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THE TWIN DEFICIT DILEMMA

April 26, 2019

RiyaKaul 1 - THE TWIN DEFICIT DILEMMAIt’s high time that the global economy addresses the Minotaur in the room, the world’s de facto economic capital, USA. During his electoral campaigning, self reliance was a primary target that Donald Trump focused on and believed in. MAGA was a vote magnet for the many local industries that couldn’t survive global competition. Over two years into his term, we’ve witnessed Trump initiate a trade war and hike rates enough to cause a currency crises in nearly all the EMEs. Massive tax cuts were federally funded to revive the local industries. And while that may seem like a sound internal policy, the republican economists have completely disregarded the Twin Deficits Hypothesis, which even though isn’t true for every other nation, certainly holds for the American economy.

Twin deficit refers to a situation when a nation’s Trade deficit is accompanied by a  simultaneous Fiscal deficit. After the Bretton Woods conference of 1945 chose the well-lobbied Global Plan as suggested by Harry Dexter (On behalf of the American Government) over the Global Surplus Recycling Mechanism (GSRM)/Bancor system proposed by Keynes, it was evident that the US couldn’t forsee a future where they’d have a Trade deficit. The GSRM was a mess-proof mechanism that would systematically bring international markets to equilibrium by appreciating the currencies of surplus nations, and depreciating those of the deficit facing nations. But since USA had a huge surpluses after the war, which they didn’t want to let go of, they put forth the Global Plan that would ameliorate deficits via IMF lending, but would do nothing about the surplus nations. This mechanism worked well for them after the implementation of the Marshall’s plan, under which money was lent to Western Europe and Japan (Cornering USSR!) to help them recover the consequences of the war. But for USA it served two purposes, eliminating communism and creating a market for the American economy, thus boosting it’s Trade surpluses. Eventually, in the 60’s, after the American government funded various Asian wars and simultaneously attempted to maintain populism by mass public welfare programs like Great Society by Lyndon Johnson or the New Frontier by JFK, it ran too deep into deficits. And this is where our twin deficit hypothesis comes in. Running fiscal deficits by cutting taxes causes consumption to rise and thus savings to fall. A reduction in savings prompts the government to borrow funds from abroad to finance their fiscal expenditure. Now  an influx of investment makes demand for dollar rise, which in turn results in appreciation of the USD. And that makes American commodities relatively expensive to purchase, thus causing a trade deficit. It can be explained mathematically through a simple equation, Y = C + I + G + NX can be written as (Y – C – Tax + Transfer) + (Tax – G – Transfer) = I + NX which signifies

Private Savings + Public Saving = Domestic Investment + Net foreign Investment

Now imagine a decline in Public Savings, due to cutting taxes and causing a fiscal deficit. This can be offset by:

  • A Rise in Private Savings: As per Ricardian equivalence, tax cuts prompt people to increase savings, because they expect taxes to rise in the This, though economically ideal, is unlikely in the real life context of the non rational people.
  • A Fall in Domestic Investment: The crowding out It’s never good.
  • A Fall in the Net foreign Investment: The Twin Deficits dilemma

These deficits in the 60’s required a free monetary policy, one that wasn’t just limited to the Special Drawing Rights over gold reserves, and eventually resulted in the collapse of the Bretton Woods in 1971, so that USA could more freely incur deficits and take advantage of the negative engineering via the unfaltered faith in the Dollar. Twin deficits were also faced during the 80’s tax cuts by Reagan, and in early 2000s under the spending programs of the Bush administration.

The contrary cases of the 90’s and the late 2000’s can be justified by changes in the ‘other’ factors. In Clinton’s 90’s, the fiscal budget was under control while the trade deficit widened due to decrease in private savings, under a phenomenon known as Ricardian equivalence. In the late 2000s, private savings shot up due to the economic crises, thus giving way to a high fiscal deficit with a low trade deficit.

Coming to the current scenario, it is important for the Trump administration to realise that the trade deficit cannot be improved unless they control their fiscal profligacy, for which tax cuts and creating artificial competitiveness are certainly not the way. The situation is even more delicate when you realise that the Federal Reserve has been increasing the Federal Funds Rate, to take up monetary tightening to control the inflation, that was created under the quantitative easing taken up after the Recession of 2008. These rising rates attract foreign capital and appreciate the Dollar which deepens the Trade deficit. Although Trump has been threatening to replace Jerome Powell, by cronies like Herman Cain unless he reduces the rates, the hikes are necessary to counter the impact of over $3 trillion pumped in the economy.

Politicians, in order to elongate their careers take up fiscal profligacy, and America could easily do that due to the it’s Reserve status advantage. But new and better alternatives are constantly coming up. Additionally, the world has started to take notice of the $21 trillion debt the American government owes to the Fed, the Public and other economies, China leading the feat by holding over $1.2 trillion. And the budget must deepen as baby boomers retire. Unless the necessary steps are taken for fiscal consolidation right now, the burden might come crashing down on the shoulders of those who never asked for it.ICoFP Article - THE TWIN DEFICIT DILEMMA

Riya Kaul,

B.A. Economic Hons.

Shri Ram College of Commerce

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