edward m gramlich : budget and trade deficits - linked, both worrisome in the long run, but not twins remarks by mr edward m gramlich, member of the board of governors of the us federal reserve system, at the los angeles chapter of the national association for business economics luncheon, los angeles, 31 march 2004. presented at the euromoney bond investors congress, london, england, 25 february 2004. * * * thank you for inviting me to speak today. while i know that most of you would welcome any insights i might have about current u. s. monetary policy - whether the open market committee will be raising or lowering interest rates at our next meeting - i prefer to focus instead on some issues that could become serious over the longer run. these issues involve the persistent budget and trade deficits facing the american economy, issues that could eventually involve significant economic adjustments around the world. 1 large budget and trade deficits are not a new phenomenon. they also arose in the united states in the mid - 1980s. at that time, the business press and many economists began referring to the situation as one of “ twin deficits. ” with the current re - emergence of both deficits, the phrase has come back into common usage - too common, in my view. to be sure, in theoretical models there is a scenario by which budget deficits can create trade deficits, and one by which trade deficits can create budget deficits. but there are also many scenarios by which either deficit can arise independently, or even by which budget and trade deficits can move in opposite directions, as they did in the 1990s. in general, while budget and trade deficits can be linked, there are important differences between the two, both in how they respond to economic forces and in their long - run consequences. i start by examining the relationship between budget and trade deficits - why they are linked but not twins. i discuss the sustainability conditions for budget and trade deficits ; the conditions that must be fulfilled for the debts on both accounts to be stabilized in relation to the size of the u. s. economy. then i discuss what happens if either debt violates this condition and rises in relation to the size of the economy. this discussion, in turn, raises further interesting distinctions between the two deficits. the link the link between budget and trade deficits can be seen most naturally through the national income accounting framework. any saving the nation does finances either private domestic investment directly

external debt, one can separately ask whether either debt level is becoming a more, or less, important economic factor over time. for government debt, this weaker standard, or stability condition, determines merely whether the ratio of debt to gross domestic product ( gdp ) is stable. if it is, interest payments on the debt will, in equilibrium, also settle down to a stable proportion of gdp. for external debt, a stable debt - to - gdp ratio means that the net interest and dividend payments of the united states to foreign investors will also settle down to a constant ratio to gdp. both debt stocks would also include a valuation adjustment to deal with capital gains and losses. the appendix derives this stability condition generically. it is that d ( g - i ) / ( 1 + g ) = p, where d is the stable ratio of debt to gdp, g is the nominal growth rate of the economy, i is the nominal interest rate in the economy, and p is the ratio of the primary deficit to gdp. for budget accounts, the primary deficit is the national income accounts budget deficit, but excluding interest payments. for trade accounts, the primary trade deficit is the current account deficit, excluding net interest and dividend payments to foreigners. 3 as a general rule, the economy ’ s growth rate and interest rate will be fairly close. the equation says that if they are equal, the primary deficit must be zero to stabilize the debt - to - gdp ratio. if the interest rate is slightly above the growth rate, as it would be in models without risk for economies that save less than the theoretical optimum, a nation with outstanding debt would have to run a slight primary surplus to stabilize its debt - to - gdp ratio. if the effective interest rate on debt is slightly below the growth rate, as it has generally been found to be in the past for both deficits, a nation with outstanding debt could run slight primary deficits and not see the debt ratio grow. 4 on the foreign side, this condition has until now been especially forgiving. even with a large net debt position, our net investment income from foreigners has exceeded that paid out to foreigners. since the net interest rate has been less than the gdp growth rate, the ratio of external debt to gdp could have been stabilized with a moderate primary trade deficit. 5 magnitudes it is well known that the u. s. economy now suffers both budget and trade deficits. but how do these deficits compare with the stability conditions?