Zombie Economics: The Myth of the Twin Deficits
Itâ€™s baaaaaack! After briefly disappearing in the late 1990s, economists have again revived the twin deficit hypothesis that asserts government budget deficits are the primary cause of trade deficits. Worse than that, some new Democrats and liberal commentators have also signed on to the â€œbudget deficits cause trade deficitsâ€ argument, especially regarding the trade deficit with China. Take Nicholas Kristof in the New York Times (April 23, 2006):
â€œItâ€™s hypocritical of us to scream at President Hu Jintao, as we did during his visit last weekend about Chinaâ€™s undervalued currency. Sure, thatâ€™s a problem for the world economy â€“ but not nearly as much as our own budget deficits, caused by tax cuts we couldnâ€™t afford.â€
This is pure nonsense. The twin deficit hypothesis is a classic case of zombie economics, refusing to die despite powerful contrary empirical evidence and theoretical argument.
The twin deficit hypothesis first appeared in the 1980s when the record Reagan budget deficits coincided with the emergence of record trade deficits. In the 2000s, simultaneous budget and trade deficits have returned, prompting a return of the twin deficits hypothesis.
However, the hypothesis is fundamentally challenged by the experience of the late 1990s when the budget was in surplus, yet the trade deficit widened and set new records. Thus, the 1990s were marked by the polar opposite of record budget surpluses and record trade deficits. Other countries also provide compelling evidence against the hypothesis, with both Germany and Japan running persistent large budget deficits and persistent large trade surpluses.
The popularity of the twin deficits hypothesis stems from politics, not economics. In the 1980s, anti-government conservatives found the twin deficit hypothesis a useful way of attacking government. Trade deficits were bad news, being associated with massive de-industrialization and manufacturing job loss. Blaming them on the budget deficit was therefore a way of blaming Americaâ€™s industrial decline on government. Not only did this advance the anti-government agenda, it also helped keep blue-collar â€œReaganâ€ Democrats in the Republican fold. The implicit message was that blue-collar job loss was due to big government rather than flawed international economic policy.
In the 2000s, it is â€œnewâ€ Democrats who have revived the twin deficit hypothesis. One reason is simple opportunism. The twin deficits hypothesis has been so drummed into the publicâ€™s head that it has become an easy way to attack George Bush and his shameful tax cuts for the rich. But such opportunism buys short-term political gain at the expense of continuing economic confusions that do not help Democrats in the long term.
A second reason is that new Democrats have been staunch allies of corporate Republicans on trade and international economic policy. With the US economy running record trade deficits and the manufacturing sector hemorrhaging jobs over the last six years, this has left new Democrats exposed. To admit that manufacturing decline is the result of international economic policy would be a devastating self-indictment. Instead, new Democrats can take shelter behind the twin deficit defense and blame President Bushâ€™s budget policies.
For purposes of basic understanding, the budget and trade deficits should be seen as significantly independent of each other. The budget deficit is principally determined by current spending policies (discretionary spending) and existing commitments (non-discretionary spending) that determine total outlays; by tax policies that determine tax revenues; and by the state of the economy that also influences tax revenues.
The trade deficit is principally determined by trade policies determining tariff and non-tariff barriers; by the exchange rate that influences the price of imports and exports; and by the state of the economy relative to the rest of the world. When the U.S. economy is strong, it tends to suck in imports; and when the rest of the world is booming it buys more, which raises exports. Unfortunately, persistent U.S de-industrialization means that the U.S. also now sucks in more imports all the time owing to lack of domestic manufacturing capacity.
These are the core determinants of the budget and trade deficits. That said, there are indirect linkages between the two, and it is these linkages that are used to muddy public understanding and push twin deficit politics. The principal linkage is the state of the economy, which affects both the trade and budget deficits. Thus, a strong economy increases imports and the trade deficit, and a strong economy also impacts tax revenues and the budget deficit. Since both the budget and trade deficits impact the economy, they can each modestly and indirectly influence the other through their impact on the economy. Thus, tax cuts worsen the budget deficit, but they also increase spending on both domestic output and (to a lesser degree) imports.
Consider the following back of the envelope calculations. Empirical models show that every dollar of new spending creates about two dollars of income because the initial spending circulates and creates additional jobs. People also spend about fifteen percent of their income on imports. If we halved the budget deficit by cutting government spending by two hundred billion dollars, income would fall by four hundred billion dollars and imports would fall by about sixty billion dollars. In other words, we would have a major recession, and though the trade deficit would fall by about eight percent it would still be around seven hundred billion dollars. That unambiguously shows that the budget deficit is not the prime cause of the trade deficit.
Thereâ€™s an old classic movie called â€œNight of the Living Dead.â€ Its message is that to kill a zombie, you have to kill the zombie master. The same holds for zombie economics, which requires exposing its supporting politics to daylight. The twin deficits hypothesis is zombie economics, being part of an anti-government economics that tries to blame government budget deficits for trade deficits and manufacturing job loss effects of corporate globalization. Itâ€™s time to stake this zombie.