Twin Deficits in the European Countries

Public debt is a burden on future electors and taxpayers. In the absence of constitutional constraints, the incumbent government may show the cost of some public expenditures or tax reductions toward the future by financing them via new debt. However, according to the Ricardian theorem of public debt, the burden of debt is always anticipated via increased saving. If this theorem were true, a budget deficit would not affect the current account of the balance of payment. This paper analyzes the relationship between trade deficit and budget deficit. Using yearly data for the period between 1970 and 2010 in 33 European countries, we find evidence supporting the hypothesis that a chronic and robust budget deficit generates a trade deficit. The dynamic estimates show that a 1% decrease in the government budget surplus/GDP ratio tends to deteriorate the current account/GDP ratio of 0.37%, confirming previous studies with a different empirical basis. Dividing the sample period into two sub-periods (1970-1991 and 1992-2010), empirical findings show that current and past values of government budget influence trade balance in the first sub-period, whilst past values of government budget affect trade balance in the most recent years. Moreover, the estimated effect of government budget on current account balance is positive and equal to 0.48 and 0.30, respectively. For the high deficit countries, a long-run relationship between these variables has been found, showing that one percentage point increase in budget surplus/GDP ratio is associated with an improvement in the current account balance of roughly 0.15 percentage point. The estimated long-run government budget elasticity is negative and statistically significant, while the estimated speed of adjustment is equal to 0.33. Finally, Granger causality tests show mixed results