Current account dynamics and expected future budget deficits: some international evidence

Journal of International Money and Finance 19 (2000) 255–271 www.elsevier.nl/locate/econbase

Current account dynamics and expected future budget deficits: some international evidence Giovanni Piersanti a

a, b,*

University of Teramo, Dipartimento di Metodi per l’Economia e il Territorio, Viale Crucioli 122, 64100 Teramo, Italy b University of Rome “Tor Vergata”, Dipartimento di Studi Economico-Finanziari e Metodi Quantitativi, Via di Tor Vergata, 00133 Rome, Italy

Abstract This paper addresses the question of whether current account deficits are linked to expected future budget deficits. We use an optimizing general equilibrium model to show the theoretical relationship between the two deficits. We then estimate the econometric equation based on the forward-looking expectations model for OECD countries, thus extending earlier research based on more conventional analysis. From the empirical investigation evidence is obtained that strongly supports the view that current account deficits have been associated with expected future budget deficits during the 1970–1997 period.  2000 Elsevier Science Ltd. All rights reserved. Keywords: Optimizing models; Budget deficits; Current account; Unit root tests; Granger–Sims causality; Forward-looking expectations

1. Introduction Large and persistent budget deficits have occurred together with current account deficits in many industrial countries over the past two decades. The best known of these events took place under the “Reagan fiscal experiment” of the 1980s, which marked a period of strong appreciation of the dollar and an unusual shift in the external balance of the United States. A similar pattern has also characterized countries such as Germany and Sweden, where the rise in the budget deficits of the early

* Tel.: +39-861-266551; fax: +39-861-266350. E-mail address: [email protected] (G. Piersanti). 0261-5606/00/$ - see front matter  2000 Elsevier Science Ltd. All rights reserved. PII: S 0 2 6 1 - 5 6 0 6 ( 0 0 ) 0 0 0 0 4 - 8

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90s was accompanied by a real appreciation of the national currency and a worsening in the current account (see Branson, 1993 and Ibrahim and Kumah, 1996). The coincidence of these events has given rise to a controversy on the causal links between the budget and current account balance, or “twin deficits” issue, that neither theoretical nor empirical analysis has been able to resolve. In short, the controversy has reflected the two opposite views on fiscal policy prevailing in the literature. One was based on the traditional view that budget deficits have important and even harmful effects on the economy. The other was based on the Ricardian view that budget deficits have no effect at all. One feature of the above controversy, however, appears rather unsatisfactory. We can see, in fact, that while theoretical models based on intertemporal optimization have incorporated the effects of expected future budget deficits into the analysis, econometric investigations have been based exclusively on backward-looking behavior. In this paper we attempt to fill this gap, by proceeding in the following steps. We first derive the theoretical relationship between the “twin” deficits from an intertemporal optimization model. We then estimate the econometric equation based on a forward-looking expectations model for OECD countries, thus extending the research of Salvatore (1993) and others based on conventional analysis. The aspect of special interest in this paper is, in fact, that it explicitily incorporates the effects of expected future budget deficits into the analysis, as in the most recent theoretical research on dynamic macroeconomic modeling. The rest of the paper is organized as follows. Section 2 presents the theoretical model. Section 3 presents the empirical results. Section 4 contains the summary and conclusion of the paper.

2. The optimizing model The following open economy macromodel is composed of households, firms, and the government. The model is a version of the Yaari (1965)–Blanchard (1985) model of forward-looking agents with uncertain lifetimes and a constant population, in which agents maximize the discounted value of an expected utility function subject to an appropriate budget constraint and where the utility function is assumed logarithmic in consumption. The model abstracts, for simplicity, from money, so that nonhuman wealth is the sum of government debt, the capital stock and foreign assets, and is built on the convenient assumption that agents have no bequest motive1. In this economy agents consume two goods, which we denote as CH (domestically produced good) and CF (foreign or imported good), so that total real consumption, C, can be written as C⬅CH+rCF⬅qC+r(1⫺q)C, where r is the relative price of 1 To eliminate unintended bequests we need, however, as in Blanchard (1985), the additional assumption that agents participate to life insurance programs by which they receive, in addition to the market interest rate, an extra premium on their non-human wealth when alive, and transfer their net wealth to the insurance company at the time of death.

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foreign good in terms of domestic good, or real exchange rate, and q and (1⫺q) are, respectively, the proportion of domestic and foreign goods over total consumption. This is a “semi-small” open economy: the prices of its import good and foreign assets are exogenous but the price of the export good is domestically set. On the production side, we assume that domestic output is produced by a twofactor neoclassical production function with constant return to scale, which can be written as Y=Y(K) normalizing population to unity, where Y is domestic output and K the stock of capital. Output equals the sum of private and government consumption, exports and investment. There are no adjustment costs, so that capital stock is always at its desired level. For simplicity, we assume that capital and government bonds are owned entirely by domestic residents. External bonds pay an exogenous given world real interest rate, r*. Uncovered interest parity holds at all times. We can write the aggregate relationship as follows:

冋

册

(1)

K˙⫽Y(K)⫺q(C⫹G)⫺X(r),

(2)

C⫽(d⫹b)

F˙⫽

w(K) ⫹K⫹rF ⫹d, r∗+d

X(r) ⫺(1⫺q)(C⫹G)⫹r∗F, r

r˙ ⫽[Y⬘(K)⫺r∗]r,

冋 册

d(d+b) d˙⫽(r∗⫺a)d⫹ ∗ Z, (r +d)

(3) (4) (5)

where, C, K, r and r* have the meaning given above, w is real labor income, F the stock of net external assets, X real exports, G government spending, d an index of fiscal policy that summarizes the effects on aggregate demand of the entire sequence of current and anticipated future budget deficits, and Z an exogenous variable that allows for the design of a lump-sum tax policy (see Blanchard, 1985). The others are constant parameters, where a is a coefficient linking taxes to the level of government debt, with the assumption that aⱖr∗ to satisfy the government transversality condition, b is the subjective discount factor and d is the constant instantaneous probability of death. Thus, (d+b) is the effective discount factor and d−1 the expected lifetime of agents. Finally, a dot on a variable denotes its time derivative or instantaneous rate of change. The aggregate consumption function is a linear function of total wealth. Eqs. (2)– (4), respectively, describe the dynamic evolution of capital, foreign assets and the expected rate of depreciation of the real exchange rate, which, given perfect foresight, is equal to the actual rate of exchange rate depreciation, r˙ . Finally, Eq. (5) describes the dynamics of fiscal policy. This is centered on a lump-sum tax cut, while government spending is set equal to zero on the entire path, so that fiscal policy can have

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effects only through consumption2. Moreover, since taxes are modeled as an increasing function of debt, through the a parameter, the policy considered here is one in which the deficit created at t=0 by a tax cut, is followed later by surpluses as debt accumulates, so as to satisfy the intertemporal government budget constraint3. Thus, the focus is on intertemporal reallocation of taxes, which is the kind of fiscal policy under debate within these dynamic macromodels. A unique stable saddle-point equilibrium path characterizes the model if bⱕ r∗⬍(d+b) and the transversality conditions are met4. Solving the model for shortrun and steady-state equilibrium, we obtain the following set of relationships among the variables of interest5: 2.1. Short-run equilibrium

C⫽C(K,F,r∗,d)

CK⬎0, CF⬎0, Cr∗⬍0, Cd⬎0

r⫽r(K,F,r ,d) rK⬎0, rF⬍0, rr∗⬎0, rd⬍0 ∗

(6) (7)

2.2. Steady-state equilibrium

C⫽C(r∗,d) Cr∗⬎0, Cd⬍0

(8)

r⫽r(r∗,d) rr∗⬍0, rd⬎0

(9)

K⫽K(r ,d) Kr∗⬍0, Kd⫽0

(10)

F⫽F(r∗,d) Fr∗⬎0, Fd⬍0

(11)

∗

From these expressions we see that, in the short-run, an increase in d implies a rise in consumption and an appreciation of the real exchange rate, which are then overturned in steady-state equilibrium where consumption, the real exchange rate and foreign assets are below their original levels and the capital stock is unchanged. The dynamics of this economy can be determined by substituting the short-run

2

The effects of government spending in models very similar to the one we are employing here may be found, for example, in Frankel and Razin (1987, parts IV and V), Obstfeld (1989), Turnovsky and Sen (1991) and Turnovsky (1995, chap. 12). 3 Obviously, we assume that the transversality conditions on K and F will also hold. 4 This condition may also be found in other studies facing similar questions within a framework of forward-looking agents with finite horizons. See, for example, Blanchard (1985), Buiter (1987), Matsuyama (1987), Giovannini (1988) and Kaway and Maccini (1995). 5 A detailed Mathematical Supplement on the derivation of these relationships together with stability conditions and transitional dynamics is available from the author upon request.

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solution for C and r into the dynamic equations of the model and invoking the fulfillment of transversality conditions. However, since for our purposes the critical equation is (3), we may focus the analysis only on it. In fact, Eq. (3) could be rewritten as X[r(W,d,r∗)] F˙⫽ ⫺(1⫺q)C(W,d,r∗)⫹r∗F, r(W,d,r∗) where W⬅K+rF. Linearizing around the steady-state equilibrium, for given r*, we obtain F˙⫽⌰(d0⫺d¯)el1t⫹r∗(F⫺F¯), where l1 is the negative root associated with the stable arm of the saddle path, 1 ⌰⬅ {[nrW⫺r(1⫺q)CW]b⫹[nrd⫺r(1⫺q)Cd]}, rW⬅rK⫹rF, CW⫽CK r X ⫹CF, n⬅X⬘⫺ ⬎0 r and b(⬍0) a parameter linking W and d along the stable path. Denoting the initial stock of foreign assets by F0, the solution to this differential equation is

冋

册

⌰ ⌰ ∗ Ft⫽F¯⫹ (d ⫺d¯)el1t⫹ F0⫺F¯⫺ (d ⫺d¯) er t l1−r∗ 0 l1−r∗ 0 which, appealing to transversality condition, becomes ⌰ Ft⫽F¯⫹ (d ⫺d¯)el1t, l1−r∗ 0

(12a)

or, equivalently, ⌰ ¯ F¯⫽Ft⫹ (d⫺dt), l1−r∗

(12b)

where the bar denotes the steady-state value6. These equations describe the relationship between the accumulation of foreign assets and the evolution of expected future budget deficits along the path approaching the steady-state equilibrium. There are both direct effects on real exchange rate (nrd) and consumption (r(1⫺q)Cd), and indirect effects via changes in real wealth ([nrW⫺r(1⫺q)CW]b). Thus according to Eq. (12a) or (12b) during the transition to

6 An equation similar to the one shown here may also be found in Turnovsky and Sen (1991), by combining Eqs. (13) and (16) of their model. The relationship, however, would be expressed in terms of stocks of foreign assets and government debt instead of foreign assets and current and expected future budget deficits.

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steady-state a rise in the budget deficit generates a continuous decumulation of external assets (or current account deficits) if ⌰⬎0. This result appeals to economic intuition. For example, assume a tax cut at t=0. This, on impact, yields an appreciation in the real exchange rate, an increase in consumption and hence a deterioration in the current account together with a decumulation of foreign assets. However, as the government budget goes from deficit to surplus, wealth begins to decline as does consumption, while the real exchange rate depreciates. When the reduction in consumption and the rise in relative price become sufficiently strong the current account starts improving to return back to its original position in the end. Since the current account is in deficit during the period of adjustment, foreign assets decline to a lower level in the new steady-state. There is also real exchange rate overshooting along the transition path. When Ricardian equivalence holds (d=0) the rise in budget deficit leads to an equal instantaneous increase in private savings with no net effect on aggregate wealth, implying that there will be no link between fiscal deficits and the current account7. In the literature, however, the relationship between internal and external deficits has received much less attention than the effects of fiscal deficits on the other macroeconomic variables (see, for example, Seater, 1993 and the literature quoted therein). In addition, the empirical work has never considered the effects of anticipated future budget deficits and mostly analyzed the cases of the United States and the United Kingdom8. These issues will now be faced in the following econometric investigation.

3. The empirical analysis In this section we present the empirical evidence for almost all OECD countries. Exceptions are Turkey, Switzerland, Portugal, Iceland, Belgium, New Zealand and the last comers for which we have not been able to find coherent data. The sample covers the period 1970–1997. The data on the budget and current account balance are measured as a percentage of GDP, rather than as absolute levels. We have first performed preliminary tests investigating the stationarity of time series employed. From the unit root tests reported in Table 1 we may detect a typical problem emphasized in Sims (1988) and Sims and Uhlig (1991). There is a sharp

7 On this point see Barro (1974, 1989). The above theorem, however, would not apply if we had considered changes in government spending (see, for example, Frankel and Razin, 1987; Turnovsky and Sen, 1991; Turnovsky, 1995). 8 See, for example, Laney (1984), Ahmed (1986, 1987), Miller and Russek (1989), Abell (1990) and Helliwell (1990). Exceptions are Evans (1988), Ibrahim and Kumah (1996) and Salvatore (1993), who report results for major industrial countries.

United States Japan Germany France Italy United Kingdom Canada Total G7 Australia Austria Denmark Finland

Country BD ⫺2.59 ⫺1.40 ⫺2.93 ⫺1.75 ⫺3.18 ⫺2.56 ⫺2.02 ⫺2.69 ⫺2.82 ⫺2.10 ⫺1.78 ⫺1.46

CA ⫺1.57 ⫺1.94 ⫺1.70 ⫺3.21 ⫺2.17 ⫺2.03 ⫺2.11 ⫺3.27 ⫺2.33 ⫺2.73 ⫺1.48 ⫺1.60

DF b

0.067 0.033 0.050 0.002 0.020 0.026 0.023 0.002 0.015 0.005 0.078 0.063

CA

Table 1 unit root tests for current account (CA) and budget deficit (BD): 1970–1997a SU c

0.008 0.089 0.004 0.046 0.002 0.008 0.027 0.006 0.005 0.023 0.044 0.081

BD ⫺2.35 ⫺5.15 ⫺2.33 ⫺2.37 ⫺1.99 ⫺2.81 ⫺2.86 ⫺3.82 ⫺3.29 ⫺3.59 ⫺2.47 ⫺1.80

CA

PP d

⫺4.55 ⫺2.05 ⫺3.86 ⫺2.35 ⫺2.73 ⫺3.91 ⫺3.45 ⫺3.01 ⫺4.35 ⫺2.06 ⫺2.20 ⫺3.01

BD

0.014 0.000 0.015 0.013 0.029 0.005 0.004 0.000 0.002 0.000 0.010 0.043 (continued

CA

SU

0.000 0.025 0.000 0.014 0.005 0.000 0.000 0.003 0.000 0.025 0.019 0.003 on next page)

BD

G. Piersanti / Journal of International Money and Finance 19 (2000) 255–271 261

BD ⫺1.58 ⫺1.60 ⫺1.77 ⫺1.97 ⫺1.89 ⫺1.56 ⫺2.27

CA ⫺2.76 ⫺0.85 ⫺2.88 ⫺1.69 ⫺2.45 ⫺1.82 ⫺1.95

DF b

0.005 0.210 0.004 0.051 0.011 0.068 0.032

CA

SU c

0.066 0.063 0.045 0.031 0.036 0.025 0.017

BD ⫺4.18 ⫺1.20 ⫺4.00 ⫺1.88 ⫺4.35 ⫺2.00 ⫺2.75

CA

PP d

⫺2.01 ⫺1.88 ⫺2.09 ⫺3.75 ⫺2.67 ⫺3.12 ⫺3.26

BD 0.000 0.127 0.000 0.037 0.000 0.028 0.005

CA

SU

0.028 0.037 0.023 0.000 0.007 0.003 0.002

BD

b

Source: OECD ECONOMIC OUTLOOK. DF: Dickey–Fuller (1979) unit root test statistics based on OLS regression of current account, or budget deficit, on a constant and its lagged value. c SU: Sims–Uhlig (1991) Bayesian criterion for unit root test. It is based on the probability that the coefficient on the lagged variable in the above regressions is greater than or equal to one, which in our case is the probability that a variable t with 28 degrees of freedom is greater than the computed t statistics. Hence, the figures reported for this test are probability values, while the computed t statistics are the same, in absolute value, as those reported for the DF and PP tests. It should be noted that we have set equal to zero probability values less than 0.001, and that the others have been obtained by interpolations of relevant values in the t-table. d PP: Phillips–Perron (1988) unit root test statistics obtained from the above OLS regression using the Newey–West (1987) adjusted variance–covariance matrix of the parameters estimates. The figures reported for this test have been obtained using a window size (or truncation point) of 6, but similar results may be acquired using other window sizes in the range [3,9]. e Total SMC stands for total smaller countries and refers to all OECD countries excluding the G7. Finally, the data used in carrying out the above tests refer to the Current Account Balance as a percentage of GDP and to General Government Financial Balances as a percentage of GDP. Data for the years 1996–1997 are OECD estimates.

a

Greece Ireland Netherlands Norway Spain Sweden Total SMCe 95% Critical value for DF and PP: ⫺2.997

Country

Table 1 (continued)

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263

contrast between the classical and Bayesian inferences about unit roots9. While the Dickey–Fuller (DF) and Phillips–Perron (PP) tests indicate that we cannot reject the unit root hypothesis in many cases, the Sims–Uhlig (SU) test suggests that the coefficient on the lagged variable is very unlikely to be equal to one, with the exception of Ireland. We may thus accept the hypothesis of stationarity. We have also run causality tests. Indeed, one prediction of our model is that a rise in the budget deficit would lead to an increase in the current account deficit, so that the two should be causally linked. The results of Granger and Sims tests are summarized in Table 2. We can see that the hypothesis of no causality between the two deficits has been rejected in five countries out of seven, for the G7, and in seven countries out of ten for the other OECD countries. It turns out that the null hypothesis has also been rejected for the two groups of countries taken as a whole (G7 and SMC) and that the rejection rate has always occurred at a level of statistical significance better than 5 or 10% standard level. Causality testing, however, has to be viewed with caution and in our contest can be better seen only as a preliminary result on the investigation of the relationship between the budget and the current account balance. We now turn to the estimation of Eq. (12). Here, we note that the negative relationship between the accumulation of foreign assets and the expected future budget deficits can be conveniently rewritten for estimation purposes as

冘 n

CAt⫽a0⫹a1CAt−1⫹a2

miBDet+i,

(13)

i⫽0

where CA is the current account balance as a percentage of GDP, BDet+i the expected government budget balance (surplus=+, deficit=⫺) as a percentage of GDP for the year t+i, m the discounting factor and n the planning horizon of agents. The lagged dependent variable in (13) captures the implied dynamics of the current account during the transition to the steady-state10. The long-run solution of (13) is CA∗⫽

a0 a2 ⫹ BD∗, 1−a1 1−a1

(14)

where starred variables denote steady-state value. According to the theoretical model, we would expect a1, a2⬎0 in Eq. (13). To test this hypothesis we have estimated Eq. (13) for values of m in the range [0.9,0.99]

9

It must also be noted that, given our results, if we centered confidence regions respectively on the point estimates of the model’s parameters and on the unit value, following the classical approach, we obtain disconnected regions, since most of them centered on the estimated parameters do not include a value of unity. As stressed by Sims and Uhlig, this is a familiar fact from application of asymptotic theory and represents one of the reasons raised by these authors to prefer Bayesian methods. 10 It is worth emphasizing, however, that (13) could also be derived from the Euler equation drawn from a model populated of agents who know the time path of the long-run variable CA*, as implied by the perfect foresight assumption of our model, and minimize a multi-period quadratic loss function, whose arguments are the cost of being out of equilibrium and the cost of adjustment.

United States Japan Germany France Italy United Kingdom Canada Total G7 Australia Austria Denmark Finland

Country

Table 2 Causality tests: 1970–1997

LMFc 11.89**(2,21) 2.83*(2,20) 5.97**(2,21) 0.44(2,21) 2.76*(2,21) 1.94(1,23) 0.49(2,21) 2.44(2,21) 0.25(1,24) 4.25**(2,22) 7.27**(3,18) 2.45(2,21)

LMb

14.87**(2)d 6.18**(2) 10.15**(2) 1.13(2) 5.83**(2) 2.18(1) 1.24(2) 5.28*(2) 0.91(1) 8.07**(2) 15.34**(3) 5.30*(2)

SIMS a

13.79**(2) 5.10*(2) 2.15 (2) 2.83(2) 10.21**(2) 1.86(2) 0.96(2) 5.24*(2) 10.79**(3) 4.21**(2) 0.85(2) 8.54**(2)

LM 11.16**(2,23) 2.34(2,21) 0.96(2,23) 1.29(2,23) 6.31**(2,22) 0.82(2,23) 0.41(2,23) 2.65*(2,23) 4.18**(3,20) 1.95(2,22) 0.36(2,23) 5.05**(2,23)

LMF

GRANGERa

13.83**(3) 5.37*(3) 9.25**(3) 7.41*(3) 10.21**(3) 2.21(3) 1.00(3) 6.63*(3) 12.96**(4) 4.36(3) 4.75(3) 10.89**(3)

LM

7.15**(3,22) 1.58 (3,20) 3.62**(3,22) 2.63*(3,22) 4.02**(3,21) 0.63(3,22) 0.27(3,22) 2.19*(3,22) 4.09**(4,19) 1.29(4,19) 1.50(3,22) 4.66**(3,22) (continued on next page)

LMF

GRANGER INST.a

264 G. Piersanti / Journal of International Money and Finance 19 (2000) 255–271

5.41(3) 0.19(2) 0.90(2) 3.82(2) 2.34(2) 8.79**(3) 5.76*(2)

LMb

SIMS a

1.36(3,17) 0.07(2,21) 0.35(2,21) 1.66(2,21) 0.96(2,21) 2.75*(3,18) 2.72*(2,21)

LMFc 6.71**(2) 0.89(2) 1.12(2) 5.56*(2) 1.98(1) 3.86**(1) 9.80**(3)

LM 3.62**(2,23) 0.36(2,23) 0.48(2,23) 2.85*(2,23) 1.82(1,24) 4.00**(1,25) 3.77**(3,21)

LMF

GRANGERa

11.19**(3) 5.29(3) 1.49(3) 7.95**(3) 3.40(2) 7.38**(2) 12.61**(4)

LM

4.88**(3,22) 1.63(3,21) 0.41(3,22) 2.91*(3,22) 1.59(2,23) 4.30**(2,24) 4.10**(4,20)

LMF

GRANGER INST.a

SIMS, GRANGER and GRANGER INST. denote, respectively, Sims and Granger tests of causality,the last being used here in the double version of causality and instantaneous causality. The first (Sims’ test) is the test developed by Geweke et al. (1983) and has been performed by regressing the budget deficit on its lagged values together with past and future values of the current account balance. The other two (Granger and Granger’s Inst. tests) have been accomplished by regressing the current account balance on its lagged values together with past values and current and past values of the budget deficit respectively. b LM: is the Lagrange multiplier statistics used to test the null hypothesis of no causality, asymptotically distributed as c2(k) under the null hypothesis, where k is the maximum lag length chosen to have white noise residuals in each regression equation. c LMF: is the modified LM statistics, asymptotically distributed as an F(k,T⫺h), where T is the sample size and h the number of regressors. d As can be seen from the degrees of freedom reported in parentheses we have also added, for some countries, dummy variables for some years and in the case of Japan also a trend to achieve the white noise in the residuals. Finally, the single and double asterisks denote a statistical level of significance better than 10 and 5% respectively.

a

Greece Ireland Netherlands Norway Spain Sweden Total SMC

Country

Table 2 (continued)

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and n=511, and assuming, following Mills (1962), that within the sample period the actual budget deficits were the best market estimates of BDet+i. The estimates were performed in GMM, using the Newey and West (1987) consistent estimator of the variance–covariance matrix to deal with the presence of MA (4) in the errors. The results, together with the implied long-run solutions of Eq. (14), are shown in Tables 3 and 4. However, since both coefficients and statistics were virtually unchanged for alternative values of m within the chosen range, we decided to present only the results for m=0.9. (The others with different values of m are however available upon request.) Looking at the two tables, we see that all the countries individually and the two groups have passed our test. In fact, all the coefficient have the expected sign and, with very few exceptions, are highly significant, giving rise to well defined short-run and long-run relationships between the fiscal and current-account deficits. Finally, we notice that, on average, the explained variation in the current account balance is satisfactory (more than 40% of variation is explained by Eq. (13)12) and that the diagnostic tests reveal no problems of misspecification. From the above results we may then conclude that in the period under investigation there is strong econometric evidence of a positive effect of expected future budget deficits on trade deficits for OECD countries. Our empirical results, obtained from the estimation of a reduced form derived from an optimizing general equilibrium model corroborate and strengthen the results obtained in earlier investigations on the same issue13. In particular, they point out that when expected future budget deficit is properly considered, there appears to be strong evidence of the so-called “twin deficits” phenomenon.

4. Summary and conclusion In this paper we have addressed the question of whether large and persistent budget deficits are associated with current account deficits. This important issue has been debated in the past two decades and has come to be known to the public as the “twin deficits” relationship. To face this question we have derived the relationship between the two deficits from a dynamic macroeconomic model based on forward-looking agents with finite lives. Then, we have obtained the econometric equation of the current account balance that incorporates the forward-looking expectations behavior of agents, thus

11 This value for the planning horizon of agents was suggested by Felstein (1986) and has been employed here only because it allows a not too great loss of degrees of freedom, given the sample size. 12 This is consistent with the findings of Helliwell (1990) who, by reviewing the model based evidence drawn by simulation of the major multicountry models, found for the first half of the 1980s that fiscal policy in the G7 explained about 50% of the build-up in the external deficit, which is very close to our own (52%) for the same group of countries. 13 See, for example, Ibrahim and Kumah (1996), Salvatore (1993), Helliwell (1990), Abell (1990) and Laney (1984).

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Table 3 Estimation results of Eq. (13). GMM estimates: 1970–1997a Country

a0

a1

a2

GR2b

SEc

SMd

United States

0.429 (1.315) 1.240 (2.284) 2.158 (2.771) 0.220 (1.761) 3.620 (1.162)

0.731 (5.796) 0.459 (2.883) 0.753 (10.264) 0.020 (0.071) 0.435 (1.792) 0.668 (4.320) 0.692 (12.133) 0.225 (0.577) 0.447 (2.611) 0.577 (3.047) 0.771 (10.583) 0.460 (3.583) 0.613 (3.352) 0.378 (1.628) 0.576 (28.759) 0.730 (6.201) 0.620 (6.395) 0.529 (1.997) 0.547 (4.704)

0.068 (1.747) 0.059 (2.223) 0.167 (2.120) 0.048 (2.107) 0.086 (1.414) 0.026 (1.122) 0.036 (2.271) 0.124 (2.688) 0.281 (2.145) 0.018 (0.891) 0.046 (1.144) 0.060 (17.830) 0.039 (2.508) 0.149 (2.146) 0.015 (0.570) 0.232 (0.200) 0.318 (2.146) 0.064 (1.913) 0.029 (2.117)

0.721

0.790

1.647(2)

0.608

1.045

7.979 (6)

0.551

1.187

2.299(4)

0.105

0.831

5.710(4)

0.144

1.582

1.465 (2)

0.570

1.311

4.019(4)

0.630

0.997

2.776 (3)

0.516

0.479

0.594 (2)

0.600

1.768

3.036 (3)

0.250

1.120

4.387 (3)

0.526

1.701

8.288 (5)

0.448

1.802

5.689 (4)

0.097

1.920

2.141 (2)

0.575

2.589

2.406 (2)

0.411

1.262

0.142 (2)

0.520

3.857

3.912 (4)

0.437

1.614

3.122 (2)

0.448

1.313

1.316 (2)

0.417

0.883

1.006 (2)

Japan Germany France Italy United Kingdom Canada Total G7 Australia

1.482 (2.724) 0.397 (0.436)

Austria Denmark Finland

⫺1.949 (8.316)

Greece Ireland Netherlands Norway

2.558 (1.510) 1.315 (2.192) ⫺0.598 (0.328)

Spain Sweden Total SMC

⫺0.208 (0.730)

a The instrumental variables used in each country estimate have been drawn from a set including lagged values (until period two) of CA and BD, current and lagged values (until period one) of world GDP growth rate and SDR interest rate, and a constant, a time trend and a squared time trend. The list of instruments used for each country is shown in Appendix A. Finally, t-statistics are reported in parentheses beneath the coefficient estimates. b GR2: Generalized R2 for IV regressions proposed by Pesaran and Smith (1994). c SE: Standard error of regression. d SM: Sargan’s general test of misspecification, asymptotically distributed, under the null hypothesis of a correct specification, as c2(s⫺h) where s is the number of instruments and h the number of regressors.

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Table 4 Long-run solutions. Estimates of Eq. (14): 1970–1997a Country

b0

United States Japan Germany France Italy

b1 1.597 (1.234) 2.293 (8.524) 8.741 (2.155) 0.225 (1.480) 6.407 (1.274)

United Kingdom Canada Total G7 Australia

1.911 (2.649) 0.761 (0.474)

Austria Denmark ⫺3.609 (8.062)

Finland Greece Ireland Netherlands Norway

4.111 (1.957) 3.099 (2.786) ⫺2.210 (0.356)

Spain ⫺0.442 (0.863)

Sweden Total SMC

a

b0⬅

0.253 (1.537) 0.109 (20.083) 0.675 (1.862) 0.049 (1.741) 0.152 (1.511) 0.078 (1.849) 0.117 (2.426) 0.159 (2.444) 0.538 (2.647) 0.043 (0.754) 0.202 (2.098) 0.110 (6.354) 0.102 (2.905) 0.240 (4.265) 0.035 (0.539) 0.086 (0.210) 0.083 (2.596) 0.136 (2.674) 0.063 (2.985)

a0 a2 ,b⬅ . t-Statistics are reported in parentheses. 1−a1 1 1−a1

making it possible to analyze the effects of anticipated future budget deficits in the empirical analysis. From the empirical investigation, we obtained evidence that strongly supports the view that current account deficits have been associated with large budget deficits during the 1970–1997 period in most industrial countries.

G. Piersanti / Journal of International Money and Finance 19 (2000) 255–271

269

It would appear therefore that the “twin deficits” relation clearly emerges from the data when future expectations of budget deficits are taken into account.

Acknowledgements This work was supported by CNR cto no. 91.04023.CT10. The author wishes to tank F. Bagliano, M. Gallegati, R. Marchetti, A. Merlini, B. Quintieri, M. Tivegna, S. Vinci and an anonymous referee for helpful comments on earlier drafts. Special thanks are due to G. Marini for his comments. Obviously, all the remaining errors are the author’s own.

Appendix A. List of instruments used in GMM estimates for each country Country United States Japan Germany France Italy United Kingdom Canada Total G7 Australia Austria Denmark Finland Greece Ireland Netherlands Norway Spain Sweden Total SMC

Instruments a0,CA(⫺1), CA(⫺2), T, T 2 a0, CA(⫺1), BD(⫺1), BD(⫺2), GW, RW, RW(⫺1), T, T 2 a0, CA(⫺1), GW, RW, RW(⫺1), T,T 2 a0, CA(⫺1), BD(⫺1), GW, RW, RW(⫺1), T a0, GW, GW(⫺1), RW, T a0, CA(⫺1), BD(⫺1), BD(⫺2), T, T 2 a0, CA(⫺1), BD(⫺1), T, T 2 a0, CA(⫺1), BD(⫺1), T, T 2 a0, CA(⫺1), GW, RW, T, T 2 a0, CA(⫺1), BD(⫺1), GW, RW, a0, CA(⫺1), BD(⫺1), GW, RW, T, T 2 a0, CA(⫺1), BD(⫺1), GW, RW, T, T 2 a0, CA(⫺1), GW, RW a0, CA(⫺1), BD(⫺1), GW, RW a0, CA(⫺1), GW, T, T 2 a0, CA(⫺1), GW, RW, T a0, CA(⫺1), GW, RW, T, T 2 a0, CA(⫺1), GW, T, T 2 a0, CA(⫺1), GW, RW

Legend a0: constant term. CA: current account balance for the relative country as a percentage of GDP. BD: general government financial balance for the relative country as a percentage of GDP GW: growth rate of GDP in the world. RW: SDR interest rate.

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T: time trend. The years 1996–1997 are OECD estimates. Source: OECD Economic Outlook and IMF International Financial Statistics.

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