The twin deficits hypothesis: an empirical examination

The ‘twin deficits hypothesis’ (TDH) claims that there is a connection between fiscal and current account deficits. In its most extreme form, popularized by the ‘New Cambridge School’ in the 1970s, the argument was that, with equilibrium in the private sector, the size of the public sector deficit was proportional to, and the principal determinant of the size of the current account deficit. In softer versions, private sector equilibrium is not assumed, but it is still argued that changes in the size of the fiscal deficit result in broadly equivalent changes in the current account. If valid, the TDH has important policy implications. In this paper we critically review the theoretical rationale for the TDH. We go on to examine the empirical evidence relating to it. We find little consistent support for the hypothesis either across our sample of advanced OECD countries or members of the BRICS group, excluding Russia. An explanation of current account disequilibria requires going beyond a narrow focus on fiscal imbalances in the context of the twin deficits hypothesis.