TWIN DEFICITS AND SUSTAINABILITY
l. randall wray
In the mid to late 1980s, the U.S. economy simultaneously produced—for the
first time in the postwar period—huge federal budget deficits as well as large current
account deficits, together known as the “twin deficits” (Blecker 1992; Rock
1991). This generated much debate and hand-wringing, most of which focused
on supposed “crowding-out” effects (Wray 1989). Many claimed that the budget
deficit was soaking up private saving, leaving too little for domestic investment,
and that the “twin” current account deficit was soaking up foreign saving. The
result would be higher interest rates and thus lower economic growth, as domestic
spending—especially on business investment and real estate construction—
was depressed. Further, the government debt and foreign debt would burden
future generations of Americans, who would have to make interest payments and
eventually retire the debt. The promulgated solution was to promote domestic
saving by cutting federal government spending and private consumption (Rock
1991; Council of Economic Advisers 2006). Many pointed to Japan’s high personal
saving rates as a model of the proper way to run an economy.
The twin deficits have returned
Clinton boom, the federal government balance turned sharply toward deficit, decreasing by nearly
with a vengeance. After running surpluses at the end of theSenior Scholar
Center for Full Employment and Price Stability. The author thanks Wynne Godley for discussion that led to this Policy Note, and for providing
the data used to produce the figure.
The Levy Economics Institute is publishing this research with the conviction that it is a constructive and positive contribution to the discussion
on relevant policy issues. Neither the Institute’s Board of Governors nor its advisers necessarily endorse any proposal made by the author.
Copyright © 2006 The Levy Economics Institute
l. randall wray is professor of economics at the University of Missouri–Kansas City and director of research at the2
Policy Note, 2006 / 37 percent of disposable income (DI). By the same token, the current
account deficit, which had shrunk by more than half during
the Clinton years, exploded. (The current account deficit is
defined as the nation’s excess of imports and other current payments
over exports and other current receipts.) It is now twice
as large, relative to DI, as it had been at its previous peak during
the 1980s. This time around, discussion nears a hysterical level,
with dire predictions concerning not only intolerable burdens
for future Americans, but even the possible bankruptcy of the
federal government and the nation as a whole (Altman 2006).
Further,Americans’ insatiable appetite for the world’s saving not
only endangers their own well-being, but also depresses growth
in developing nations. The Council of Economic Advisers recommends
that the “United States should raise its domestic saving
rate” to reduce its current account deficit and reduce reliance
on foreign saving (2006, p. 127). There is widespread agreement
that both deficits are unsustainable.
In this Policy Note, I argue that the twin deficits are,
indeed, “unsustainable,” but for reasons that are completely
absent from public discourse. I first briefly review the framework
being adopted for this analysis. I next review the recent
historical record, then turn to an examination of whether the
twin deficits are sustainable.
A Framework for Analysis
The figure provides a plot of empirical data, including the overall
government balance and current account balance, with both
variables presented as a percent of DI. It is important to note
that the sign of the government’s balance is reversed (a deficit is
positive)—for reasons to be made clear in a moment. There are
two additional variables shown: the private sector balance and
the unemployment rate.
For many years, the Levy Institute has been using the “three
balances” approach developed by Wynne Godley (1996, 1999)
to provide insight into the relations among the three sectors of
the economy: private, government, and foreign. Previous work
has rigorously demonstrated that the balances are inexorably
linked through an identity, and, more importantly, that analysis
of the balances can yield information about cause and effect. I
do not repeat a detailed argument here, but briefly describe this
analysis before turning to the twin deficits.
If one of the three sectors spends more than its income, at
least one of the others must spend less than its income, because
for the economy as a whole, total spending must equal total
receipts or income.While there is no reason why any one sector
has to run a balanced budget, the system as a whole must. In
basic textbooks, this is summarized as “injections equal leakages”
at the aggregate level. In practice, the private sector traditionally
runs a surplus—spending less than its income. This is
how it accumulates net financial wealth. For the United States,
the private sector surplus has averaged about 2 to 3 percent of
DI, but it does vary considerably over the cycle, reaching as high
as plus 9 percent and falling below zero in recent years (see figure).
Private sector saving (or surplus) is a leakage that must be
matched by an injection. Before Reagan, the United States essentially
had a balanced foreign sector; the current account balance
swung between small deficits and surpluses. Over the course
of the Reagan-Bush years, the current account deficit grew to
3.2 percent of DI, and fell to less than 2 percent at the end of the
1990s, before growing to more than 6 percent of GDP today.
That is another leakage that drains domestic demand.
In the United States, the government sector, taken as a
whole, almost always runs a budget deficit, reaching to well
above 5 percent of DI under Reagan and both Bushes. For the
United States, the budget deficit has been the injection that offsets
the “normal” private sector and occasional foreign sector
leakages.With a traditional private sector surplus of 2 to 3 percent
of DI and a more or less balanced current account, the
“normal” budget deficit needed to be about 2 to 3 percent of
DI during the early Reagan years. Until the Clinton expansion,
the private sector never ran a deficit. However, since 1996, the
private sector has been in deficit every year except one (during
-
8-4
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2
4
6
8
10
12
The Three Balances and the Unem
ployment RatePe
Pe
1962 1967 1972 1977 19
rcent of Disposable Incomercent82 1987 1992 1997 2002Sources:
Gove
P
Cu
Unem
U.S. Bureau of Labor Statistics and Bureau of Economic Analysisrnment Deficit (Left Scale)rivate Sector Balance (Left Scale)rrent Account Balance (Left Scale)ployment Rate (Right Scale)The Levy Economics Institute of Bard College
3the depths of the last recession), and that deficit climbed to
more than 5 percent of DI at the peak of the boom. A private
sector deficit acts as an injection, raising domestic demand and
encouraging production. As production and employment rise,
tax revenues grow faster than government spending, reducing
the budget deficit. This chain of events actually drove the federal
budget into surplus—as high as 2.5 percent of GDP—at the
peak of the Clinton boom. At the same time, the growing economy
caused imports to rise faster than exports, generating a
current account deficit. Almost all economists and policymakers
thought the Clinton budget surplus was a great achievement
and projected the surplus to continue for 15 years or more.
However, most never realized that, by definition, the large surpluses
meant that the private sector had to spend more than its
income on a hitherto unknown scale, as long as the current
account deficit remained constant. Therefore, rather than accumulating
financial wealth, the private sector was running up
debt (Wray 1999). The budget surplus was short lived, because
it drove the economy into recession, causing tax revenues to fall
below government expenditures, as jobs were lost and income
stopped growing.
As mentioned, the trade deficit represents a leakage of
demand from the U.S. economy to foreign production. There
is nothing necessarily bad about this, so long as we have another
source of demand for U.S. output, such as a federal budget that
is biased to run an equal and offsetting deficit. Private sector
net saving (that is, running a surplus) is also a leakage. If
we add the current account deficit that we have today (about
6 percent of DI), to the normal private sector surplus of 2 to
3 percent of DI, that gives us a total “normal” leakage, out of
aggregate demand, of 8 or 9 percent of DI. This leakage would
have to be made up by an injection from the government sector;
the only way to sustain such a large leakage is for all levels
of government together to run a deficit of that size. Since state
and local governments are required by constitutions and markets
to balance their budgets, and, on average, actually run surpluses,
it is up to the federal government to run deficits on the
necessary scale.
The federal budget deficit is largely nondiscretionary over
the span of a business cycle; and at least over the shorter run, we
can take the current account as also largely outside the scope of
policy—with imports a function of domestic demand, but
exports depending on demand from the rest of the world. A
driving force of the cycle, then, is the private sector leakages.
(However, this is not to be interpreted as an endorsement of the
view that leakages “cause” or “finance” injections, which has it
backwards.) When the private sector has a strong desire to save,
it tries to reduce its spending below its income. Domestic firms
cut production, and imports might fall too. The economy cycles
downward into a recession as demand falls and unemployment
rises. Tax revenues fall and some kinds of social spending (such
as unemployment compensation) rise. The budget deficit
increases more or less automatically. On the other hand, when
the private sector has a high desire to spend, as it has had on an
unprecedented scale for nearly a decade, it can accumulate debt,
driving the current account balance into deficit and reducing
(or even eliminating) the budget deficit.
The Twin Deficits in Historical Perspective
From this perspective, the 1980s experience is not too difficult
to explain. As the economy began to recover from the Reagan
recession of the early 1980s, the private sector balance fell
from a very high surplus—above 6.3 percent of DI—to just
over 1 percent by 1989. Unemployment gradually declined,
from almost 11 percent to a trough below 5.5 percent by the late
1980s. The budget deficit also declined, although with a lag, by
3 percent of DI, as income growth increased tax revenue. The
increased demand by the private sector was not completely offset
by the adjustment of the government’s balance; the remainder
“leaked” to the foreign sector, as the current account moved
from a balance to a deficit above 3 percent of DI. Near the end
of the 1980s, private sector spending failed to keep pace with
income, as a large and growing surplus (saving) reappeared,
again reaching close to 6 percent of DI at the beginning of 1992.
The resulting recession drove the budget deficit back above
6 percent as unemployment rose, and lower demand for foreign
output closed the current account deficit.
Recall, from the beginning of this Policy Note, that discussion
during the 1980s focused on the necessity of reducing the
budget deficit and increasing private saving in order to increase
the supply of loanable funds for investment and encourage economic
growth. Actually, as the private sector reduced spending
and increased its surplus, the economy stagnated. Rather than
generating better economic performance, the higher level of
private sector saving was associated with higher government
deficits, higher unemployment (reaching nearly 8 percent), a
recession, and a lower current account deficit.
4
Policy Note, 2006 / 3However, after a long but weak recovery in the early 1990s—
associated with continued but falling private sector surpluses—
the economy finally started to grow at a robust rate in the
middle of the decade. By the end of 1995, the private sector balance
had returned to a more normal surplus of about 2 percent
of DI; faster growth also reduced the budget deficit—to about
3.5 percent—while the current account deficit grew to 1.5 percent.
Over the remainder of the 1990s, as discussed above, the
private sector surplus continued to deteriorate and turned negative
in 1997. Unemployment fell to its lowest levels since the
1960s. Strong economic growth drove the overall government
budget to historically large surpluses, and the current account
to record deficits. It is important to recall that the budget surplus
was projected at the time to continue for at least 15 years,
and retirement of federal government debt was supposed to be
adding to the nation’s net wealth. In fact, the sum of the current
account deficit and the government surplus equaled the private
sector deficit; given the current account, each additional dollar
of government surplus, by identity, meant another dollar of private
sector deficit. Indeed, retirement of federal government
debt equals a net reduction of private sector wealth. The leakage
of private sector income and wealth to budget surpluses and
current account deficits eventually contributed to recessionary
forces that brought the boom to an end by 2000.
The recession under the younger Bush saw a sharp turnaround
of the private sector and government balances. The government
surplus morphed into a deficit of more than 5 percent
of DI, a swing of 6.7 percent of DI—the largest turnaround
since the 1974–75 recession. Similarly, the private sector balance
moved, by about 6 percent of DI, to a small surplus.While there
was initially a small reduction of the current account deficit,
recovery quickly turned the trend downward. Finally, the
unemployment rate rose quickly in the recession, but has only
very slowly fallen in recovery—at a pace that is even slower than
that experienced in the “jobless” 1990s recovery.
Note how closely the unemployment rate tracks trends of
the private sector balance in the figure—rising when saving rises
and falling when saving falls. The period after 1995, to the right
of the heavy vertical line, stands out because the private sector
surplus fell much more quickly than did the unemployment
rate. This more rapid fall in the private sector balance is a result
of the current account balance behaving differently after 1995: as
the current account deficit opened up, the demand injection created
by a lower private sector balance was dissipated through
imports. A larger increase of private sector spending, relative to
income, was thus required to drive the unemployment rate
lower. The required boost depends on the government’s fiscal
stance. If the budget is biased to run surpluses when growth is
robust—as was the case in the late 1990s—then larger private
sector deficits are needed to fuel growth.
Given how large the external leakage has become, even at
current moderate rates of growth, the private sector cannot
achieve balance between income and spending unless the
budget deficit is above 6 percent of DI. The problem is that it
appears unlikely that there is much political will to deliberately
allow the budget deficit to rise to, say, 8 percent or 9 percent of
DI, should the private sector finally decide to return to a normal
surplus balance of 2 or 3 percent of DI. Rather, the adjustment
would almost certainly have to come through growth
rates that are slow enough to permit some combination of a
reduced current account deficit and a budget deficit far beyond
that which is thought desirable.
Sustainability of the Twin Deficits
This brings us back to the issue of sustainability. Let us first look
at the sustainability of the fiscal deficit.
Recall that one of the main arguments about the twin
deficits of the 1980s revolved around the supposed “crowdingout”
effect.While the mainstream recognizes that interest rates
are still low—even after concerted efforts by the Fed to raise
them—mainstream economists still hold out the possibility
that budget deficits, in the context of low private sector savings,
will eventually push up rates.“Mark Zandi, an economist at the
analysts’ website Economy.com, said the low level of savings
would become a problem only if interest rates continued to
climb” (Thornton 2006). Insufficient domestic saving would
then force the United States to turn to foreign savers—but these
are already tapped out, lending to finance the current account
deficit. Hence, investment will falter, and long-run growth will
be hindered.
According to conventional wisdom, if domestic saving rates
cannot be improved, then the budget deficit must be reduced.
Indeed, in its latest projections, the White House claims the
budget deficit is on course to fall to 2.6 percent of GDP for 2007,
and to less than 1 percent of GDP by the end of the decade
(Daniel and Balls 2006). Federal tax revenues grew by 15 percent
in fiscal year 2005, and are expected to rise by 7.3 percent in
The Levy Economics Institute of Bard College
52006—obviously this is much in excess of private sector income
growth (
conventional wisdom maintains it will reduce the absorption of
private sector saving (both domestic and foreign) and thereby
leave more saving for private investment. At the same time, the
tightening will have some impact on the projected trillions of
dollars of fiscal deficits—said to burden future generations and
even to threaten the solvency of the U.S. government.
Such mainstream analyses fail to understand the connections
among the sectors. Tightening the fiscal stance will not
Financial Times 2006). If this tightening can continue,substitute
for low private sector saving, but rather will reduceprivate sector saving (all else being equal). Continued growth of
tax revenue beyond the rate of private sector income growth is
likely to reduce net income and lower the rate of growth of private
sector wealth. It is improbable that this environment will
encourage investment or long-term U.S. growth. Indeed, there
is already evidence that U.S. growth is being hindered by the
tightening fiscal stance. The GDP grew at only 1.1 percent in
the fourth quarter of 2005; disposable income grew by only 1.4
percent in 2005 (Bajaj 2006). It appears the real estate bubble
might finally burst, as new home sales fell by 10.5 percent in
February (Reuters 2006). As discussed, any reversion of private
sector balances toward a “normal” surplus of 2 to 3 percent of
DI would have a devastating effect on domestic demand and
employment. In the current politically charged environment
(with both Republicans and Democrats vying to reduce the
budget deficit), policymakers probably would be unwilling to
relax the fiscal stance toward a budget deficit that would allow,
without a substantial slowing (or elimination) of growth, a private
sector surplus. In the past, a swing of the private sector balance
of, say, 5 percent of DI has been associated with a rise of
the unemployment rate by 3 percentage points or more.
It is likely that the trade imbalance is “unsustainable”—but
not for the reasons usually cited (U.S. solvency; external
demand for the dollar). Rather, because economic growth currently
requires that U.S. consumers continue to run up deficits
and accumulate debt, growth probably will come to an end
when consumers eventually cut back spending. This will reduce
imports, albeit by an unknown amount. Similarly, the U.S.
budget deficit is also “unsustainable”—in the sense that it will
surely change—but again, not for the usual reasons. The budget
deficit will rise if the U.S. private sector reduces its net spending;
it will fall if the pace of private spending increases. It is misguided
to speak of the U.S. federal government, or the nation as
a whole, facing financial constraints in a regime of sovereign
currency and floating exchange rates. The next U.S. recession—
and global slowdown—will not be due to the insolvency of the
United States, but rather will result from a slowdown of the rate
of growth of spending by U.S. consumers.
While household debt ratios, as well as debt-service ratios,
have trended upward, an end to the current sluggish expansion
is not likely to be initiated by a sudden wave of defaults and
bankruptcies. Instead, it will come when household borrowers
and banking sector lenders decide it is time to retrench—to
slow the growth of borrowing by, and lending to, the personal
sector. Conceivably, this slowdown could trigger a snowball of
defaults. The question is whether policymakers will react to a
deceleration quickly enough to prevent a major and prolonged
recession, or, worse, a debt deflation of the sort feared by
Hyman Minsky.
References
Altman, Daniel. 2006. “A Stickier Trade Gap.”
New York Times,March 26.
Bajaj, Vikas. 2006. “Economy Grows at Slowest Pace in 3 Years.”
New York Times,
Blecker, Robert A. 1992.
Strategy for the 1990s.
Council of Economic Advisers. 2006.
President.
Daniel, Caroline, and Andrew Balls. 2006. “Bush Seeks
$65 Billion Cut in Federal Spending.”
January 27.Beyond the Twin Deficits: A TradeArmonk, New York: M. E. Sharpe.Economic Report of thewww.whitehouse.gov/cea/pubs.htmlFinancial Times,February 7.
Financial Times.
Strain on US Public Finances.” February 6.
Godley,Wynne. 1996.“Money, Finance and National Income
Determination: An Integrated Approach.”Working Paper
No. 167. Annandale-on-Hudson, New York: The Levy
Economics Institute.
———. 1999.
Prospects and Policies for the United States and the World.
2006. “Budget Set to Highlight the HeavySeven Unsustainable Processes: Medium-TermStrategic Analysis. Annandale-on-Hudson, New York: The
Levy Economics Institute.
Reuters. 2006. “Biggest Drop in 9 Years for New Home Sales.”
New York Times,
Rock, James M., ed. 1991.
Mountain View, California: Mayfield Publishing.
March 25.Debt and the Twin Deficits Debate.6
Policy Note, 2006 / 3Thornton, Philip. 2006. “US Saving Rate Sinks to Lowest since
Great Depression.”
Wray, L. Randall. 1989. “A Keynesian Presentation of the
Relations among Government Deficits, Investment,
Saving, and Growth.”
The Independent, January 31.Journal of Economic Issues23:4: 977–1002.
———. 1999. “Surplus Mania: A Reality Check.” Policy Note
1999/3. Annandale-on-Hudson, New York: The Levy
Economics Institute.
Recent Levy Institute Publications
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