1. Fiscal Deficits and The Current Account Roberto Chang March 2007

2. Twin Deficits? National Savings = Private Savings + Government Savings Government Savings = Budget Surplus So, it is easy to conclude that a reduction in the budget surplus (i.e. a larger budget deficit) reduces national savings and, hence, leads to larger CA deficits.

3. “The only effective US policy response to the [CA] problem…is a conversion of our present (and especially prospective) budget deficits into modest surpluses a la 1998-2001.” C. Fred Bergsten, “The Current Account Deficit and the US Economy,” Testimony before the U.S. Senate, Budget Committee, Feb. 1 2007.

4. Problems with the Twin Deficits Argument As we have discussed, the argument implies that interest rates would have risen, which has not been the case in recent years. It may be more relevant, however, for other periods, such as the 1980s.

6. A second problem is that the “Twin Deficits” argument relies on the assumption that private savings do not change when fiscal deficits increase. This is arguably not always the case. In fact, in theory private savings may completely offset changes in the fiscal deficit: Ricardian Equivalence.

7. Ricardian Equivalence Consider a two period small open endowment economy with a government. The representative household has to pay taxes T t taxes in period t = 1,2.

8. The present value budget constraint of the household is, hence, C 1 + C 2 /(1+r * ) = Q 1 + Q 2 /(1+r * ) – (T 1 + T 2 /(1+r * )) and optimal consumption is given by the usual condition: MU 1 /MU 2 = (1+r * )  What matters is only the present value of taxes

9. The government has expenditures G t in period t = 1,2, so its flow budget constraints are: G 1 + B 1 g = T 1 G 2 = T 2 + (1+r * ) B 1 g where B 1 g denotes government assets at the end of period 1.

10. Combining the flow government budget constraints we obtain the government present value budget constraint: G 1 + G 2 /(1+r * ) = T 1 + T 2 /(1+r * )  The present value of taxes must be equal to the present value of expenditures.

11. Implications Government policy matters only through the present value of expenditure. Hence the timing of taxes and the budget deficit does not affect consumption, given government expenditures.

12. Since household savings are: S 1 = Q 1 – T 1 – C 1 any reduction in taxes (T 1 ) will be offset by an equal increase in savings.  Given government expenditure, an increase in the government deficit (caused by lower taxes) will be offset by an increase in private savings, leaving national savings and the CA untouched!

13. Another implication is that, to analyze the effects of changes of government expenditure, one can assume that the budget is balanced (i.e. G t = T t )

14. The 1980s Twin Deficits, Again One can conjecture that government policy affected the CA in the 1980s not because of the budget deficits, but because of increased government expenditures. In our model, increases in government expenditures are just like falls in the household’s endowment.

15. However, this seems to be quantitatively insufficient: government expenditures increased by about 1.5% of GNP between 1978 and 1985, so national savings and the CA would have fallen by at most that amount. But the CA deteriorated by about 3%.

18. Ricardian Equivalence May Fail Possible causes: Borrowing Constraints Intergenerational Effects Distortionary Taxation See SU, chapter 5 for a discussion.