Understanding the drivers of twin deficit theory

Abstract

According to the twin-deficit hypothesis, when a government increases its fiscal deficit—for instance, by cutting taxes—domestic residents use some of the income windfall to boost consumption, causing total national (private and public) saving to decline. The decline in saving requires the country either to borrow from abroad or reduce its foreign lending, unless domestic investment decreases enough to offset the saving shortfall. Thus, a wider fiscal deficit typically should be accompanied by a wider current account deficit. In general the investment scenario in an economy is fueled by multiple factors including the government deficit part. A variety of factors like private saving, country demographics, regulatory environment etc has huge implication on the investment and hence on growth and prosperity. Most of the past studies on the national accounting and economic development have restricted scope limited to determine the relationship between the two deficits.. This study aims at doing deeper empirical analysis to find out the implications of various underlying characteristics of economy and showing their alignment or differences to the validity of twin deficit theory and their role in growth and development of the economy. This study also extends the scope of past studies looking at a much wider cross section of economies. Over the last three years, world has seen the biggest peacetime fiscal expansion in the history. Across the globe governments have countered downturn by cutting taxes and boosting government spending. This has led to huge fiscal deficit on their balance sheet and its ramifications are widely evident on North American and South European economies. With differential rate of recovery across the world the debate for the validity of twin deficit hypothesis and study on roles of other economic characteristics becomes far more relevant and contextual. Objectives: * To develop a frame work and group economies into homogeneous groups based on various national accounting variables like the level of Investment, national savings and Current Account. * To analyze the obtained groups (in stage 1) and determine the key common economic characteristics of these economies and implications on differential performance of these economies. * To do deeper qualitative analysis of some representative economies from each group to look at other softer features.