Twin deficit theory

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The twin deficits theory is the contention that there is a strong link between a current account deficit and a government budget deficit, in the sense that a large budget deficit leads to a large current account deficit. It is taught in macroeconomics courses at every University and is easily provable using only basic economic equations. The proof goes as follows:

Y = C + I + G + NX

where Y represents National Income or GDP, C is consumption, I is investment, G is government spending and NX stands for net exports. This represents GDP because all the production in an economy (the left hand side of the equation) is used by consumers, C, investors, I, and the government, G, and the leftover production is exported, NX. Another equation defining GDP using alternative terms (which result in the same value) is

Y = C + S + T

where Y is again GDP, S is savings, and T is taxes. Since,

Y = C + I + G + NX, and Y = C + S + T, then C + I + G + NX = C + S + T, which simplifies to G − T = (S − I) − NX, or G − T = (S − I) − (X − M)

G-T is the budget deficit (government expenditures less government tax collections). The difference can be made up in only two ways. The government can borrow savings that would otherwise be invested, thus increasing S-I. This is known as the "crowding-out effect" because it reduces the funds available for investment and causes interest rates to rise. The government borrowing is "crowding-out" private investment, and since investment is the key to economic growth, this is a very bad thing. The other way to maintain the equation in the face of a budget deficit is by reducing net exports, causing a trade deficit. Hence, the twin deficits.

Though the economics behind which of the two is used to finance the government is much more complicated than what is shown above, the essence of it is that if foreigners savings pay for the budget deficit, the trade deficit grows. If the countries own citizens' savings finance the borrowing, it causes a crowding out effect. In the US, the budget deficit is financed about half from foreigners, half domestically. Therefore, with a $400 billion deficit, the trade deficit would, according to the theory, be increased by some $200 billion.