Twin deficits fallacy returns
Gerard Jackson
The twin deficits fallacy seems to be the economic equivalent of the Ghost Who Walks. No matter how many times it is buried it manages to resurrect itself. Alan Wood from Murdoch's Australian quotes European Central Bank president Wim Duisenberg's as saying: "We mentioned our concern about the twin US [current account and budget] deficits. We were backed up . . . by especially the director of the IMF" (Burst bubbles lead US to twin deficits 15/3).
The continual re-emergence of the twin deficits fallacy is an excellent example of Keynesian thinking banishing money and prices to the wilderness. In its extreme form, the one Treasury officials sold to Keating, there is a dollar-to-dollar relationship between the deficits. Therefore a fall in the PSBR (public sector borrowing requirement) will result in a corresponding fall in the current account deficit.
The theory is obviously still conning a lot of economists and executives into believing that budget surpluses would result in the elimination of current account deficits, a fall in interest rates and a stable currency. Nothing like it. The theory is based on the Keynesian accounting identity CAD = PSBR + [I-S] This clearly shows that CAD (current account deficit), which is considered passive, can be changed by changing PBSR (public sector borrowing requirement) or I (investment) or S (savings) or a combination of all three.
Now, were PSBR to fall to zero and CAD rise, the identity suggests that this development would be caused by investment exceeding savings. (Incidentally, this contradicts the popular fallacy that surpluses are additions to real national savings; a view based on the observation that deficits are dissavings). It then follows that the way to reduce CAD is to either cut 'investment', raise savings or do both. Quite frankly, this is convoluted nonsense. What is really being said is that CAD is caused by excess spending which in turn sucks in imports. In short, we are inflating faster than our trading partners.
It is said that the proof of the pudding is in the eating of it. Regrettably, this maxim seems to be lost on a great many economists. The twin deficit theory has been falsified a number of times. For example, Norway had one of the largest current account deficits as a per centage of GDP of all the OECD countries — it also had one of the biggest domestic surpluses. Then we had Italy with the largest domestic deficit among the OECD countries but the current account virtually in balance.
America is considered the one country where the twin deficit theory really holds up. However, these people overlook the fact that in the 1960s America also ran a domestic surplus while simultaneously running a balance of payments deficit. It is argued that the problem is that investment and savings are volatile and upset the identity. Thus a fall in the PSBR can be offset by investment rising faster than savings. This is nonsense.
The reader may have noticed that what is missing from the twin deficit theory is prices and money. Under a constant money supply investment always equals savings. Therefore, when investment in money terms exceeds savings we have inflation. In physical terms investment must always equal savings where savings are defined as the process by which present goods are transformed into future goods. So how does investment exceed savings? Simple. We call it inflation.
The banking system expands credit and business draws on the credit for investment purposes. Thus the money value of investment exceeds real savings. This credit expansion results in nominal incomes rising. The rise sucks in imports and causes a balance of payments deficit. The authors and disciples of the twin deficit theory overlook the fact that the volume of foreign trade is dependent upon prices. Any theory that ignores that fact is worse than useless. Furthermore, our domestic surplus was largely obtained through fiscal drag.
Labour governments allowed the money supply to expand at such a rapid rate (approaching 30 per cent a year at one stage) that it generated a rapid rise in nominal incomes which then inflated government revenues. Basically, all the government had to do is let revenue expand faster than its own spending. This process also happened in America during the '60s.
By the same token, however, balance-of-payments problems will emerge as part of our inflation — expressed as an increased demand for imports — is exported to our trading partners. The idea that the deficits are twins seems to owe its development to the erroneous belief that deficits are inflationary. Not so. Inflation is caused by monetary expansion regardless of what Keynesians tell us. Hence when deficits are funded by monetary expansion we get inflation and balance-of-payments problems.
The preceding puts paid to Alan Wood's assertion that "The reason the twin deficits theory didn't work was that Treasury forgot about the role of private sector borrowing by corporations and households, in Australia's case mainly corporates. The '80s were when the Alan Bonds and Christopher Skases thrived, and gearing up was all the go."
Therefore, the reason that "The story of the US in the '90s was remarkably like Australia in the '80s, only more so" is that they ran similar monetary policies. But for unrepentant Keynesians like Wynne Godley money truly does not matter.
So long as Keynesians — including those in the Treasury and the media — insist on sticking to capital flows and income effects, we shall keep getting the type of shoddy analysis that gave us the twin deficits theory and a horrendous foreign debt.
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