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What happened to the Twin Deficit Hypothesis?

    The UK current account deficit was 4.4% of GDP at current market prices in 2013, according to ONS figures released last week. This was an increase on the deficit of 3.8% of GDP in 2012, and whilst the deficit in trade in goods and services improved to 1.6% from 2.1% in 2012, the figures were overall to the downside. This deterioration has placed renewed focus on the Twin Deficit Hypothesis.

    The hypothesis states that as government budget deficits rise, so should trade deficits. As such, we should not be concerned with the high current account deficit because as the budget deficit falls, the current account deficit will naturally also fall. This is based on viewing GDP (Y) as the sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (NX).

    Y = C + I + G + NX

    GDP can also be defined as the sum of Consumption, Saving and Taxation. Essentially this means that all income goes to consuming, saving or taxation.

    Y = C + S +T

    We can then combine these equations to get:

    (S – I) + (T – G) = NX

    If Government Spending is higher than Taxation then there is clearly a budget deficit. If Saving and Investment are stable then as the budget deficit rises i.e. G is higher than T, then Net Exports should fall and the trade deficit should therefore rise.

    At equilibrium, the trade deficit should be equal to net capital inflow. Also at equilibrium, savings and net capital inflow must equal investment and the budget deficit.

    Therefore we get: Budget Deficit = Savings – Investment + Trade Deficit.

    A paper from the IMF by Bluedorn and Leigh provides support for this by concluding that for each 1% of GDP for which a budget is in deficit, the current account shows a deficit of 0.6% of GDP.

    However as this graph from the Wall Street Journal highlights, this relationship has broken down over the last three years. As the budget deficit has shrunk in 2011-13, the current account deficit has actually increased.

    We must remember that we have assumed Savings and Investment are stable. For example, if UK savings rather than foreign savings finance the budget deficit, then an improved fiscal situation may ‘crowd in’ investment rather than lead to a smaller current account deficit. However, this seems unlikely given that investment has hovered at just above £120bn in 2011-13. A more probable explanation is the fall in the savings ratio from 7.3% in 2012 to 5.1% in 2013; although that wouldn’t be entirely satisfactory because in 2012 both savings and the current account deficit rose relative to 2011. Of course, hideous Eurozone growth and not being at equilibrium may have had something to do with it. 

    So if the Twin Deficit Hypothesis has not entirely broken down, it has at least been on an extended break. Persistent twin deficits are never healthy, so we must hope that the OBR’s forecasts for falling current account deficits are accurate.

    Adam joined the Centre for Policy Studies as Head of Economic Research in January 2014. 

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