Understanding the Twin Deficits

“Twin deficits” (occasionally also called the double deficits) is a shorthand summary for two related economic problems, the government budget deficit and the current account (or international trade) deficit. The government budget deficit is the difference between government revenue (mostly taxes) and government spending; the current account deficit is the difference between exports and imports (there are some adjustments for items such as funds sent abroad). Both deficits occur when someone is spending more than they earn; during the last 25 years the US government has tended to spend more than it collects in taxes and US residents have tended to spend more on imports than they export.

If an individual spends more than he earns he must either borrow money or sell off some assets. Advice columns are filled with stories of people who regularly spend more than they owe and finance the difference with multiple credit card loans that they will never be able to pay off; eventually they face bankruptcy and a reduced standard of living. Presumably a country that follows the same path will experience the same problems.

But it is well understood that individuals tend to have life-cycle consumption patterns: young people spend more than they earn (incurring student loans and mortgage debt), those in middle age tend to be net savers (investing in 401(k)s and building up portfolios and paying off their mortgage); and retirees return to net spending after they stop working.

So it is not necessary to exactly match income and spending in each period. But there are some limits to how much you can borrow if you are going to have a realistic chance of escaping financial ruin. If your lender sees that you are spending more than you will ever be able to pay then it is likely he will start charging you a higher price to reflect the increased risk associated with your debt. The same should be true for a country.

THE US TWIN DEFICIT EXPERIENCE

Starting in the 1980s (during the Reagan Administration) the US had both large budget and trade deficits. The budget deficit (see here for data) had been around around $50 to $75 billion in the late 1970s and grew to over $200 billion in 1983. The current account deficit (see the last line of the table here; you can select annual data for any recent period) was around zero through the early 1980s but exceeded $100 billion in 1985.

Some economists believed that the large budget deficits and large current account deficits of the early 1980s would result in higher interest rates. See here for a February 1986 expression of this view by Walter Heller, who argued that the deficits could “send interest rates shooting up”; yet yields on 3 month Treasury Bills fell from 7.29% in February 1986 to 5.75% in February 1987 and yields on 30 year Treasury Bonds fell from 8.93% in February 1986 to 7.54% in February 1987 while the budget deficit remained around the same size and the trade deficit increased a bit).

The relationship between the twin deficits and interest rates is complex. Instead of directly addressing it, I will try to provide some tools to examine the question of whether the deficits are “too large”.

THE GOVERNMENT BUDGET DEFICIT

It is a fact of life that in recent years virtually every national government spends more than it takes in, resulting in a deficit. These deficits are financed by the issuance of government bonds; the sum total of all past deficits is the current debt. It is important to carefully distinguish between the deficit, the gap between government revenue and spending in any given year, and the debt, or the outstanding obligations of the government.

Making the situation more complicated is that the government makes promises for future spending (for example, social security and Medicare) that do not directly enter into the calculation of government debt. And if that were not enough, the government often borrows money on behalf of others, incurring debt without increasing the deficit by an equal amount. So the data are, to use a precise economic term, messy. See here for a recent speech by a Federal Reserve Bank President who believes that the future obligations are much larger than the measured debt.

To determine whether the US budget deficit is a problem we must know (1) how much does the US government owe, (2) how much is this debt likely to increase in future years, and (3) how much is the government likely able to pay. A way to restate this question to ask whether the US debt to GDP ratio is likely to be stable or growing indefinitely.

As of 2007 the US had a debt to GDP ratio of around 61% (see here for a table of estimates of the debt to GDP ratios of 126 countries), about the same as France (64%) and Germany (63%), much smaller than Italy (104%) and Japan (195%), but larger than the UK (43%) and Spain (35%).

But the level is not the problem, it is the growth rate. For the growth rate to be stable, the size of the deficit must be less than or equal to the growth of the economy. The deficit to GDP ratio is expected to be around 2.7 to 3.2% in 2008 and 2009 (see recent projections in a pdf here at page 1), decreasing to around 1% in 2010 and 2011. The deficit projections are dependent on political and economic conditions and are far from certain (earlier this year, before the troubles in the real estate and financial markets, the CBO estimated that the budget deficit would be 1.4% in 2009 (see this pdf, until the new report is published). As long as the budget deficit is around the same magnitude as GDP growth, the debt to GDP ratio should not increase.

One big problem will occur when baby boomers (people born between 1945 and 1965) start to retire en masse around 2018. There a number of programs that pay for benefits for retirees such as Social Security and Medicare that, if the current levels of benefits are maintained (and tax revenues do not increase sharply), will cause the budget deficit to reach 10% of GDP by 2030, when debt to GDP would be over 100% (see here for several scenarios).

So, for the budget deficit, the short answer is things are fine for the next few years, but things could go very badly in twenty or thirty years. One way to look at this problem is to look at the government bond yield and to note that the interest rate on 30 year bonds is only a bit higher than the interest rate on 10 year bonds, meaning that bond investors do not seem that worried about the events of the late 2030s. Markets seem to expect the government to “do something” about the problem, possibly some combination of benefit cuts and tax increases.

THE US CURRENT ACCOUNT DEFICIT

The current account deficit measures the difference between the exports of US goods and services and US imports of foreign goods and services (the trade deficit measures only goods, which are increasingly less important in recent years). If the US has a deficit, this means that we are buying things from the rest of the world, and must pay for them in some way. The ratio of the current account deficit to GDP has been as high as 6% in recent years; in 2007:III the current account deficit was around $178 billion, implying a deficit to GDP ratio of around 5.1%.

The high current account deficits in recent years have led to an increase in US international indebtedness, although this is a controversial topic (briefly, foreigners who invest in the US tend to look for safety and buy bonds, which have relatively low rates of return; Americans who invest abroad tend to look for riskier assets that have higher rates of return; it is extremely difficult to track the value of these investments over time; see the pdf article on “Dark Matter” or possible inconsistencies in the measurement of the US international indebtedness here).

In any event, measured US international indebtedness to GDP (see here for some estimates) is probably around 25% and increasing. A crude estimate reveals that if the US current account deficit decreases to around 3%, then indebtedness to GDP will converge to around 50%. If the deficit to GDP ratio remains around 5 or 6%, the indebtedness ratio could rise to 100% of GDP. Most analysts believe that such a ratio around 50% would be sustainable, but a ratio of 100% would have dire consequences. So if the US current account to GDP ratio remains at current levels (or gets larger) then the US will eventually face a crisis. The Dollar has lost considerable value in recent years against some currencies, helping exporters and modestly reducing imports. Credit markets seem willing to absorb US debt at reasonable prices, indicating that they believe that the situation will revert to a sustainable level.

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