Download budget deficits into modest surpluses a la 1998-2001

Fiscal Deficits and The
Current Account
Roberto Chang
March 2007
Twin Deficits?
• National Savings = Private Savings +
Government Savings
• Government Savings = Budget Surplus
• So, it is easy to conclude that a reduction
in the budget surplus (i.e. a larger budget
deficit) reduces national savings and,
hence, leads to larger CA deficits.
• “The only effective US policy response to
the [CA] problem…is a conversion of our
present (and especially prospective)
budget deficits into modest surpluses a la
1998-2001.”
C. Fred Bergsten, “The Current Account
Deficit and the US Economy,” Testimony
before the U.S. Senate, Budget
Committee, Feb. 1 2007.
Problems with the Twin Deficits
Argument
• As we have discussed, the argument
implies that interest rates would have
risen, which has not been the case in
recent years.
• It may be more relevant, however, for
other periods, such as the 1980s.
• A second problem is that the “Twin
Deficits” argument relies on the
assumption that private savings do not
change when fiscal deficits increase.
• This is arguably not always the case.
• In fact, in theory private savings may
completely offset changes in the fiscal
deficit: Ricardian Equivalence.
Ricardian Equivalence
• Consider a two period small open
endowment economy with a government.
• The representative household has to pay
taxes Tt taxes in period t = 1,2.
• The present value budget constraint of the
household is, hence,
C1 + C2/(1+r*)
= Q1+ Q2/(1+r*) – (T1 + T2/(1+r*))
and optimal consumption is given by the
usual condition:
MU1/MU2 = (1+r*)
 What matters is only the present value of
taxes
• The government has expenditures Gt in
period t = 1,2, so its flow budget
constraints are:
G1 + B1g = T1
G2 = T2 + (1+r*) B1g
where B1g denotes government assets at the
end of period 1.
• Combining the flow government budget
constraints we obtain the government
present value budget constraint:
G1 + G2/(1+r*) = T1 + T2 /(1+r*)
 The present value of taxes must be equal
to the present value of expenditures.
Implications
• Government policy matters only through
the present value of expenditure.
• Hence the timing of taxes and the budget
deficit does not affect consumption, given
government expenditures.
• Since household savings are:
S1 = Q1 – T1 – C1
any reduction in taxes (T1) will be offset by
an equal increase in savings.
 Given government expenditure, an
increase in the government deficit (caused
by lower taxes) will be offset by an
increase in private savings, leaving
national savings and the CA untouched!
• Another implication is that, to analyze the
effects of changes of government
expenditure, one can assume that the
budget is balanced (i.e. Gt = Tt)
The 1980s Twin Deficits, Again
• One can conjecture that government
policy affected the CA in the 1980s not
because of the budget deficits, but
because of increased government
expenditures.
• In our model, increases in government
expenditures are just like falls in the
household’s endowment.
• However, this seems to be quantitatively
insufficient: government expenditures
increased by about 1.5% of GNP between
1978 and 1985, so national savings and
the CA would have fallen by at most that
amount.
• But the CA deteriorated by about 3%.
Ricardian Equivalence May Fail
Possible causes:
• Borrowing Constraints
• Intergenerational Effects
• Distortionary Taxation
See SU, chapter 5 for a discussion.