Learning Objectives

• Discuss twin deficits as they related to budget and trade deficit
• Explain the relationship between budget deficits and exchange rates
• Explain the relationship between budget deficits and inflation
• Identify causes of recessions

Twin Deficits?

During the mid 1980s, it was common to hear economists and even newspaper articles refer to the twin deficits, as the budget deficit and trade deficit both grew substantially. Figure 17.8 shows the pattern. The federal budget deficit went from 2.6 percent of the GDP in 1981 to 5.1 percent of the GDP in 1985—a drop of 2.5 percent of the GDP. During that time, the trade deficit moved from 0.5 percent in 1981 to 2.9 percent in 1985—a drop of 2.4 percent of the GDP. During the mid 1980s, the considerable increase in government borrowing was matched by an inflow of foreign investment capital, so the government budget deficit and the trade deficit moved together.

Figure 17.8 U.S. Budget Deficits and Trade Deficits During the 1980s, the budget deficit and the trade deficit declined at the same time. However, since then, the deficits have stopped being twins. The trade deficit grew smaller during the early 1990s, as the budget deficit increased, and then the trade deficit grew larger during the late 1990s as the budget deficit turned into a surplus. During the first half of the 2000s, both budget and trade deficits increased. But, in 2009, the trade deficit declined as the budget deficit increased.

Of course, no one should expect the budget deficit and trade deficit to move in lockstep, because the other parts of the national saving and investment identity—investment and private savings—often change as well. During the late 1990s, for example, the government budget balance turned from deficit to surplus, but the trade deficit remained large and growing. During this time, the inflow of foreign financial investment was supporting a surge of physical capital investment by U.S. firms. During the first half of the 2000s, the budget and trade deficits again increased together, but in 2009, the budget deficit increased while the trade deficit declined. The budget deficit and the trade deficits are related to each other, but they are more like cousins than twins.

Budget Deficits and Exchange Rates

Exchange rates can also help to explain why budget deficits are linked to trade deficits. Figure 17.9 shows a situation using the exchange rate for the U.S. dollar, measured in euros. At original equilibrium (E₀), where the demand for U.S. dollars (D₀) intersects the supply of U.S. dollars (S₀) on the foreign exchange market, the exchange rate is 0.9 euros per U.S. dollar and the equilibrium quantity traded in the market is $100 billion per day, which was roughly the quantity of dollar–euro trading in exchange rate markets during the mid 2000s. Then, the U.S. budget deficit rises and foreign financial investment provides the source of funds for that budget deficit.

International financial investors, as a group, demand more U.S. dollars on foreign exchange markets to purchase U.S. government bonds, and they supply fewer of the U.S. dollars that they already hold in these markets. Demand for U.S. dollars on the foreign exchange market shifts from D₀ to D₁, and the supply of U.S. dollars falls from S₀ to S₁. At the new equilibrium (E₁), the exchange rate has appreciated to 1.05 euros per dollar whereas, in this example, the quantity of dollars traded remains the same.

Figure 17.9 Budget Deficits and Exchange Rates Imagine the U.S. government increases its borrowing and the funds come from European financial investors. To purchase U.S. government bonds, these European investors need to demand more U.S. dollars on foreign exchange markets, causing the demand for U.S. dollars to shift to the right from D₀ to D₁. European financial investors as a group are also less likely to supply U.S. dollars to the foreign exchange markets, causing the supply of U.S. dollars to shift from S₀ to S₁. The equilibrium exchange rate strengthens from 0.9 euro/dollar at E₀ to 1.05 euros/dollar at E₁.

A stronger exchange rate, of course, makes it more difficult for exporters to sell their goods abroad while making imports cheaper, so a trade deficit—or a reduced trade surplus—results. Thus, a budget deficit can easily result in an inflow of foreign financial capital, a stronger exchange rate, and a trade deficit.

You can also imagine this appreciation of the exchange rate as being driven by interest rates. As explained earlier in Budget Deficits and Interest Rates in Fiscal Policy, Investment, and Economic Growth, a budget deficit increases demand in markets for domestic financial capital, raising the domestic interest rate. A higher interest rate attracts an inflow of foreign financial capital, and appreciates the exchange rate in response to the increase in demand for U.S. dollars by foreign investors and a decrease in supply of U. S. dollars. Because of higher interest rates in the United States, Americans find U.S. bonds more attractive than foreign bonds. When Americans are buying fewer foreign bonds, they are supplying fewer U.S. dollars. The depreciation of the U.S. dollar leads to a larger trade deficit—or reduced surplus. The connections between inflows of foreign investment capital, interest rates, and exchange rates are all just different ways of drawing the same economic connections: A larger budget deficit can result in a larger trade deficit, although the connection should not be expected to be one-to-one.

From Budget Deficits to International Economic Crisis

The economic story of how an outflow of international financial capital can cause a deep recession is laid out, step by step, in the Exchange Rates and International Capital Flows chapter. When international financial investors decide to withdraw their funds from a country such as Turkey, they increase the supply of the Turkish lira and reduce the demand for lira, depreciating the lira exchange rate. When firms and the government in a country such as Turkey borrow money in international financial markets, they typically do so in stages. First, banks in Turkey borrow in a widely used currency such as U.S. dollars or euros, then convert those U.S. dollars to lira, and then lend the money to borrowers in Turkey. If the value of the lira exchange rate depreciates, then Turkey’s banks find it impossible to repay the international loans that are in U.S. dollars or euros.

The combination of less foreign investment capital and banks that are bankrupt can reduce aggregate demand sharply, which causes a deep recession. Many countries around the world have experienced this kind of recession in recent years. Along with Turkey in 2002, this general pattern was followed by Mexico in 1995, Thailand and countries across East Asia from 1997 to 1998, Russia in 1998, and Argentina in 2002. In many of these countries, large government budget deficits played a role in setting the stage for the financial crisis. A moderate increase in a budget deficit that leads to a moderate increase in a trade deficit and a moderate appreciation of the exchange rate is not necessarily a cause for concern. But, beyond some point that is hard to define in advance, a series of large budget deficits can become a cause for concern among international investors.

One reason for concern is that extremely large budget deficits mean that aggregate demand may shift so far to the right that it causes high inflation. The example of Turkey is a situation in which very large budget deficits brought inflation rates well into double digits. In addition, very large budget deficits, at some point, begin to raise a fear that the borrowing will not be repaid. During the past 175 years, the government of Turkey has been unable to pay its debts and has defaulted on its loans six times. Brazil’s government has been unable to pay its debts and has defaulted on its loans seven times; Venezuela, nine times; and Argentina, five times. The risk of high inflation or a default on repaying international loans worries international investors, because both factors imply that the rate of return on their investments in that country may end up lower than expected. If international investors start withdrawing the funds from a country rapidly, a scenario of less investment, a depreciated exchange rate, widespread bank failure, and deep recession can occur. The following Clear It Up feature explains other impacts of large deficits.

Using Fiscal Policy to Address Trade Imbalances

If a nation is experiencing the inflow of foreign investment capital associated with a trade deficit because foreign investors are making long-term direct investments in firms, there may be no substantial reason for concern. After all, many low-income nations around the world welcome direct investment by multinational firms that ties them more closely into the global networks of production and distribution of goods and services. In this case, the inflows of foreign investment capital and the trade deficit are attracted by the opportunities for a good rate of return on private-sector investment in an economy.

However, governments should beware of a sustained pattern of high budget deficits and high trade deficits. The danger arises in particular when the inflow of foreign investment capital is not funding long-term physical capital investment by firms, but instead is short-term portfolio investment in government bonds. When inflows of foreign financial investment reach high levels, foreign financial investors will be on the alert for any reason to fear that the country’s exchange rate may decline or the government may be unable to repay what it has borrowed on time. Just as a few falling rocks can trigger an avalanche, a relatively small piece of bad news about an economy can trigger an enormous outflow of short-term financial capital.

Reducing a nation’s budget deficit will not always be a successful method of reducing its trade deficit, because other elements of the national saving and investment identity, like private saving or investment, may change instead. In those cases when the budget deficit is the main cause of the trade deficit, governments should take steps to reduce their budget deficits, lest they make their economy vulnerable to a rapid outflow of international financial capital that could bring a deep recession.