TWIN SONS OF DIFFERENT MOTHERS: THE LONG AND THE SHORT OF THE TWIN DEFICITS DEBATE

I. INTRODUCTION The relationship between the government budget deficit and the current account deficit has been a contentious subject in empirical macroeconomics for at least the past 20 yr. Papers have variously found a positive link, no link, and three recent pieces even find a negative link between the two. There are, however, some things that almost all these studies have in common. For example, they ignore the possibility of structural breaks in the series when examining their time series properties. Most previous studies treat the variables under study as being integrated of order 1, which is to say as having a unit root. This is a hard assumption to square with the fact that the variables are measured as fractions of gross domestic product (GDP) and have, over the last half century at least, shown no inclination toward typical unit root behavior. By contrast, in three recent pieces (Corsetti and Muller 2006; Kim and Roubini 2008; Muller 2006), the two series are simply treated as pure stationary processes without any pretesting, which obviously conflicts with results from the traditional unit root tests. In this article, we show that both the budget deficit and the current account deficit are stationary around an occasionally shifting mean (which is to say that they have structural breaks but are stationary after allowing for those breaks). Since it is well known that traditional unit root tests have little power when the underlying data contain structural breaks, this explains the puzzling finding that the budget deficit and the current account deficit expressed as fractions of GDP test out as I(1) series in practice. Our findings also cast doubt on the validity of assuming the two series are purely stationary processes. Given our framework, a simple test for the existence of a long-run equilibrium relationship between budget and current account deficits is to compare the number and timing of their structural shifts. We find that the two series are not closely related either in their number of breaks or in their timing of structural shifts. We thus conclude that over the long run (genetically?), the deficits are not twins. Another factor that existing studies have in common is their treatment of the error structure of the model as homoskedastic, despite relatively clear visual evidence of volatility clustering (conditional heteroskedasticity) in least squares residuals. When we consider the short-run dynamics of the demeaned variables through a vector autoregression (VAR) analysis, we show that the error covariance of this VAR model is significantly conditionally heteroskedastic and go on to specifically account for this phenomenon with a VAR-generalized autoregressive conditional heteroskedasticity (GARCH) model. We consider a trivariate model that also includes the real interest rate. Here, we find a significant and sizeable positive short-run effect of budget deficit innovations on the current account deficit in both the impulse response functions and the variance decompositions of the model. Our answer to the question of the paternity of the two deficits thus depends on the horizon studied. Each series has structural breaks that are largely independent of each other so they are not twins at all over the long run. However, once we allow for these secular shifts, the short-run dynamics reveal a very strong family resemblance indeed. The rest of the article is organized as follows. In Section II, we review some of the existing empirical literature. Section III discusses the time series properties of the data and presents our results about the long-run evidence on the twin deficits question. Section IV sets out our VAR-GARCH model and presents our results on short-run twin deficits behavior. Section V is a brief conclusion. II. AN OVERVIEW OF THE EMPIRICAL LITERATURE The relationship between current account deficits and government budget deficits has been a subject of extensive study. …