Twin Deficits and Twin Decades Jeffrey Frankel Harpel Professor of Capital Formation and Growth Kennedy School of Government Harvard University conference on the Macroeconomics of Fiscal Policy sponsored by the Federal Reserve Bank of Boston, at Wequasett, June 14-16, 2004

Three propositions were put to the test by fiscal expansion of 1980s PropositionPredictionOutcome in 1980s Barro’s debt neutrality BD would be offset by increased private saving, so National Saving would not fall. Private & National Saving rates fell Mundell- Fleming: high capital mobility & floating rates The fall in national saving rate would crowd out TB, more than crowding out investment (via rise in real interest rate and $) As predicted. The Twin Deficits are born. Feldstein- Horioka finding Fall in NS => fall in investment, < rise in current account deficit (Capital mobility is not that high.) Saving-retention coefficient fell some. Both kinds of crowding out occur.

Remarkably close parallels between fiscal expansion of the 1980s and the current decade tax cuts => big deficits (despite claims to long-run fiscal probity) ( Figure 1) part of the problem: overly optimistic forecasts (Figure 4) incl. the Laffer hypothesis: “US tax rate cuts => growth up => tax receipts up” optimistic forecasts soon shattered, although Administration still blames deficits on recession and claims they will go away soon (Figure 5) failure of budget outcomes to follow script => switch to “Starve the Beast” claim “Starve the Beast” claim rings hollow <= WH increases spending (Figure 6) Private saving does not offset deficits => national saving falls. (Figure 2 or 2b) Economists debate if deficits affect interest rates Fall in national saving reflected in current account deficit. (Figure 3) Twin deficits. (Admittedly, cyclical factors responsible for exaggerating decline in budget, NS, & I at the beginning of decade, but not for overall pattern.)

Fig.1: US Federal Deficit as Share of GDP by Presidential Term

Fig. 4: Three years of budget forecasts that soon proved too optimistic

Fig. 5: As of 2004, official budget forecasts are still too optimistic Source: Alice Rivlin & Isabel Sawhill, Brookings, 1/13/2004

Fig. 6: US Federal Spending as a Share of GDP, by Presidential Term

Fig. 2b: Private Saving Fails to Rise to Offset Budget Deficits; Rather National Saving Falls ( shares of GDP )

Fig. 2: Budget Balances, Private Saving, & National Saving, as Shares of GDP

Fig. 3: National Saving, Investment, % Current Account, as Shares of GDP

Table 2: Feldstein-Horioka Regressions for US Dependent Variable: Current Account / GDP, Cyclically Adjusted Coefficient is about 1/2 Some evidence of upward trend in capital mobility

Differences between the two decades Differences between early 00s and early 80s: –Interest rates have been low, –The dollar began to depreciate in 2003 Not surprising: –The Fed has been very accommodating, so far –Asian central banks, too, have bought US Treasury securities –People are apparently not yet fully aware of the likely magnitude of coming deficits. Likely to change: i trend will be up

Interest Rates & Expected Budget Deficits Source: Menzie Chinn and Jeffrey Frankel, October 15, 2003 OLS regression using annual data, in levels (Newey-West robust standard errors in parentheses). % variables defined in decimal form. *(**)[***] denotes significance at the 10%(5%)[1%] level.