Understanding the twin deficits: new approaches, new results

Since 2002, the U.S. has seen the emergence of twin deficits—that is, a growing budget deficit along with a growing current account deficit, which reflects increasing U.S. borrowing from abroad. To some analysts, this situation seems very reminiscent of the early 1980s. In the earlier episode, there were significant tax rate cuts that were not matched by spending cuts, and between 1981 and 1986, the U.S. budget deficit went from 2.5% of GDP to about 5% of GDP and the current account went from being roughly in balance to a deficit of 3.3% of GDP. In 2001, there were tax rate cuts that were not matched by spending cuts, and the U.S. budget went from a surplus to a deficit that reached 3.5% of GDP in 2004; the current account deficit also soared, rising from 3.8% of GDP in 2001 to 5.7% in 2004. ; A number of factors may affect how much budget deficits explain current account deficits, and an extensive theoretical and empirical literature has emerged to evaluate them. This Economic Letter reviews several of these studies. The findings suggest that the relationship between the deficits may be fairly tenuous. And in a surprising result, one study finds that—in the short run, at least—budget deficits actually have a positive effect on the current account balance.