FISCAL POLICY AND TRADE ADJUSTMENT: ARE THE DEFICITS REALLY TWINS?

I. INTRODUCTION The unprecedented increase of both the fiscal and trade deficits in the United States during the 1980s led many observers to posit a causal linkage. A sizable contingent of economists believe that the "twin deficits" concept aptly characterizes the recent relationship between federal budgetary policy and the U.S. trade balance. In this view, increased federal fiscal deficits during the 1980s were a primary cause of the massive U.S. trade deficits experienced as the decade unfolded. However, this posited causal relationship does not command universal acceptance. In this paper, we examine data on U.S. trade and federal fiscal measures along with exchange and interest rates to uncover the empirical relationship between them and to discover whether fiscal policy plays an essential role in the adjustment of the massive U.S. trade imbalance. The twin deficits concept asserts that the deficits are "twins" because they are related in the following manner. Increased government deficits are thought to put incipient upward pressure on real interest rates. This induces incipient capital in-flows that lift or appreciate the real exchange value of the currency, which erodes competitiveness and, after a time lag, results in increased trade deficits. A number of recent papers examine the relationship between budget and trade deficits. Each contributes important insights, but nothing approaching a consensus has yet emerged. Miller and Russek |1989~ find evidence of a secular relationship between the deficits under two of the three statistical techniques they employ. Bernheim |1988~ concludes that the government deficit is a prime determinant of U.S. trade deficits, whereas Evans |1989~, Enders and Lee |1990~, and Dewald and Ulan |1990~ find no such causal impact of fiscal deficits. Darrat |1988~ and Abell |1990~ report somewhat mixed results. The conflicting results in the existing literature stem from wide differences in the empirical techniques, data measures and samples employed. Further, we have found in the literature and in our work reported below that the use of differenced data versus data in level form has a major impact on the results produced and inferences drawn. Recent empirical literature suggests that stationarity of data is a crucial element in model specification. Thus, the question of whether or not to difference the data should be addressed before estimation and inference. Classical inference about stationarity of data suffers from what Sims |1988~ refers to as a "discontinuity" in the asymptotic theory. Hence, the classical tests used in much of the previous literature have low power to reject the null hypothesis of nonstationarity in levels. Bayesian inference does not suffer from this problem; therefore, we generate posterior probabilities using Monte Carlo integration that estimate probabilities that suggest whether the data are better analyzed in level or difference form. Despite somewhat contrasting results, the classical augmented Dickey-Fuller tests and the Bayesian probability estimates both suggest that a difference specification is inappropriate. We analyze empirically a five-variable nonstructural vector autoregressive (VAR) model. The model includes both a federal government balance and a government purchases measure to summarize fiscal policy. Along with these two variables and a trade balance measure, we constructed real interest rate and real exchange rate variables spanning a quarterly data sample from 1961 to 1989. We estimate the model in both levels and difference form. Using the level specification, we find strong support for the twin deficit notion that government deficits are a cause of trade deficits, whereas in differences we find no such relationship. Furthermore, the results from our Monte Carlo work imply that the model specified in levels is likely most appropriate for estimation and inference. II. CONTRASTING THEORETICAL FRAMEWORKS The presence of both deficits in a variant of the basic savings/investment identity may provide a useful reference, as in Bernheim |1988~ and Branson |1985~, for discussing the hypothesized causal relationship embodied in popular twin deficits stories: (1) TDEF = GDEF + (I - |S. …