THE TWIN-DEFICIT ILLUSION
William G. Dewald and Michael Ulan
Despite employment and income gains in the 1980s, is the United
States in trouble because it has become the world’s largest debtor?
The common perception is that Americans havebecome spendthrifts,
with private consumption and government deficits financed by loans
from and sales ofassets to foreigners. The inference commonlydrawn
is that futureconsumption will have to be cnt back in order to service
the nation’s rapidly deteriorating net external wealth position.
So much depends on the underlying measures that it is surprising
how little attention has been paid to their quality. Thousands of
regressions have been run to estimate the relationship between the
budget and current-account deficits. But the data are suspect because
official measures of these magnitudes typically have not been
adjusted for either inflation or changes inmarket values. This paper’s
main objective is toanalyze the twin-deficit phenomenon using data
that have been adjusted for inflation and market values.
The conventional wisdom is that there is a causal link between
large U.S. fiscal deficits and current-account deficits. This observa-
tion seems confirmed by Figure 1. Such a relationship is theoretically
possible if fiscal deficits raise real interest rates enough to induce a
capital inflow. Nonetheless, there is considerable dispute about the
historical relationship between current-account and fiscal balances.
For example, the United States ran large fiscal deficits during both
World Wars, but there was a current-account surplus during World
War I and a current-account deficit during World War II.
Cato journal, Vol. 9, No. 3 (Winter 1990). Copyright © Cato Institute. All rights
The authors are members ofthe Planning and Economic Analysis StafF in the Bureau
of Economic and Business Affairs, U.S. Department of State. The views expressed in
this paper are those of the authors alone and not necessarily thoseof the Department
of State or the U.S. government.