Twin deficits in the G-7 countries and global structural imbalances

Journal of Policy Modeling 28 (2006) 701–712

Twin deficits in the G-7 countries andglobal structural imbalances

Dominick Salvatore ∗Department of Economics, Fordham University, New York 10458, USA

Abstract

According to open economy macroeconomics, a government budget deficit leads to a current accountdeficit. The link is as follows: a budget deficit leads to an increase in the real domestic interest rate; thisattracts foreign capital and results in an appreciation of the domestic currency, which leads to a currentaccount (imports plus net transfers abroad, minus exports) deficit. Thus, the entire current account deficitand part of the budget deficit is financed by a net capital inflow. This paper reviews and extends the theoreticalanalysis of the “twin deficits” and then confirms this relationship empirically for the G-7 countries over thepast three decades.© 2006 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.

JEL classification: F4

Keywords: Twin deficits; Budget deficit; Current account deficit; Structural imbalance

1. Introduction

In recent years, there has been a revival of interest in the relationship between the budget deficitand the current account deficit, or “twin deficits” (Bordo, 2006; Coughlin, Pakko, & Pool, 2006;Mann, 2002; Obstfeld & Rogoff, 2004, 2005; OECD, 2004; Sinai, 2006). In the United States,this interest has been fueled by the reappearance of huge budget and trade deficits since the turnof the century. The term “twin deficits” itself was coined to describe the relationship betweenthe budget and current account deficits in the United States during the early 1980s (Abell, 1990;Gordon, 1986; Laney, 1984; McKinnon, 1980, 1990; Miller & Russek, 1989). In a nutshell, thetheoretical relationship links casually an increase in the budget deficit to an increase in domesticinterest rates, to an inflow of foreign capital, to the appreciation of the domestic currency, which

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702 D. Salvatore / Journal of Policy Modeling 28 (2006) 701–712

then results in a current account deficit. Section 2 of this paper reviews and extends the analysisof the chain in this theoretical relationship.

There are two ways of testing empirically the relationship between budget and current accountdeficits. One test relies on examining the relationship between them directly, without examiningeach of the intermediate steps that links them together. The other test is indirect and focusesspecifically on each of the intermediate links between the budget deficit and the current accountdeficit. That is, it focuses on the link between the budget deficit and domestic interest rates,between the latter and exchange rates, and finally between exchange rates and the current account.In examining the empirical evidence, I will concentrate on the direct relationship between thebudget deficit and the current account deficit. This is done in Section 3 of the paper. Long chainsof theoretical reasoning, as in the indirect test between the budget and current account deficits,are notoriously dangerous in economics and can best be done by simulations using large-scale,detailed general-equilibrium models of the entire economy.

The theoretical discussion in Section 2 is broad and general and is applicable to any openmarket economy. The direct empirical evidence examined in Section 3 refers to the G-7 countriesand covers the flexible exchange rate period from 1973 to the present. Only by focusing on sucha sample of important countries over a relatively long period of time can we hope to detect somegeneral empirical regularities. Not only are country-specific experiences during short periods oftime (say, a few years) almost useless from a general theoretical point of view but they cannot evenbe interpreted correctly, except within a broader context that includes the most important nationsover a period of many years. Furthermore, the dichotomy often made in the literature betweenthe national accounting framework or saving-investment approach and the balance of paymentsaccounting framework or elasticity approach to the analysis of the twin deficits is inappropriate.The latter is simply one of the links in the former. Specifically, the relationship between theexchange rate (and relative growth rates), on the one hand, and the current account, on the other,is the last link in the chain of reasoning that runs from budget deficits to interest rates, from interestrates to exchange rates, and from exchange rates changes to the current account. To consider theseas conflicting alternatives of examining the twin deficits is at best misleading.

2. The relationship between budget and current account deficits: the theory

We begin our examination of the relationship between budget deficits and current accountdeficits by reviewing the national accounting framework or savings-investment approach andthen examining the causal chain of events that links budget deficits to current account deficits.

2.1. The national accounting framework of the analysis

In order to examine the theoretical relationship between government budget deficits and currentaccount deficits in the balance of payments for an open economy, we begin with the familiarnational accounting identity:

C + I + G + (X − M) − R = C + SD + T (1)

where C is the private consumption expenditures; I the private domestic investments; G thegovernment expenditures; X the exports; M the imports; R the net transfers to abroad; SD theprivate domestic savings; T is the government tax receipts.

D. Salvatore / Journal of Policy Modeling 28 (2006) 701–712 703

Identity (1) is true in nominal and in real terms, but our future discussion will generally bein real terms. Rearranging identity (1) to highlight the relationship between budget deficits andcurrent account deficits, we get:

(G − T ) = (SD − I) + (M + R − X) (2)

Relationship (2) postulates that the government budget deficit, or expenditures less taxes (G − T),must equal to or be financed by the excess of domestic savings over domestic investment (SD − I)plus the current account deficit (M + R − X). The current account deficit is equal to a nation’sexpenditures on foreign goods and services or imports (M) plus net transfers (R), minus foreignexpenditures on the nation’s goods and services or exports (X). This current account deficit mustbe financed by an equal net foreign capital inflow or net foreign savings (SF). Thus, we can rewriterelationship (2) as

(G − T ) = (SD − I) + SF (3)

From relationship (3) we can see that an exogenous increase in the budget deficit (G − T) canonly be financed by an increase in net domestic savings (SD − I) and/or net foreign savings (SF).In terms of flow of funds terminology, we can rewrite relationship (3) as

(G − T ) + I = SD + SF (4)

This postulates that for equilibrium, the sum of the budget deficit and domestic investments,which represent the total domestic demand or uses of savings (D), must equal the sum of grossdomestic savings and net foreign savings, which represent the total sources or supply of savings(S) to the economy. In order to trace the economic chain of causation from a budget deficit to acurrent account deficit for an open economy under a flexible exchange rate system, we rewriterelationship (3) in functional form and substitute net foreign saving (SF) by its current accountdeficit or net import-balance counterpart (NM):

(G − T ) = SD(r) − I(r) + NM(e), SD(r) > 0, I(r) < 0, and NM(e) > 0 (5)

where real domestic saving (SD) is postulated to be directly related to the real interest rate (r),real domestic investment (I) is inversely related to the real interest rate (r), and net imports (NM)are inversely related to the real exchange rate (e), defined as the foreign currency price of a unitof the domestic currency, adjusted for the differential rate of inflation in the home and foreigncountries (so that an increase in the real exchange rate represents a real appreciation of the domesticcurrency). Thus, an exogenous increase in the budget deficit can only be financed by an increasein domestic savings, a reduction in domestic investment (both of which are functions of the realinterest rate), and/or an increase in the nation net trade deficit or inflow of net foreign saving(which is a function of the real exchange rate).

Several points must be made before we go on to examine in detail the chain of causationbetween budget and current account deficits. First, all the variables in relationship (5) should beexpressed in real terms so as to eliminate the inflationary impact common to them all. Second,a budget deficit of a given size represents a declining relative burden when GNP rises. Thus, weconcentrate on the ratio of budget deficits to GNP, rather than on the absolute levels of budgetdeficits. Third, we should examine structural rather than actual budget deficits. A structural, full-or high-employment, or cyclically adjusted budget deficit is the budget deficit that would prevailif the economy were operating at full- or high-employment (which in the United States nowmeans about 5% unemployment). The difference between the actual and the structural deficit


arises because both government revenues and expenditures respond in a systematic manner overthe business cycle. Specifically, with given tax rates, government revenues rise with a cyclicalincrease in GNP, while government expenditures increase with a cyclical decline in GNP (becauseof higher unemployment benefits paid out). The problem, in using structural rather than actualdeficits in the empirical analysis is that data on structural deficits are not available for the earlierpart of the period under analysis, and even the data that are available are somewhat controversial.

2.2. The effect of a budget deficit on interest rates, exchange rates, and the current account

We now go on to examine the dynamic short-term effects of an exogenous increase in the budgetdeficit on interest rates, exchange rates, and the current account in an open economy operatingunder a flexible exchange rate system. An exogenous increase in a budget deficit is one that affectsdirectly neither private domestic savings and investment nor the current account. We adapt the wellknown loanable fund and Mundell–Fleming models, which are usually used for other purposes,to analyze and summarize the relationship between the budget and the current account deficits.

In Fig. 1, D represents the initial total domestic demand or uses of loanable funds (savings),while S refers to the initial total short-run supply or sources of loanable funds or savings, as inrelationship (4) above. Thus, S represents the sum of gross private domestic savings plus netforeign savings flowing into the economy for a given current account deficit. The economy isinitially in equilibrium at point E, with real interest rate of r and quantity demanded and suppliedof funds of F.

An increase in the budget deficit shifts D out to D′. At the unchanged interest rate of r, there isnow an excess demand for funds. This leads to an increase in the real interest rate to r′, at whichthe quantity demanded of loanable funds equals the quantity supplied at the higher level of F′(equilibrium point E′). Interest rate pressure is more likely to be averted the larger is the slack orrate of unemployment in the economy and the larger is the increase in real GNP resulting from thefiscal stimulus. As the economy approaches full employment, however, the pressure on interestrates to rise increases. This stimulates private domestic savings, discourages private domesticinvestment, and encourages net capital inflows from abroad.

Fig. 1. Relationship between budget and current account deficits.


As investors switch from foreign to domestic assets to take advantage of higher interest ratesin the nation and purchase the domestic currency with foreign currencies to affect the switch, thereal exchange rate rises (i.e., the domestic currency appreciates). The rise in the real exchange rateor real appreciation of the domestic currency results in a gradual increase in the current accountdeficit or net imports (NM). This is the mechanism that allows foreign savings to supplementdomestic savings in financing the domestic budget deficit and domestic investments. In Fig. 1,this is shown by a gradual shift of S to the right to S′ and results in equilibrium point E′′, at whichthe real interest rate is r′′ and the equilibrium level of loanable funds is F′′. Thus, as foreign fundsflow in to take advantage of higher real interest rates in the nation, the original increase in thereal interest rate to r′ falls back toward the lower world level, and the initial appreciation of thedomestic currency and deterioration in the current account balance fall toward the long-run level.

Several things must be noted with respect to the above adjustment process to an exogenousincrease in the budget deficit in an open economy under flexible exchange rates. First, the slug-gish current account response to the initial appreciation of the domestic currency is primarilyresponsible for the initial overshooting of domestic real interest rates and appreciation of realexchange rates above their long-run equilibrium level (see Dornbusch, 1976). Second, the samegeneral pattern of adjustment described above for an exogenous increase in the budget deficitwould result from any other policy, such as a reduction in business taxes that increase the after-taxreturns on domestic investments without necessarily increasing the budget deficit. If the increasein the domestic demand for investment occurred at the same time as the exogenous increase inthe budget deficit, domestic real interest and exchange rates would tend initially to rise even morebefore eventually falling back toward their long-run equilibrium levels.

Third, for a closed economy or for a given foreign account deficit or net foreign capital inflow(savings), the Barro-Ricardo equivalence theorem (BRET) postulates that an exogenous increasein the budget deficit (decline in public savings) will lead to an instantaneous equal increase inprivate savings (Barro, 1974). That is, according to the BRET, economic agents fully perceive thatan increase in the budget deficit implies an equal present value of future taxes, and thus it has no neteffect on aggregate demand and GNP. As it is well known, there are many theoretical objectionsto the BRET, such as lack of information, imperfect capital markets, and especially the fact thatbequests may be involuntary, and there is little empirical support for this extreme proposition.In any event, an exogenous increase in the budget deficit in an open economy operating undera flexible exchange rate system is likely to lead to some increase in domestic private savingsas well as to an increase in net foreign savings (capital inflows) without much or any crowdingout of private domestic investments. This does not mean that the budget deficit invariably leadsto current account deficits. For example, during a recession a budget deficit tends to rise butnet private domestic savings typically increase even more because of the depressed demand forprivate domestic investments. Furthermore, the changes in taxes and expenditures underlyingthe change in the budget deficit may directly affect private domestic savings and investments.These effects must be assessed before the effect of a budget deficit on the current account canproperly be evaluated. Different national rates of trade protection also affect the response ofcurrent account balances to budget deficits (Salvatore, 1987, 1989, 1991, 1997, 1998). In short,there is no mechanical relationship between the two.

2.3. Analysis of budget and current account deficits with the Mundell–Fleming model

The Mundell–Fleming model can be used to analyze more explicitly the short-run dynamicrelationship between budget and current account deficits for an open economy operating under a


Fig. 2. Budget and current account deficits with the Mundell–Fleming model.

flexible exchange rate system (Frenkel & Razin, 1987; Mundell, 1960a, 1960b). This is shown inFig. 2.

The IS curve shows the various combinations of interest rates (r) and national incomes (Y) atwhich the real goods market is in equilibrium. The negative slope of the IS curve indicates thatlower interest rates lead to higher investment levels and are thus associated with higher levelsof national income through the familiar multiplier process. The LM curve shows equilibrium inthe money market. The rising slope of the LM curve indicates that higher interest rates reducesthe speculative demand form money requiring a higher level of national income and transactiondemand for money to absorb the entire fixed supply of money. The BP curve shows the variouscombinations of r and Y at which the nation’s balance of payments is in equilibrium at a givenexchange rate. The balance of payments is in equilibrium when a trade deficit is matched byan equal capital inflow. The BP curve is positively sloped because higher interest rates lead togreater capital inflows (or smaller outflows) and must be balanced with higher levels of nationalincome and imports for the balance of payments to remain in equilibrium. The more responsiveare international capital flows to positive interest differentials the flatter will be the BP curve. Tothe left of the BP curve, the nation has a balance of payments surplus and to the right a balance ofpayments deficit. A devaluation or depreciation of the nation’s currency shifts the BP curve downsince the nation’s trade balance improves, and so a lower interest rate and smaller capital inflows(or greater capital outflows) are required to keep the balance of payments in equilibrium. On theother hand, a revaluation or appreciation of the nation’s currency shifts the BP curve upward.

Fig. 2 shows that initially the nation is simultaneously in equilibrium in the goods market, inthe money market, and in the balance of payments at point E, where the IS, LM, and BP curvesintersect. Suppose that the equilibrium level of national income (Y) at point E is below full employ-ment and the nation uses expansionary fiscal policy to reduce unemployment. Expansionary fiscalpolicy (which leads to a budget deficit or to an increase in the budget deficit for the nation) shiftsthe IS curve to the right to IS′ so at to intersect the LM curve at point E′, resulting in the higherlevel of income (Y′) and interest rate (r′). Since point E′ is above the BP curve, the nation faces anexternal surplus because of the net inflow of foreign capital induced by the increase in the interestrate. This causes an appreciation of the domestic currency, which shifts the BP curve up to BP′.


The appreciation of the domestic currency worsens the nation’s current account balance causingthe IS′ curve to shift back part of the way to IS′′. The appreciation of the domestic currency alsoreduces the domestic currency price of imports and the general price level in the nation. Withlower domestic prices and a fixed money supply, the LM curve shifts to the right, say, to LM′(i.e., it is equivalent to an increase in the nominal money supply). The final equilibrium might beindicated by a point such as E′′, at which IS′′, LM′, and BP′ cross, thus defining the equilibriuminterest rate of r′′ and the equilibrium level of national income of Y′′.

Note that the interest rate in the nation first increases from r to r′ and then falls back partof the way to r′′. This leads to a similar overshooting and appreciation of the nation’s currency(as r increases to r′), followed by a depreciation that eliminates part, but not all, of the originalappreciation as r′ falls back part of the way to r′′. Fig. 2 also shows the final net appreciation ofthe domestic currency. Thus, the larger budget deficit is associated with a larger capital inflow anda current account deficit than originally, establishing a direct link between the budget deficit andthe current account deficit. This final outcome depends, however, on the assumption of a fairlyelastic or gently rising BP curve (or, in any event, on the BP curve being flatter than the LMcurve). This is realistic for the real world of today. Thus, the dynamic progression from budgetdeficits to higher interest rates, to appreciation of the domestic currency and, finally, to currentaccount deficits seems to be based on sound theoretical analysis. There are, of course, situations(which can be shown with the Mundell–Fleming model) where this progression is interruptedand different results can be obtained, but under normal conditions we expect the above resultsto hold.

3. The relationship between budget and current account deficits: the evidence

We now examine the empirical evidence for the relationship between budget deficits andcurrent account deficits. I will first present briefly the descriptive evidence, such as it is, in theform of simple correlations to get a feeling for the data and the lag structure involved (if any).After all, it is such a simple graphic and correlation information that is often introduced either insupport for or against the relationship between budget and the current account balances. Then,I will present more analytically rigorous and conclusive evidence with regression analysis.

3.1. Descriptive evidence on the relationship between budget and current account deficits

Table 1 shows simple correlations between the current account and the budget account balances(both expressed as a percentage of GNP), unlagged and lagged by 1–3 years, as well as leading

Table 1Correlations between current account and budget balances

t − 3 t − 2 t − 1 t t + 1 t + 2 t + 3

CUS with BUS 0.065 −0.021 −0.117 −0.047 0.015 0.100 0.148CJA with BJA 0.163 0.243 0.259 0.111 0.056 0.022 −0.014CGE with BGE 0.166 0.247 0.269 0.292 0.289 0.277 0.181CUK with BUK −0.347 −0.412 −0.456 −0.382 −0.195 0.113 0.385CFR with BFR −0.525 −0.603 −0.576 −0.339 0.130 0.419 0.489CIT with BIT 0.011 0.117 0.296 0.391 0.522 0.563 0.555CCA with BCA 0.383 0.442 0.514 0.440 0.490 0.519 0.527


by 1–3 years the current account for the 1973–2005 period. The general rather than central gov-ernment budget balances are used because the latter are available for a shorter period of time andare generally highly correlated with the former. Data are from IMF (2006a, b) and OECD (2006).

The correlations in Table 1 do not seem to support the theory that budget balances are directlyrelated to current account balances (i.e., that budget deficits are positively related and lead currentaccount deficits, and budget surpluses are associated with and lead current account surpluses).The theory seems to hold only for Japan, where budget deficits lead current account deficits by 1year (but the correlation is small). For Germany budget and current account balances are directlyrelated but contemporaneous. For the United Kingdom and France budget deficits lead currentaccount deficits by 1 and 2 years, respectively, but the correlations are negative or inverse (i.e.,budget deficits seem to be associated with and lead current account surpluses rather than beingassociated with and leading current account deficits), which completely contradicts the theory.For the United States, Italy and Canada the correlation between changes in budget and currentaccount balances are positive, but the latter seem to lead in time by 2 or 3 years the former,rather than vice versa as postulated by theory. It is true that even if changes in budget balancescause changes in current account balances, changes in the latter will have feed back effects on theformer. But for theory to be confirmed, changes in budget balances must lead and cause changesin current account balances, rather than the other way around. The figures for the United States,Italy and Canada do not show this and, as such, go counter theoretical expectations. The generalconclusion that can be reached by these simple correlations is that the theory that budget deficitslead to current account deficits does not seem to hold. Simple correlations, however, is a superficialand unrigorous method of analyzing data and, in complex situations such as the one at hand, canbe very misleading. Thus, we turn to regression analysis.

3.2. Regression analysis evidence

The theory presented in Section 2 postulates that a nation’s current account balance is directlyrelated to the government budget balance; that is, larger budget deficits are supposed to lead tohigher current account deficits. The link or chain of causation, we remember, is from a budgetdeficit to higher domestic real interest rate, to appreciation of the domestic currency, and finallyto a deterioration of the nation’s current account balance (which paves the way for foreign capitalinflows). Since it takes time for this chain of events to unfold and fully work itself out, we canexpect a nation’s current account balance to be related to both contemporaneous and lagged valuesof the budget balance. Since it is also well known that the current account responds sluggishlyover the course of several years to exchange rate changes, a change in the budget balance in agiven year may affect the current account balance over the course of the next 2, or even 3 years.This means that current account balances are a function of or depend on current as well as lagged(by 1, 2, or even 3 years) budget balances.

In fact, a nation’s current account may first improve as a result of the appreciation of itscurrency (following the budget deficit) before eventually worsening (the so-called inverse J-curve effect—see Mann, 1986). Thus, a current account surplus may first be associated with acontemporaneous budget deficit before the direct relationship between the current account deficitand the budget deficit becomes evident over the course of the subsequent 2 or 3 years. A nation’scurrent account balance depends also on the rate of growth in the nation as well as in the rest ofthe world. Higher domestic rates of growth spill into increased imports of goods and services (adeterioration in the nation’s current account balance), while higher growth abroad stimulates thenation’s exports of goods and services (an improvement in the nation’s current account balance).


Thus, we can postulate the following functional relationship for estimation:

Ct = a0 + a1Bt + a2Bt−1 + a3Bt−2 + a4Bt−3 + a5Gt + a6GRt (6)

where, C is the current account balance as a percentage of GNP; B the general government budgetbalance (surplus = + , deficit = −) as a percentage of GNP; G the growth of real GNP in the nation;GR the growth of real GNP in the rest of the world; t is the current year.

According to theory, a2, a3, a4, a6 > 0, a5 < 0, while the sign of a1 is ambiguous.An econometric problem arises in estimating Eq. (6), however, because the lagged values of

the budget balance are highly intercorrelated. As a result, the regression may provide relativelyhigh coefficients of multiple correlation (R2), but statistically insignificant estimated coefficientsfor the various lagged values of the budget balance (so that we are unable to confirm or rejectthe expected positive relationship between current account and budget deficits). Indeed, thisis confirmed by estimating Eq. (6). To be noted is that the problem here is econometric, nottheoretical. An adequate econometric solution is possible, however. This involves the assumptionthat the current account balance is a function of the expected value of the budget balance. That is,if it is assumed that the current account balance in year t is a function of the expected value of thebudget balance and that these expectations are generally formed on the basis of a distributed lagof the current and past values of the budget balance, we can then postulate a general distributedlag model which states that the current account balance in year t is partly determined by its ownvalue in the previous period and partly by the contemporaneous budget balance and the otherexogenous variables in the model (in our case, mostly the former). Since distributed lag modelslead to a first order autoregressive disturbance term (and thus violates two basic assumptions ofOLS), they have to be estimated by generalized least square methods rather than by ordinary leastsquares.

Thus, we can reformulate Eq. (6) as

Ct = b0 + b1Bt + b2Gt + b3GRt + b4Ct−1 (7)

where Ct−1 is the current account balance lagged 1 year. We expect coefficient b1 to remainambiguous in sign, b2 to be negative, and b3 and b4 to be positive. Since Ct−1 reflects entirely orfor the most part the lagged values of the budget deficit (it also allows different nations to havedifferent lag structures), the test of a direct causal relationship running from the budget balanceto the current account balance requires a positive and statistically significant b4 coefficient.

The econometric results are presented in Table 2. From Table 2, we see that coefficients (b2,b3, and b4) of the Gt, GRt, and Ct−1 variables have the correct sign, with more than half of thesecoefficients being statistically significant at better than the 5 or 10% levels. This is remarkable inview of the great complexity of the relationship postulated by Eq. (7), the diversity of the nationsexamined, and the economic turmoil of the past three decades. The results for b2 and b3 indicatethat higher domestic growth worsens while higher foreign growth improves the nation’s currentaccount balance, as predicted by theory. Particularly important are the b4 results for the laggeddependent variable since all seven estimated slope coefficients have the predicted positive signand all of them are statistically significant at better than the 0.05 level. This means that laggedbudget deficits result in current account deficits, as predicted by the theory of Section 2. While thelag structure may differ for different countries, lagged budget deficits seem to be the single mostimportant determinant of current account deficits. This confirms the results of simulations of largemacroeconometric models (reviewed in Congressional Budget Office, 1989), which indicate thatfrom 2/5 to 2/3 of U.S. current account deficits are due to current and past U.S. budget deficits.

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Table 2Econometric test of the relationship between current account and budget balances

Nation Constant Bt Gt GRt Ct−1 R2 SEE D–W

U.S. 0.062 (0.16) 0.014 (0.23) −0.100 (−0.97) −0.014 (−0.08) 0.958** (11.89) 0.89 12.28 1.82Japan 1.024* (1.74) 0.489 (0.64) −0.304** (−2.07) 0.355 (1.59) 0.479** (2.93) 0.43 36.91 1.96Germany 0.579 (0.74) 0.230 (1.32) −0.622** (−4.24) 0.464** (2.38) 0.976** (9.80) 0.77 29.75 2.09U.K. −0.390 (−0.68) −0.125 (−1.64) −0.240* (−1.72) 0.106 (0.52) 0.800** (7.22) 0.65 30.52 1.74France −1.554 (−1.61) −0.427** (−2.07) −0.152 (−0.54) 0.219 (0.91) 0.572** (3.60) 0.54 43.01 1.81Italy −0.883 (−1.09) −0.100 (−1.21) −0.544** (−3.54) 0.399* (1.78) 0.750** (3.65) 0.57 40.06 1.73Canada −0.059 (−0.08) 0.140 (1.37) −0.147 (−0.69) 0.213 (0.66) 0.636** (3.90) 0.52 72.68 2.07

* Statistically significant at the 0.1 level.** Statistically significant at the 0.05 level.


Turning to the b1 coefficients in Table 2, we see that for the United Kingdom and Francecurrent account deficits are inversely and significantly associated with concurrent budget deficits(very likely because of the inverse J-curve effect mentioned above). For the United States, Japan,Germany, Italy, and Canada current budget balances do not seem to affect contemporaneouscurrent account balances.

The coefficient of multiple determination (R2) ranges from 0.43 for Japan to 0.89 for the UnitedStates, for a simple average of 0.62 for all seven countries. Thus, a respectable 62% of the variationin the current account balances of the G-7 countries over the past three decades was explained, onthe average, by the model. Finally, Table 2 shows that the D–W statistic indicates no remainingserial correlation of the error term. The overall conclusion that we can reach, therefore, is thatcurrent account balances in the G-7 countries seem to respond to budget deficits (but with a lag)as postulated by theory.

To be noted is that re-estimating Eq. (7) for each of the G-7 countries using a dummy variablewhich assumes a value of 0 for the 1973–1980 period and the value of 1 for the 1981–2005 period(to assess the structural response of each of the G-7 countries to the petroleum shock and resultingdouble digit inflation in the 1970s) does not change the conclusions. That is, all of the estimateddummy coefficients are statistically insignificant and the sign, size, and statistical significance ofall the other explanatory variables remain practically the same as those reported in Table 2. Weexpected D to be positive and statistically significant for Japan and Germany and negative for theother countries because Japan and Germany were able to adjust to the structural problems muchbetter than the other countries. But the results of re-estimating Eq. (7) with the dummy variabledid not show this.

4. Summary

According to open economy macroeconomics, a government budget deficit leads to a currentaccount deficit. The link is as follows: a budget deficit leads to an increase in the real domesticinterest rate; this attracts foreign capital and results in an appreciation of the domestic currency,which leads to a current account (imports plus net transfers abroad, minus exports) deficit. Thus,the entire current account deficit and part of the budget deficit is financed by a net capital inflow.

There is strong empirical evidence that a direct relationship exists between the budget andthe current account deficits for all the seven largest and most important industrial countries (theUnited States, Japan, Germany, United Kingdom, France, Italy, and Canada), but the relationshipis a lagged one, with budget deficits leading to current account deficits by one or more years.

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Documents

Twin deficits in the G-7 countries and global structural imbalances