percent of GDP during the same period. The explanation seemed clear: expansionary fiscal policies led to strong growth through domestic spending and increase in imports. At the same time, tight monetary policy and the large fiscal deficit led to high interest rates, which attracted foreign investment and strengthened the dollar. The end-result was a decline in competitiveness and a large current account. Surprisingly, when the fiscal balance turned into surplus in the 1990s, the current account continued to deteriorate. The contraction in fiscal policy did not lead to a reduction in domestic demand and a curtailing of imports. The lower fiscal deficit did not ease pressure on the cost of funds, lower interest rates, and induce a depreciation of the dollar—which would have been good for the current account. To the contrary, there was a significant appreciation of the dollar in the 1990s.

The US story is comparable to Japan’s of the 1990s, when the evolution of the current account seemed inconsistent with the sharp decline in the country’s fiscal balance—it was an example of private savings rising to compensate a deteriorating fiscal stance, to the point of leaving the current account unaffected. It also confirms results from various cross-country empirical studies that often fail to establish a clear chain of causality between the twin deficits, not least because they use data on a very small sample of countries, focused on short periods of time.7 Such “anomalies” are hardly surprising since equations (1) through (8) have no causal significance. Because they are identities, all variables are endogenously determined as part of a general equilibrium outcome for the whole international economy. The three sectoral balances—saving-investment balance (S – I), the government deficit (G – T), and the trade or current account deficit (M – X) are in fact functions of many other variables such as national income, interest and exchange rates, etc.

The weakness of the twin-deficit hypothesis pertains to its definition of current account balances in isolation of changes in other influential variables such as public debt or the real exchange rate. A possible way of rehabilitating (at least partially) the twin-deficit hypothesis is to adopt a two-step analysis of the relationship between fiscal and current account deficits: first, one needs to look at the link between fiscal policy and national savings,8 which itself is controversial: 7 The literature on the subject is quite confusing. In an influential study, Miller and Russek (1989) found fiscal deficits to be the main determinants of trade deficits. Kim and Roubini (2003) and Gruber and Kamin (2005) either found no link between the two, or concluded that there was a link in the opposite direction of the one predicted by the twin-deficit hypothesis.

8 Bartolini and Lahiri (2006) adopt a cross-country methodology for 26 industrial and emerging economies and find that each dollar rise in fiscal deficits is associated with an average rise in private consumption of 33 to 37 cents. While their finding supports the proposition that consumption responds significantly to fiscal policy changes, their estimated rise in consumption is smaller than the increase of 40 to 50 cents calculated by Bernheim (1987).

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