Simply put the twin deficit hypothesis is the view that an economy running a fiscal budget deficit will also run a current account deficit. It stems from a national accounting equation which says that NX = S-I. We arrive at this point because Classical economists take S = Y-C-G, so we can arrange our national accounting equation of Y = C + I + G + NX to get the above NX = S – I. Where Y is national output (i.e. GDP), S is savings, C is consumption, I is investment, G is government spending and NX is net exports (exports minus imports).
If the government is running a large budget deficit such that S<I then NX would be negative and the budget deficit means – by definition – a current account deficit. To explain the mechanism for how this could occur we need to assume that we are in a small open economy which perfect capital mobility. This means that our economy, being small, can’t affect world interest rates through changes in domestic savings or investment. Having perfect capital mobility means that domestic interest rates are equal to the world interest rate: if there is downward pressure on domestic rates (because S>I) then capital flows abroad and if there is upward pressure on domestic rates (because S<I) then capital flows into the economy. This means that at all times the domestic interest rate equals the world interest rate. Hence, we say upward/downward pressure on interest rates, but this doesn’t mean that interest rates have risen/fallen unless explicitly mentioned.
We can now proceed making using of the above assumptions. An increase in government spending with taxes being held constant would weaken the government fiscal balance and it would also lower savings. Remember, S = Y-C-G. If there are lower savings then S<I and there is upward pressure on domestic interest rates, hence capital flows in from abroad. These inward capital flows causes the domestic currency to appreciate. This is because foreigners have to purchase Sterling to be able to save their money in a British bank/asset to relieve the upward pressure on interest rates. An appreciated currency makes British exports more expensive for foreigners and imports cheaper for domestic citizens. Thus, assuming the Marshall-Lerner condition holds, we would expect the appreciated exchange rate to cause a deterioration in net exports. It is this mechanism which can explain how we move from a situation of fiscal weakening to current account weakening which underlies the twin deficit hypothesis.
Despite the explained mechanism and identity there has been little empirical evidence to support the twin deficit hypothesis. Although, Bluedorn and Leigh looked at fiscal consolidation – conducted to reduce the budget deficit, and not as a response to short-term economic policy which might affect the export situation – and find that fiscal consolidation of 1% of GDP raises the current account balance-to-GDP ratio by approximately 0.6 percentage points. This is significant due to their methodology, many other empirical studies may suffer from issues of reverse causality. The government may tighten fiscal policy due to increasing domestic demand growth alongside a rising current account deficit. First there may be developments affecting both economic activity (which would affect the government’s fiscal budget through the automatic stabilisers) and the current account. Bluedorn and Leigh use the example of domestic stock-market boom which improves the fiscal budget (higher capital gain and tax revenues) but may provide a wealth-effect causing an increase in imports, thus resulting in a negative link which would work against the twin deficit hypothesis. Secondly, there may be deliberate policy responses in order to control economy activity. This could be due to inflationary pressure which causes the government to reduce spending and increase taxation (improve fiscal budget). Finally, the fiscal budget may change in order to directly affect the current account balance. A government with large imports and a large current account deficit may wish to ameliorate this situation by reducing government spending and increasing taxation. Again this would imply a negative causation and downplay the hypothesis. Interestingly, they find that a fiscal consolidation of 1% of GDP would cause national saving to GDP to rise by 0.3 percentage points. National saving is rising despite fiscal consolidation which provides evidence against Ricardian equivalence.