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Causality Relationships between the Twin Deficits
in the Regional Economy
Jui-Chuan Chang* and Zao-Zhou Hsu +
Department of Economics
National Chi Nan University
ABSTRACT
Utilizing the simpler Granger non-causality procedure developed by Toda and
Yamamoto (1995), this paper attempts to investigate the causality relationship
between the budget deficit and the current account deficit for five North European
countries, Four Asian Tigers and the United States. In order to circumvent the
distortion of the causality inferences which could be due to omission of relevant
variables, this study conducts the modified Wald test procedure in a multi-variate
framework, apart from previous researches in a bi-variate model. The empirical
results not only provide some alternative views of theoretical prediction, but also
show the structural imbalances of the economies studied.
Keywords: Twin deficits; causality test
JEL classification: F41, C22
*
Corresponding Author: Assistant Professor, Department of Economics, National Chi Nan University,
1 University Rd., Pu-li, Nantou 54561, Taiwan; E-mail: [email protected]; Phone: 886-492910960 ext. 4632; Fax: 886-49-2914435.
+
Graduate, Department of Economics, National Chi Nan University; E-mail: [email protected].
1
Introduction
During the early 1980s, the term ‘twin deficits’ was initially invented to describe the
co-movement between the budget deficit and the current account deficit in the United
States (Abell, 1990; Gordon, 1986; Laney, 1984; McKinnon, 1980, 1990; Miller and
Russek, 1989).1 Since the switch of the century in the United States the recurrence of
huge fiscal and trade deficits have revived public interests in the edge relations
between the twin deficits (Bordo, 2006; Coughlin et al., 2006; Mann, 2002; Obstfeld
and Rogoff, 2004, 2005; Sinai, 2006; Salvatore, 2006). As shown in the literature,
however, the causal directions between budget and current deficits are not exclusive
to the United States yet.
In the 1990s, European countries, such as Sweden and Germany, also faced
similar situations where the rise in budget deficits was accompanied by the real
appreciation of their national currencies that adversely affected the current accounts
(Ibrahim and Kumah, 1996). Due to the differences in the structure of the economy,
furthermore, developing economies are more likely to experience the same expansion
of budget and current account deficits (Laney, 1984; Khalid and Kuan, 1999; Anoruo
and Ramchander, 1998; Edwards, 2001; Megarbane, 2002; Kouassi et al., 2004). As
such the macroeconomic dynamics governing the two deficits may be different from
the developed economy.
Thus, this paper mainly attempts to investigate the causality relationship between
the twin deficits using the expanded data from five North European countries, Four
Asian Tigers and the United States. This paper plans to extend the existing literature
on causality between the twin deficits in three significant aspects. First of all, this
paper explicitly takes into account the lately causality testing procedure proposed by
1
The so-called ‘twin deficits hypothesis’ that emerged in the 1980s is characterized by an unusual
shift in current account and budget deficits. Another feature is the strong appreciation of the dollar.
1
Toda and Yamamoto (1995). This method has no regards that the VARs may be
stationary integrated of any order, or cointegrated of any order; consequently, one can
test linear or nonlinear restrictions on the coefficients by estimating a VAR in levels
and applying the modified Wald statistics. Besides, this approach is much attractive
not just because it is computationally simpler than the traditional F-test for Granger
causality, but also because the finite sample performance of this Monte Carlo based
testing procedure has proven to be superior to that of Toda and Phillips (1993, 1994).
Second, this study employs a multi-variate rather than a bi-variate framework, in
order to keep away from the distortion of the causality inferences which could be due
to omission of relevant variables. For example, the role of the dollar in causing the
trade deficit is a key part of the widely accepted doctrine that links trade deficit to
budget deficit in the United States. To our best knowledge, since Abell (1990)
discusses the importance of the mediating variables in the twin deficits nexus, there
are few studies conducting in the multi-variate frameworks, except Anoruo and
Ramchander (1998) and Kim and Kim (2006).
Third, this research provides broader evidence on such a debating relationship
using the longer time spanned data from five North European countries, Four Asian
Tigers and the United States, respectively. This will enhance the robustness of our
empirical findings by potentially revealing both specific and general information on
the vastly structural imbalances of the economies studied. Once the causality
relationships could be confirmed, policymaker might effectively make the twin
deficits under control and keep economic growth sustainable.
The structure of this paper is organized as follows. Section 2 reviews four
possible causality relationships between the twin deficits in the extant literature.
Section 3 discusses the empirical method of Toda and Yamamoto (1995). Section 4
gives the data description and presents the empirical results. Last section draws the
2
conclusions.
2 Literature Review
There might be four possible causation linkages between budget deficit (BD) and
current account deficit (CAD), including BD → CAD, BD ↔
/ CAD, CAD → BD and
BD ↔ CAD. A first theoretical explanation of the relation between BD and CAD is
the Mundell-Fleming framework. The Mundell-Fleming approach argues that an
increase in BD induces an upward pressure on interest rates that, in turn, will trigger
capital inflows and an appreciation of exchange rates, ultimately leading to an
increase in CAD. A second theoretical explanation of the linkage between the twin
deficits is the Keynesian absorption theory, which suggests that an increase in BD
would induce domestic absorption and hence import expansion, causing an increase or
a worsening of the CAD. Both the Mundell-Fleming model and Keynesian absorption
theory support the uni-directional relationship of BD causing CAD (BD → CAD).
Another explanation of the relation between BD and CAD is based on the
presumption that the twin deficits are not related. Adherents of the Ricardian
equivalence hypothesis dispense entirely with the income-expenditure approach and
rely instead on the inter-temporal approach. Since a government’s means of finance
do not alter private agents’ inter-temporal budget constraints, the real interest rate, the
quantity of investment, or the current account balance. They claim that budget deficits
do not cause any interest and exchange rate changes (Garcia and Ramajo, 2004),
which thus have no effect on current account imbalances. Hence, under the Ricardian
equivalence hypothesis, budget and current account deficits are causally independent;
that is, BD ↔
/ CAD.
Third, a uni-directional causality that may run from current account to budget
3
deficits may also exist. This outcome occurs when the deterioration in current account
leads to a slower pace of growth and hence an increase in the budget deficit. A
country experiencing a financial or solvency crisis resulting from chronic, excessive
current account deficits may face a situation in which large injections of public funds
are required to rehabilitate troubled financial sectors, to improve the corporate
governance system, and to attenuate a recession. In Korea, for example, fiscal deficits
were allowed to increase considerably for the purposes of supporting economic
activity and strengthening the social safety net after the financial crisis of 1997. The
causal relationship in this instance proceeds from the current account deficit to the
budget deficit (CAD → BD).
This reverse causation is termed ‘current account targeting’ by Summers (1988).
He argued that external adjustment may be sought via fiscal policy. This causal
pattern may be more relevant for developing countries that have accumulated large
foreign debts. Recently, Alkswani and Al-Towaijari (1999) provide empirical
evidence on reverse causation between the two deficits for Saudi Arabia. While
Anoruo and Ramchander (1998) discover that trade deficit causes fiscal deficit in
some Asian countries. They argue that governments in developing countries might
engage in fiscal stimulus to lessen the deleterious economic and financial
consequences of large trade imbalances. The economic slowdowns brought about by
huge current account deficits not only increase government spending but also reduce
tax revenues.
Besides, bi-directional causality might exist between budget and current account
deficits; that is, BD ↔ CAD. While budget deficits may cause current account deficits,
the existence of significant feedback may cause causality between the two variables to
run in both directions. The Latin American currency crisis in the 1980s may have
reflected just such a vicious circle. Feldstein and Horioka (1980) also find that savings
4
and investments are highly correlated, causing BD and CAD to move together. Hence,
the validity of the twin deficits hypothesis could be linked to the degree of
international capital mobility.
According to the above-mentioned literature, each of possible causal linkages
between budget deficit and current account deficit corresponds to one of theoretical
predictions. To be clarified, Figure 1 demonstrates that the four possible causality
relationships between the twin deficits are associated with their corresponding theory.
3 Empirical Method
Many economists have applied the Granger causality to test causal relationships
among variables since 1969, but the procedure of Granger causality analysis is very
sensitive to model specifications, such as the chosen lag length and stationary
properties. If a VAR system is cointegrated, the Granger causality test may be
conducted in the environment of vector error correction model (VECM); otherwise,
the analyses may be conducted as a standard first-difference VAR model.
In other words, when the variables are cointegrated, the corresponding error
correction representations must be included in the system (Granger, 1988). By doing
so, one can avoid misspecification and omission of the important constraints;
meanwhile, the traditional F-test for Granger non-causality is not valid as well. That is
because the test statistic does not follow its own distribution when the variables are
integrated or cointegrated. On the other hand, if the variables are not integrated of the
same order or are not cointegrated, the VECM cannot be applied either. In addition,
possibly severe pre-test biases in ECM may exist, especially for finite samples.
In this sense that the workhorses of testing the non-causality in the very of
VECM are cumbersome and sensitive to the values of nuisance parameters in finite
5
samples; therefore, the virtues of simplicity and ease of application have been largely
lost (Rambaldi and Doran, 1996, p. 3). Besides, the formulation does have its
drawbacks in that it is implicitly dependent upon a pre-test of integration and
cointegration (Lütkepohl and Reimers, 1992).
One way to circumvent this problem is to posit a VAR in which variables appear
purely in their level form. Toda and Yamamoto (1995) have proposed the modified
wald (MWALD) for testing Granger non-causality that allows causal inference to be
conducted in the level VARs that may contain integrated of an arbitrary order and/or
(non-) cointegrated of an arbitrary order processes. That is, this procedure imposes
(non-) linear restrictions on the parameters of VAR models without having to pre-test
for unit roots and cointegrating ranks. Thus, if one is primarily interested in testing
zero-restrictions on the coefficients, rather than in testing for the presence of unit
roots or for cointegrating relations, the MWALD test is appropriate. Of particular
notice that the MWALD test requires that the true lag length exceed the order of
integration.
Moreover, this procedure is much attractive not just because the MWALD test is
computationally simpler than the traditional F-test for Granger non-causality. But also
because the MWALD test has the finite sample performance of this Monte Carlo
based testing procedure in size and power. Zapata and Rambaldi (1997) verify that the
MWALD test is superior to both the LR test of Mosconi and Giannini (1992) and the
WALD of Toda and Phillips (1993, 1994) in samples of 50 or more observations.
In what follows, we thus rely on the Toda-Yamamoto (1995) MWALD tests to
make the causal inference among the variables in the VAR system. The whole
procedure may be summarized as follows: First of all, we establish the maximum
order of integration (dmax) and the optimal lag length (k) of the VAR model. Second,
we estimate the (k + dmax)th-order VAR model in levels. Because Rambaldi and
6
Doran (1996) show that the seemingly unrelated regression could easily compute the
MWALD test, we estimate the specified VAR system by the least squares and
seemingly unrelated regression methods, respectively. Once the congruency of the
VAR duly examined through the standard diagnostics tests, the non-causality test is
formulated as a zero restriction on the first k coefficient matrices, ignoring the last
dmax lagged vectors in the model. The MWALD test statistic asymptotically follows a
chi-square distribution having the usual degrees of freedom.
4 Data and Estimation Results
4.1
Data Description
A plenty of empirical studies have investigated the causal relationship between the
budget and current account balances for annual data set of developed and developing
countries. Moreover, most of these studies employ the Granger causality test in
bi-variate VAR models. According to the above-mentioned literature, however, both
the interest rate and the exchange rate play important roles in a channel through which
the budget deficit affects the current account deficit (Abell, 1990; Ibrahim and Kumah,
1996). Owing to the omission of relevant explanatory variables, these results from
bi-variate frameworks may have been biased. In order to keep away from such
possible distortion of the causality inferences, this paper examines the possible causal
relationships by utilizing a multi-variate setup, which contains budget deficit (BD),
current account deficit (CAD), the interest rate (IR) and the exchange rate (EXC).
This paper adopts both annual and quarterly macroeconomic data for five North
European countries, Four Asian Tigers and the United States. These ten countries are
Denmark, Finland, Iceland, Norway, Sweden, Hong Kong, Korea, Singapore, Taiwan,
and the United States. The regional countries included in our sample are primarily
7
selected on the basis of data availability and historical background, while the United
States is embedded for comparison purpose. To be specific, Table 1 summarizes the
related literature on the twin deficits for the ten countries. It is clear for us to see that
there are very few papers regarding the North European countries and the bi-variate
framework is most utilized. Also, this study is not the first one to conduct the
Toda-Yamamoto (1995) MWALD test, but is the first one to apply this procedure to a
four-variable setup.
With the exception of Taiwan and Hong Kong, all of the annul data are drawn
from the World Economic Outlook databases (WEO) of IMF, while the quarterly data
are collected from the International Financial Statistics (IFS) of IMF. For Taiwan data,
they are obtained from the AREMOS databases, and for Hong Kong, they are from
the Census and Statistics Department of Hong Kong and the INTLINE International
Macroeconomic Statistical Databank. Due to the data availability, the annual data
cover the period from 1980 to 2007, while the quarterly data are not symmetric for all
countries. The budget and current account variables are scaled by GDP, the exchange
rate is measured by the nominal effective exchange rate, and the interest rate is a
proxy of policy measure via the discount rate. For details, we exhibit a listing of the
ten countries as well as the corresponding sample periods in Table 2.
In order to apply the MWALD test for Granger non-causality, it is necessary to
determine the maximum order of integration of each of the series being studied. To do
this, the standard unit root tests are used: the Augmented Dickey-Fuller (ADF),
Phillips and Perron (PP), and Kwiatkowsi et al. (KPSS) tests. The test results of unit
roots for all series of each country indicate that the maximum order of integration is
one, I(1); that is, dmax = 1. In selecting the optimal lag length for a VAR system, both
the Akaike information criterion (AIC) and the Schwarz Bayesian criterion (SBC) are
first used. Since these criteria yield different lag lengths, Sim’s modified
8
log-likelihood ratio (LR) test is then employed and diagnostic tests examined. To
identify the direction of any causality between BD and CAD, the four-equation VAR
model is estimated using the least squares and seemingly unrelated regression
methods, respectively.2 After that, the MWALD test is then applied to examine
whether the coefficients of the optimally lagged variables are jointly equal to zero. In
particular, the diagnostic tests shall suggest that the VAR model, on which the
MWALD test is based, is quite well-specified.
4.2
Estimation Results
The results of the MWALD test for each country are illustrated in Figure 2. The
graphs are arranged by the regional economy. Since the adoption of the quarterly data
is much apart from the previous researches, this section will focus on analyzing the
results from the quarterly data. The arrow
,
and
denotes that the null
hypothesis of the non-causality is rejected at the 10%, 5% and 1% significance levels,
respectively. The order of the estimated VAR system is determined by the sum of the
optimal lag length (k) and maximum of integration (dmax), which are shown in the
‘orders’ column. The specified VAR model is estimated using the least squares (LS)
and seemingly unrelated regression (SUR) methods, separately. Some countries have
a few observations so that their results from the SUR method show ‘near singular
matrix’. Moreover, comparing the available outcomes from the LS to those from the
SUR, this demonstrates both are very similar in terms of the significantly direct causal
link between BD and CAD except Sweden.
Let’s look at the results from five North European countries first. Among these
2
For comparison, we also estimate the bi-variate VAR system using the least squares and SUR
methods, respectively. Except that Hong Kong has the bi-directional causality relationships between
BD and CAD, others confirm the twin deficit hypothesis which the uni-directional causality of BD
leading to CAD although this is against the study for Sweden which posits the Ricardian equivalence
hypothesis.
9
five North European countries, there are three out of five countries (Finland, Iceland
and Sweden) consistent with the twin deficits hypothesis which indicates
uni-directional causality from BD to CAD. The outcomes are in conformity with that
of Afonso and Rault (2009) for Finland but against that of Kouassi et al. (2004) for
Sweden.3 To be specific, the exchange rate mediates the relationship between the
twin deficits for Finland while the interest rate does so for Iceland. The results for
Denmark show that the uni-direction of causality runs reversely from CAD to BD and
is mediated either by the exchange rate or by both exchange and interest rates. On the
other hand, the consequences for Norway indicate a predominantly bi-directional
causality even at the 1% significance level.
Among Four Asian Tigers, the results for both Korea and Taiwan are consistent
with the causal link of twin deficits hypothesis, implying that BD leads to CAD. This
confirms the bi-variate outcomes of Lau and Baharumshah (2006) for Korea as well
as that of Chang (2004) for Taiwan. Of particular interest, the indirect causal link for
Taiwan is completely reversed to run from CAD to BD through the exchange rate and
interest rate when the four-equation VAR system is estimated by the SUR method. In
a multi-variate framework, the strongly bi-directional results for Singapore are
contrary to that of Lau and Baharumshah (2006). A two-way causality is detected
between the twin deficits, giving credence to both twin deficits and current account
targeting propositions in which budget cuts improve current account and this further
leads to a further reduction in budget deficit. Following the Feldstein and Horioka
(1980), we may further check whether or not the investment and saving are highly
correlated in Singapore. Lastly, using the quarterly data after 1997, the causal link for
Hong Kong runs from CAD to BD.
3
In a bi-variate framework, Kouassi et al. (2004) declare that the twin deficits are independent for
Sweden, which is consistent with the Ricardian equivalence hypothesis.
10
Recent declines in the United States fiscal and current account balances have
sparked renewed debate over the twin-deficit hypothesis, which argues that a larger
fiscal deficit, through its effect on national saving, leads to an expanded current
account deficit. The empirical results for the United States in this paper are parallel to
the literature; however, the indirect causal link is possibly mediated by the interest
rate, not by the exchange rate.
5 Concluding Remarks
Utilizing the simpler Granger non-causality procedure proposed by Toda and
Yamamoto (1995), this paper provides broader evidence on a debating causal linkage
between the budget and current account deficits for five North European countries,
Four Asian Tigers, and the United States. Througout the empirical investigation, this
study finds some support for the twin defiicts hypothesis although the strength of the
relationship varies across countries. Yet, none of the economies studied in this paper
is supportive of the validity of th eRicardian equivalence hypothesis.
From the policy perspectives, this analysis will enhance the robustness of our
empirical findings by potentially revealing both specific and general information on
the vastly structural imbalances of the economies studied. Especially, adding the
realistic likely costs of the financial tsunami to the previous national debt puts the
national debt to Gross Domestic Product (GDP) ratio at over 100% in both the United
States and most of North European countries. Lately government bailouts as well as a
fall in the tax revenues due to a decline in business in export sector, tends to support
the causality from current account to budget deficits. Thus, since the causality
relationships could be confirmed, policymaker might effectively make the twin
deficits under control and keep economic growth sustainable.
11
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14
Table 1
Summary of Related Literature
Five North European Countries
Number of Variables
Methodology
Causality
Finland
Number of Variables
Methodology
Causality
Afonso
3: BD, CAD, EXC
Bootstrap panel Granger-causality
BD → CAD
Number of Variables
Methodology
Causality
Number of Variables
Methodology
Causality
Sweden
Number of Variables
Methodology
Causality
Kouassi
2: BD, CAD
Toda-Yamamoto test (1995)
BD ↔
/ CAD
Denmark
None
Rault (2009)
Iceland
None
Norway
None
Mougoue
Kymn (2004)
Four Asian Tigers
Number of Variables
Methodology
Causality
Korea
Number of Variables
Methodology
Causality
Anoruo
2: BD, CAD
Granger causality test
CAD → BD
2: BD, CAD
Toda-Yamamoto test (1995)
BD → CAD
3: BD, CAD, EXC
Toda-Yamamoto test (1995)
CAD → BD
Kalyoncu (2007)
2: BD, CAD
Granger causality tests
BD ↔ CAD
Singapore
Number of Variables
Methodology
Causality
Lau
2: BD, CAD
Toda-Yamamoto test (1995)
BD → CAD
Kalyoncu (2007)
2: BD, CAD
Granger causality tests
BD ↔
/ CAD
Taiwan
Number of Variables
Methodology
Causality
Chang (2004)
2: BD, CAD
Granger causality tests
BD → CAD
Hong Kong
None
Ramchander (1998)
Lau
Baharumshah (2006)
Kim
Kim (2006)
Baharumshah (2006)
15
United States
Number of Variables
Methodology
Causality
Abell (1990)
4: BD, CAD, IR, EXC
VAR model
BD → CAD
Zietz
2: BD, CAD
Small simultaneous-equation model
BD → CAD
3: BD, CAD, EXC
Five-variable VAR model
BD → CAD
2: BD, CAD
Unconstrained VAR model
BD ↔
/ CAD
2: BD, CAD
Granger causality tests
BD → CAD
2: BD, CAD
Error correction models
BD → CAD
Hatemi-J
2: BD, CAD (1975-1989)
Granger causality tests
BD → CAD
Shukur (2002)
2: BD, CAD (1990-1998)
Kouassi
2: BD, CAD
Toda-Yamamoto test (1995)
BD ↔
/ CAD
2: BD, CAD
Multiple regression model
BD → CAD
Pemberton (1990)
Rosenswieg
Tallman (1993)
Enders
Lee (1990)
Kasibhatla
Johnson
Malindretos (2001)
Leachman
Francis (2002)
CAD → BD
Mougoue
Kymn (2004)
Salvatore (2006)
16
Table 2
List of Countries Studied
Country
Frequency
Sample Period
Specific Variable
Five North European countries
Denmark
Finland
Iceland
Norway
Sweden
Annual
1980-2007 (28)
Quarterly
1998Q1-2007Q4 (36)
Annual
1980-2007 (28)
IR: Average cost of CB debt
Quarterly
1978Q1-2007Q4 (120)
IR: Average cost of CB debt
Annual
1980-2007 (28)
IR: General loans, bonds
Quarterly
19798Q1-2007Q4 (40)
Annual
1980-2007 (28)
Quarterly
1996Q1-2007Q4 (48)
BD: Net operating balance / gdp
Annual
1980-2007 (28)
IR: Bank rate (end of period)
Quarterly
1994Q1-2006Q4 (52)
IR: Bank rate (end of period)
1980-2007 (28)
IR: Savings deposit rate
1999Q1-2008Q1 (37)
IR: Discount rate
Four Asian Tigers
Hong Kong Annual
Quarterly
EXC: Market rate, period average
Korea
Singapore
Taiwan
Annual
1980-2007 (28)
EXC: Market rate, period average
Quarterly
1976Q1-2000Q3 (99)
EXC: Market rate, period average
Annual
1980-2007 (28)
IR: Saving rate
Quarterly
2003Q1-2006Q3 (15)
IR: Saving rate
Annual
1980-2007 (28)
IR: Rediscount rate
EXC: Market rate, period average
Quarterly
1984Q3-2008Q (97)
IR: Rediscount rate
EXC: Market rate, period average
United States
United
States
Annual
1980-2007 (28)
Quarterly
1975Q1-2007Q4 (132)
Notes: For the annual data, BD: General government balance (percent of GDP), CAD: Current account
balance (percent of GDP), IR: Discount rate (end of period), and EXC: nominal effective exchange rate.
But for the quarterly data, BD: Cash surplus or deficit (percent of GDP), CAD: Current account
(percent of GDP), IR: Discount rate (end of period), and EXC: nominal effective exchange rate.
17
Figure 1
Four Possible Types of Relationships between twin deficits
18
Denmark (1980-2007)
Orders
LS
SUR
4+1=5
Near singular matrix
(AIC)
(SC)
(HQ)
Finland (1978Q1-2007Q4)
Orders
LS
SUR
4+1=5
(AIC:
26)
Iceland (1980-2007)
Orders
LS
SUR
4+1=5
Near singular matrix
(AIC)
(SC)
(HQ)
Norway (1996Q1-2007Q4)
Orders
LS
SUR
1+1=2
(SC: 6)
19
Sweden (1994Q1-2006Q4)
Orders
LS
SUR
1+1=2
(SC: 6)
(HQ: 6)
Hong Kong (1999Q1-2008Q1)
Orders
LS
SUR
1+1=2
(SC: 3)
Korea (1976Q1-2000Q3)
Orders
LS
SUR
1+1=2
(SC: 3)
Singapore (1980-2007)
Orders
LS
SUR
4+1=5
Near singular matrix
(AIC)
(SC)
(HQ)
20
Taiwan (1984Q3-2008Q3)
Orders
LS
SUR
3+1=4
(AIC: 7)
The United States (1975Q1-2007Q4)
Orders
LS
SUR
7+1=8
(AIC:
20)
(HQ: 20)
Notes:
Figure 2
denotes that the null hypothesis of the non-causality is rejected at 10% significance level,
denotes that the null hypothesis of the non-causality is rejected at 5% significance level, and
denotes that the null hypothesis of the non-causality is rejected at 1% significance level.
Empirical Results
21