (1)

where

NCF = net foreign capital inflows to the U.S., CA = current account of the balance of payments,

G = government spending, T = government tax revenue, Z = domestic private investment spending, and S = domestic private saving.

Hutchinson (1984) points out that the current account of the bal- ance of payments (of which the merchandise trade balance is the major component) is simply the real sector counterpart of the cap- ital account which reflects the net foreign capital flows. This sym- metrical relationship is noted in the introduction, where it is stated that an inflow of foreign capital caused the dollar exchange rate to rise, which led to a corresponding worsening of the trade deficit.

Equation (1) is useful in a number of ways. It shows that, for a given savings rate, a budget deficit will either crowd out private investment or lead to an inflow of foreign capital (or both). By def- inition, anything that affects budget deficits, investment, or savings, in turn, affects both capital flows and the trade deficit. According to Dornbusch (1976) real interest rates are the key linkage between domestic activity and merchandise trade.

A loanable funds model of interest rate determination, such as that described by Hoelscher (1983, 1986), suggests that, after accounting for monetary changes and the stance of the business cycle, an increase in government borrowing to finance the deficit will in- crease real interest rates. Indeed, it is hard to avoid the fact that real rates in the U.S. have risen at the same time that domestic deficits were on the rise. In addition, the spread between U.S. rates

John D. Abel1

and foreign rates increased, which hastened the inflow of foreign capital.2

In addition to budget deficits, the behavior of the Federal Re- serve is an often-mentioned source of interest rate pressure because of its shift to a non-borrowed reserve operating procedure in Oc- tober 1979.3 Sellon (1984) suggests that the purpose of this regime change was to provide the Federal Reserve with greater control over inflation and money growth, as well as the growth of credit. According to Gilbert (1985), the implementation of this policy was facilitated by the widening of the ranges on interest rates. Not sur- prisingly, Roley and Troll (1983) report that this policy indeed gen- erated both higher and more volatile interest rates. However, this connection of tight money and high interest rates was short-lived because, according to Gilbert (1985), in October 1982, the Federal Reserve abandoned its non-borrowed reserves operating procedure in favor of what was equivalent to an interest rate targeting pro- cedure again. Money growth surged at a 13% annual rate following this regime change, yet real rates remained high. This influence of money on interest rates and the supply of domestic savings suggests that the money supply should also be included as a variable in the VAR representation in addition to those already discussed as being directly involved in the twin deficits linkage.

The vigorous U.S. recovery from the recession of the early 198Os, relative to the rest of the world and the accompanying surge of investment that followed, contributed to relatively higher interest rates here in the U.S., resulting in a net inflow of foreign capital. The other side of the coin is that the relatively stronger growth of the U.S. economy led to a surge in foreign imports which caused a worsening of the trade deficit. This suggests that a measure of economic growth needs to be included as a separate variable in the VAR representation.

The VAR representation is appropriate because of the possi-

‘The spread between U.S. and Japanese ex-post real short-term market rates, for example, increased over four percentage points during the sample period of this analysis. Also, in the VAR model, the yield on AAA rated bonds is used as a proxy for the spread between U.S. rates and a trade weighted average of rates of our trading partners.

3Bradley and Jansen (1986) verify th is reported regime change using VAR anal- ysis. Kvasnicka (1965) argues that the tight monetary policy which led to higher interest rates was an important determinant of the rise in the value of the dollar in the early part of the sample period examined here.

84

Twin Deficits during the 1980s: An Empirical lnvestigation

bility of simultaneity among many of the above variables and be- cause of the dynamic nature of the relationships. Such a model can be viewed as a system of reduced form equations-one for each variable in the system.

The variables are as follows:

Ml = monthly observations of the seasonally adjusted Ml money suPPlY7

DEF = the seasonally adjusted federal government budget defi- cit,

AAA = the yield on Moody’s AAA rated bonds, $ = the Dallas Federal Reserve real 101 country trade weighted

U.S. dollar exchange rate,4 MTB = the seasonally adjusted U.S. merchandise trade balance,

Y = real disposable personal income, and CPZ = the Consumer Price Index.

The inclusion of the CPZ allows the analysis to focus on inflation adjusted responses of the other variables. In particular, this allows the influence of bond rates on other variables to be in real terms.

The VAR technique requires stationary data, and for the vari- ables in this study, the autocorrelation functions of various trans- formations were examined in order to select that which was most parsimonious. In subsequent regressions on a constant and time, it was found that first differences of levels of DEF, AAA, $, MTB, and Y produced stationarity, while second differences of logs of Ml and CPZ were necessary.5

The model is estimated over 1979:ii-1985:ii. This sample pe- riod focuses exclusively on the period of almost unlimited dollar exchange rate appreciation during the early 1980s. This period stands in contrast to that following March 1985, in which there is persis- tent downward pressure on the dollar, either due to exchange rate

“This measure avoids the problem of not including our smaller trading partners, which is the case for many of the more popular indices. For a discussion of this measure, see Cox (1987). This data was made available by the Federal Reserve Bank of Dallas. All other data came from the Citibase data tape.

?hese transformations are similar to those of Fackler (lQ85), who used second differencing on his money and price variables and first differencing on the remain- ing variables. Hsiao (1982) also uses mixed transformations. Intuitively, the rates of growth of MI and prices were not observed to be stable during the period under study.

85

John D. Abel1

intervention on the part of the G-5 countries or due to inertia of its own6

3. Empirical Results The VAR model is specified using the multivariate extension

of Hsiao (1981, 1982), proposed by Ahking and Miller (1985).’ The technique makes use of Akaike’s final prediction error (FPE) cri- terion to determine optimal lag length, along with likelihood ratio tests to determine (Granger) causality.’ Because the steps used in specifying the preliminary VAR are nearly identical to those of Ah- king and Miller (1985), one may refer to that article for specifics.

Using the Ahking and Miller technique, the following VAR, shown in Figure 1, is specified containing a matrix of seven equa- tions and seven sets of lagged variables. To overcome the problem of contemporaneous covariance (see Theil 1971, 298), the system is estimated using full information maximum likelihood, thus gener- ating estimates that are asymptotically more efficient than equation- by-equation OLS. Diagnostic over- and under-fitting of the model is conducted using likelihood ratio tests to determine the adequacy of the system. Included in this series of hypothesis tests are zero- restrictions on each of the lagged sets of variables which allows for a determination of causality. A final diagnostic test involved a com- parison of the FPE model (as reported below) with an unrestricted model containing eight lags of every variable. This overfitting yielded a likelihood ratio test statistic of 163.36. With 304 degrees of fi-ee- dom, the null hypothesis that the unrestricted model fails to sta- tistically improve upon the restricted FPE model cannot be re- jected at the 1% significance level. Results from the other diagnostic tests are available upon request.

An entry in the coefficient matrix such as a&(L) has the fol- lowing interpretation. The subscript 15 identifies the equation num- ber (in this case 1 denotes the Ml equation) and the explanatory variable (in this case 5 denotes the AAA variable). The superscript

6A review of the ‘“Treasury and Federal Reserve Foreign Exchange Operations” in back issues of the Federal Reserve Bank of New York Quarterly Reoiew from Autumn 1985 to the present provides a chronology of the efforts of the G-5 and G-7 nations to manage the value of the dollar.

‘This technique incorporates features from Caines, Keng, and Sethi (1981), Lut- kepohl (1982), and Hsiao (1982).

‘A lag search of up to 8 months is conducted for each variable.

86

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John D. Abel1

identifies the order of the lag (in this case 8 lags on AAA), and the L is a lag operator.

A variable (X) is said to (Granger) cause another variable (Y) if the past values of X, along with the past values of Y, can be used to predict future values of Y more accurately than if only past val- ues of Y are used. Thus, according to Granger (1969), a zero in the coefficient matrix in an off-diagonal position indicates the absence of direct causality. However, in a system with more than two vari- ables, causality among two variables may exist indirectly by the presence of other variables.g The following discussion will focus ini- tially on direct (Granger) causality of budget deficits (DEF) and trade deficits (MTB). Next, the economic linkages that connect these two variables will be considered by examining issues of indirect (Gran- ger) causality. Whenever causality is addressed in the remaining discussion it is meant in the Granger sense of the word.

Examination of DEF and MTB in the coefficient matrix of the VAR model indicates that budget deficits are not (directly) causally prior to trade deficits, while on the other hand, trade deficits are (directly) causally prior to budget deficits. However, this finding does not settle the debate related to the contention of Volcker (1984) and others that budget deficits are related to the U.S. trade prob- lems of the 1980s. In fact, a closer reading of the literature reveals very specifically that the twin deficits are only indirectly related. This connection will be examined momentarily.

The result that trade deficits are (directly) causally prior to budget deficits is consistent with the findings of Darrat (1988) and his suggestion that government spending may have been a response to the domestic hardships caused by a worsening trade balance dur- ing this period.

There are a number of channels through which budget deficits may influence trade deficits. The primary set of linkages, according to Volcker, involves causality flowing from budget deficits to inter- est rates, to foreign capital flows, to exchange rates, and finally, to trade deficits. With regard to this particular set of linkages, the model suggests that changes in interest rates (AAA) are influenced by prior changes in budget deficits (DEF). This shows up as the lag polynomial ~2% in the model. The presence of AAA (a,& in the $ equation suggests that the dollar exchange rate is influenced by prior changes in interest rates. In addition to altering the demand

‘%xlirect causality is addressed by Hsiao (1982) and Kang (1982).

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Twin Deficits during the 1980s: An Empirical Investigation

for dollar denominated assets and thereby influencing the exchange rate, changes in interest rates may also act as a signaling mechanism to exchange market arbitrageurs. For example, during the sample period under examination, if the spread between U.S. rates and foreign rates would increase, market participants might profit from buying dollars in advance of the increased demand caused from for- eign capital flows. The final linkage in the twin deficit connection is the causally prior relationship of exchange rates and merchandise trade deficits as shown by the lag polynomial a76. It is interesting to note that this causal relationship is not uni-directional. The pres- ence of a6, suggests that a change in the trade deficit influences the dollar exchange rate, indicating that market concerns over the size or persistence of the trade deficit tend to affect the demand for the dollar.

Contrary to the findings of Evans (1986), the above evidence suggests that not only do prior changes in deficits cause changes in the dollar value (operating through the interest rate linkage), but they also cause changes in the merchandise trade deficit (operating through the exchange rate linkage). Additional evidence regarding these relationships was obtained by generating impulse response functions from the moving average representation of the VAR (see footnote 10 below for a discussion of the ordering of the variables). The moving average representation expresses each of the variables of the VAR system as functions of current and past disturbances. Using the coefficients of these disturbances or shocks, one can then trace out over time the response of any variable to a given shock to another variable. The entire time path of the affected variable is called an impulse response function. Figure 2 reports impulse re- sponse functions for the primary “twin deficit” connections that have been accumulated to show the total impact over a 24-month period. Panel (a) indicates a positive response of interest rates to a one standard deviation shock (a widening) to the deficit variable over a 24-month horizon. In turn, a shock to interest rates leads to an increase in the dollar ($) exchange rate, as shown in panel (b). Lastly, a shock to the dollar exchange rate leads to an eventually widening trade gap, as shown in panel (c). The negative response from months two through seven may reflect the presence of a J-curve effect, or it may reflect some degree of bidirectional feedback from MTB to the dollar exchange rate. However, after 24 months, there is an unambiguous increase in the size of the trade deficit.

These findings suggest that studies which fail to report a sig- nificant relationship between deficits and interest rates may suffer

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Twin Deficits during the 1980s: An Empirical Znvestigation

from misspecification problems when they omit a measure of for- eign capital flows or an exchange rate in their interest rate models.

There is one last channel through which deficits may influence the trade deficit, and this is through the influence of budget deficits on domestic monetary policy. Note that changes in M.2 are influ- enced by prior changes in the deficit (aI& along with prior changes in interest rates (aJ. Changes in Ml influence the trade deficit through the causally prior relationship with interest rates, as seen by the presence of a51. Interest rates then proceed to influence trade deficits through the aforementioned channels.

Finally, there are two direct causal influences on MTB: in- come and inflation. Recall that the U.S. economy expanded more rapidly than the economies of its trading partners following the recession of the early 1980s. The increase in import purchases that followed this expansion may help to account for the causal rela- tionship of real income and trade deficits as seen by the presence of aT3. The inflationary impact on trade deficits, as shown by aT2, is an intuitive result, given that changes in the rate of inflation af- fect the relative desirability of internationally traded goods and, thereby, affect the trade balance.

Sims (1980a, I98Ob, 1982) introduces a more discerning test of causality based on the variance decomposition of a variable’s fore- cast error variance. The decompositions are generated from a mov- ing average representation of the VAR system and show the pro- portion of forecast error variance for each variable that is attributable to both its ‘own innovations and those from the other variables. Thus, relationships among the variables may be evaluated in terms of de- gree of causality. Table 1 presents the results of this procedure. lo

The results of this analysis highlight two important facts re- garding the influence of budget deficits on trade deficits. First is the fact that deficits explain 2.5% of the forecast error variance of interest rates. This is over three times the amount explained by

“The variance decomposition r&suits as well as those of the impulse response functions are often sensitive to the ordering of the variables. The particular order- ing, as reported in Table 1, was chosen partly on the basis of the discussion in Volcker (1984). Recall that causality was thought to proceed from budget deficits to interest rates, to capital flows, to exchange rates, and finally to trade deficits. Also, money changes might be expected to cause changes in inflation, income, and interest rates. The perceptible change that came from alternative orderings was that the influence of budget deficits on other variables was magnified. Thus, the or- dering presented casts DEF in the most conservative light.

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John D. Abel1

TABLE 1. Variance Decompositions: Proportion of 24-month Variance Explained: 1979:ii-1985:ii

Percent Variation in: Due to innovations in:

Ml CPZ Y DEF AAA $ MTB

Ml 56.6 2.7 1.5 20.3 10.3 2.3 6.3 CPZ 1.1 69.0 0.9 0.4 0.4 26.1 1.9 Y 0.0 0.1 99.0 0.0 0.0 0.8 0.1 DEF 4.0 8.6 4.2 59.4 1.0 2.7 20.1 AAA 5.9 2.4 1.5 25.0 53.4 9.6 2.2 $ 2.9 3.3 2.6 1.8 3.8 79.7 6.8 MTB 1.2 8.1 13.2 5.5 0.1 9.2 62.5

money growth. This result lends further support to the body of lit- erature that suggests that deficits do indeed have a causal relation- ship with interest rates. Recall also that deficits influenced MTB through their causal relationship with money growth. The extent of this relationship is emphasized by the fact that deficits explain over 20% of the forecast error variance of Ml, twice that of any other variable.

4. Policy Implications and Conclusions Apparently, policy makers in 1985 believed strongly enough

in some of the linkages that have been detailed in this study to cause them to embark upon an internationally coordinated effort to depreciate the value of the dollar. Specifically, their actions focused upon the causally prior relationship of exchange rates and the trade deficit. However, the merchandise trade deficit continued to worsen following the depreciation of the dollar exchange rate, suggesting that some of the , relationships among the variables might have changed after February 1985. The VAR constructed in this paper is used to generate a dynamic forecast of MTB through 1986:xii and graphically illustrates such changes.” The results shown in Figure 3 indicate that, had in the in-sample relationships continued to hold, the trade deficit would have continued to grow, but at a more mod-

“The plot of the MTB forecast required a transformation back into levels.

92

Twin Deficits during the 1980s: An Empirical Investigation

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erate rate than what was actually observed. The forecasts could cap- ture neither the magnitude of the decline in the actual trade deficit nor the volatility.

Reasons for the failure of the trade deficit to respond to ex- change rate intervention can be partly attributed to what is known as a J-curve effect. See Kvasnicka (1986) for a discussion of this. Such explanations include discussions of inelastic demand for for- eign products, foreign price cutting, long-term contracting, and the fact that the dollar has not fallen as dramatically with respect to the currencies of many of the “newly industrialized countries. ”

On the other hand, one could make the argument that the reason for the failure of the trade deficit to respond to changes in

93

John D. Abel1

the value of the dollar is that the exchange rate intervention ig- nored all of the other relationships in the model specified above. Recall that causality was supposed to flow from budget deficits to interest rates, to capital flows, to exchange rates, and finally, to trade deficits. Addressing exchange rates while ignoring these link- ages is analogous to treating the symptoms of a major physiological infirmity with a Band-Aid while ignoring the source of the disease.

The evidence in this paper suggests that another approach may be taken to reducing the U.S. trade deficit, namely, reducing the federal budget deficit. The persistent upward pressure on real in- terest rates caused by the massive amounts of federal borrowing leads to a number of international market distortions. It encourages the inflow of foreign capital, which, when other things are equal, puts upward pressure on the dollar. The exchange rate management techniques that have been used to attempt to combat this have been rather inconsistent, and, at times, have led to a “free fall” of the dollar. This, in part, has been due to market fears about the size of the budget deficit itself and the resolve of the government to address this problem. Such concerns are why Paul Volcker, on a number of trips before congress, has repeatedly requested cuts in the budget deficit. Given the focus in this country on free trade and minimal government interference, a reduction in the size of the budget deficit would go a long way toward alleviating the cur- rent international imbalances and the need for exchange rate man- agement.

Received: January 1988 Final Version: May 1989

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Twin Deficits during the 1980s: An Empirical Inoestigation

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