One of the concerns about government running an increasing f

One of the concerns about government running an increasing fiscal deficit (e.g., by increasing spending) is that it exposes the economy to a rising current account deficit – the “twin deficit” story. Explain.

Solution

ANSWER:

There exists a direct and strong relationship between the national economy’s current account balance and its government budget balance and can become twinned – which means move together dollar-for-dollar. This is stated as twin deficit hypothesis.

The hypothesis is based on national accounting relationships that can be utilised to depict that a current account deficit measures the difference among total domestic (public and private) saving and investment. It considers the total investment to be the sum of private and public capital formation; and “national” saving to be the sum of private saving and budget surpluses. Thus when the budget moves into deficit, it consider national saving have reduced and/or national investment to have risen, depending on whether the increase in the deficit is driven by investment spending or public consumption. Assuming other things equal, a rise in the budget deficit will result in an increase in the current account deficit.

Additionally when the country has an increasing budget deficit, it is to be increasingly dependent on the foreign purchases of its debt for supplementing the domestic savers’ purchases of government debt. Thus, with both an increasing budget deficit and increasing current account deficit depicts an increased reliance on foreign debt purchases, which as per the viewpoint it renders the domestic economy vulnerable to sudden and unexpected changes in economic fortunes.

Thus twin deficits hypothesis relies on a direct link between current account deficits and budget deficits, which is considered to result to undesirable consequences.