So this is a supremely legitimate question. Infact, after dipping one’s toes into the vast ocean that is the economics of international trade and the Balance of Payments, I’d go as far saying that this question is inevitable. Let’s put this to bed, shall we?
Macroeconomic theory suggests that the Current Account Balance (X-M) and the Budget Balance (T-G) of a country are closely related. Lets look at the National Income Identity to see how.
Note: I’m using the term Current Account Balance to loosely mean Net Exports (X-M), even though the Current Account includes other items such as investment income and current transfers.
Y = C + I + G + (X - M)
Where Y = Output, C = Consumption, I = Investment, G = Government Spending, X = Exports, and M = Imports.
Let’s move a few things around.
Y - C - G = I + (X - M)
Adding and subtracting T (taxes) from the LHS, we get:
(Y - T - C) + (T - G) = I + (X - M)
Where (Y - T - C) = Sp (Private Saving), (T - G) = Budget Balance and (X - M) = Current Account Balance.
This implies:
Sp + (T - G) = I + (X - M)
(Sp - I) + (T - G) = (X - M)
Or
(Private Saving - Investment) + Budget Balance = Current Account Balance
So, this is how the Current Account Balance and the Budget Balance are related in theory.
Twin Deficit Hypothesis
Now that we know what the theory is, let’s assume there’s a Current Account Deficit i.e. the Current Account Balance is negative. Per the equation above, the following scenarios are possible:
- There’s a Budget Deficit (Budget Balance is negative) and Private Saving is < Investment i.e. (Sp - I) is also negative.
- There’s a Budget Deficit (Budget Balance is negative) and Private Saving is > Investment, but the Budget Deficit is > (Sp - I) in absolute terms.
- There’s a Budget Surplus, but Private Saving is < Investment, and the absolute value of (Sp - I) is greater that the Budget Surplus.
If we assume that all scenarios are equally likely, the odds of a Current Account Deficit implying a Budget Deficit are 2/3 or 67%. That said, all scenarios are not equally likely. Budget Deficits are much much more common that Budget Surpluses. Per the CIA World Fact book (Link here), 85% of the countries of the world were running Budget Deficits based on 2015 estimates (some estimates included are for earlier years). Based on these two inputs, it is reasonable to assume that if a country is running a Current Account Deficit, in the vast majority of the cases, it is also running a Budget Deficit.
This brings us to the “Twin Deficits Hypothesis”, which refers to the tendency of nations to run a Current Account Deficit as well as a Budget Deficit together. The term became popular in the 1980s and 1990s when the US began to run deficits in both these accounts. However, as we’ve shown above, this (running twin deficits) is not a rule - it’s just what is observed in a majority of the cases.
You can run a Budget Surplus while running a Current Account Deficit e.g. New Zealand in 2015 (source: CIA Factbook).
What does it really mean to run Twin Deficits? Let’s look at the US.
Let’s explore further to understand what it means when a nation is running a Current Account Deficit and a Budget Deficit concurrently. Let’s use the example of the US. For context, the US runs the largest Current Account Deficit in the world ($484 Bn in 2015). It’s Budget Deficit for FY2015 was $439 Bn (2.5% of GDP).
The US has been running Current Account Deficits (CAD) for decades. When the US runs a CAD, it is importing more than it exports, which means that on a net basis, it is buying foreign goods and paying foreigners USD in return.
(Note: Even if we assume that the US pays importers in their own currency (the importer’s currency), it still effectively means that the US is paying for its net import of foreign goods in USD. Lets see how. The US would exchange USD for foreign currency from the importer country and then use this foreign currency to pay the importer. The buying of foreign currency and then using it to pay for imports would cancel each other out, and the US would still have bought foreign goods and paid in USD.)
When foreigners accumulate net USD (after paying for imports from the US), they invest these dollars in American equity, debt and other assets. They are effectively lending to the US. The US is a net debtor/borrower.
Separately, it is well know that Private Savings in the US are low and inadequate to fund all of the investment required in the economy (Sp - I < 0). America is heavily dependent on foreign funds to bridge this shortfall.
Now look at the identity below and put both these pieces together.
(Private Saving - Investment) + Budget Balance = Current Account Balance
(-) + (-) = (-)
When the US runs a CAD (has run CADs for decades), it borrows funds from the ROW, which are then used to finance the Budget Deficit (has run budget deficits in all years since 1970 except for 1998-2001) as well as the Investment that domestic Private Saving has been unable to finance.
Finally the Logic - Why a Current Account Deficit makes a Budget Deficit quite Likely
Lets assume country X is running a balanced budget while its Current Account is in surplus. Great situation really. Now lets assume that country X’s key trade partners fall into recession, or the goods of other nations become more competitive globally, causing X’s exports to fall while its imports remain at the same level. This will lead to a Current Account Deficit.
When country X’s exports fall, it will lower demand for its products which can lead to lower output and unemployment. To counter this scenario/avoid a slowdown, the government will usually tend to increase government spending (G) in order to boost demand. Increased G (while taxes remain the same) funded in part by borrowing from abroad will lead to a Budget Deficit.
Hopefully now it all makes more sense.
Bottom-line: Current Account Deficits don’t have to lead to Budget Deficits, but they usually do.
Signing off.
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