Twin deficits and financial integration in EU member-states

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Journal of Policy Modeling 28 (2006) 595602Twin deficits and financial integrationin EU member-statesTheodore Papadogonas a,, Yannis Stournaras ba Bank of Greece, Greeceb University of Athens, GreeceReceived 1 September 2005; received in revised form 1 January 2006; accepted 1 February 2006AbstractIn this paper, we find that changes in general government balances in the EU-15 member-states arematched to a large extent by opposite changes in the private savingsinvestment gap, implying that changesin public sector deficits have a rather small relationship with current account deficits. Also, using an empiricalframework implied by a well-known, intertemporal model of the current account, we find that current accountdevelopments in Greece are explained by factors which are related to financial and economic integration,such as interest rate spreads and growth differentials, as well as to the general government balance. 2006 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.JEL classication: F15; F32; F41Keywords: Financial integration; Public sector and current account balances1. IntroductionOne of the central issues in both economic policy and open-economy macroeconomics is therelationship between public sector (general government) deficits and current account deficits. Itis often argued that the two deficits are related strongly and positively (twin deficits) and this isthe way that this relationship is usually presented in the financial press. If this is true, national orworld current account imbalances can be (easily?) tackled to the extent that public sector deficitsare, more or less, under government control.However, the relationship between public sector and current account deficits is more com-plicated, depending on the behavior of the private sector savings/investment gap, since the Corresponding author at: 10 Kivelis street, 111 46 Athens, Greece. Tel.: +30 2103203601.E-mail address: (T. Papadogonas).0161-8938/$ see front matter 2006 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.doi:10.1016/j.jpolmod.2006.02.002596 T. Papadogonas, Y. Stournaras / Journal of Policy Modeling 28 (2006) 595602well-known national account identity states that the current account deficit is equal to the sum ofthe public sector deficit (that is, the difference between government investment and governmentsaving) and the private sector deficit (that is, the difference between private sector investment andsaving).Almost every contribution to the literature on open-economy macroeconomics examines themacroeconomic implications of a higher public sector deficit and, in particular, its effects onthe real exchange rate, output, private savings, private investment and the current account. TheMundellFlemingDornbusch model might be said to remain the standard paradigm althoughmany authors are also using the new, open-economy macroeconomics framework (for differencesand similarities between the different models see, among others, Lane (2001), Obstfeld and Rogoff(1996), Vines (2003)).According to the standard paradigm, the effects of a higher public sector deficit are transmittedthrough two channels of influence, namely the goods market (via the real exchange rate) and thecapital account (via the real interest rate). A higher public sector deficit is associated with anappreciation of the real exchange rate and higher output (as aggregate demand increases). As aconsequence, it is also associated with a deterioration of the current account. In addition, a currentaccount deficit results in net asset decumulation and higher foreign debt. The impact of this onexpenditure, as well as long-term considerations regarding the need to raise taxes to repay thepublic sector debt, are additional transmission mechanisms through which public deficits mightaffect external deficits.Two particular cases deserve special attention for being at the two opposite extremes. Firstly, thedebt neutrality (Ricardian) hypothesis: according to one version this hypothesis suggests that in aworld with no imperfections and infinite horizons, changes in budget deficits cause offsetting, one-to-one changes in private savings through anticipations of changes in future taxation. Therefore,national savings and the current account remain unaffected (Barro, 1988).Secondly, complete crowding out of net exports: in a small open-economy where all goods areperfect substitutes and freely traded (that is, the law of one price holds) while domestic productionis either at the full employment level or is fixed due to a rigid real product wage, a higher budgetdeficit causes a one-to-one increase in the current account deficit. It may be noted that this resultremains valid in two other cases: (a) in the conventional MundellFlemingDornbusch model withperfect capital mobility and a floating nominal exchange rate, and (b) under the New Cambridgeassumption (Fetherston & Godley, 1978) that the private sectors (households and corporations)net acquisition of financial assets is zero (that is, under the assumption that private disposableincome is equal to private consumption and investment).In an interesting contribution, Blanchard and Giavazzi (2002) attempt to explain current accountdevelopments in certain European Union (EU) member-states emphasizing factors related toeconomic and financial integration. First, the reduction in interest rate spreads and in currency riskdue to nominal convergence, which, for net borrowing countries, increase private investment andreduce national savings. Unless government net lending (that is, the general government surplus)moves sufficiently in the opposite direction, this channel implies an increase in the current accountdeficit to GDP ratio. Second, the increase in competition through economic integration, whichis expected to increase total factor productivity, improving the home countrys growth prospects.Unless the growth rate of trade partners exceeds the home countrys growth rate, this channel alsoimplies an increase in the current account deficit to GDP ratio.Blanchard and Giavazzi (2002) use an explicit utilitarian approach with households living fortwo periods and maximizing a logarithmic utility function under a two-period budget constraint.Their model is thus different than the more traditional MundellFlemingDornbusch models ofT. Papadogonas, Y. Stournaras / Journal of Policy Modeling 28 (2006) 595602 597the current account, which emphasize competitiveness and national incomes of the home andforeign country as the main determinants of the current account. However, differences are moreapparent than real: as we will explain later, competitiveness in the Blanchard and Giavazzi (2002)model does not appear in their current account equation because it is an endogenous variable, whichdepends on relative output. Actually, models with aggregate demandaggregate supply equationsof the MundellFlemingDornbusch tradition emphasize variables (as determinants of the currentaccount), which are closer to those of Blanchard and Giavazzi (2002), see Stournaras (2004).The present paper addresses the following two empirical questions: (a) What is the empiricalrelationship between changes in the net lending of general government (that is, in the surplus of thepublic sector) and changes in the private sector savingsinvestment gap and, therefore, betweenchanges in the net lending of general government and the current account balance in EU member-states? (b) Can the Greek current account balance be explained by factors related to economic andfinancial integration a la Blanchard and Giavazzi (2002) as well as the general government deficit?2. Government savings and investment and the private sector savingsinvestment gapIt is well known that we can express the difference between national savings and nationalinvestment (that is, the current account surplus) as the sum of the net lending of general government(NLG)1 and the private sector savingsinvestment gap (SpIp). To the extent that NLG can beconsidered, more or less, as an exogenous variable under government control, it is important toexamine the contribution of the net lending of general government to the overall balance betweennational savings and national investment and, thus, to the evolution of the current account balance.Incidentally it is interesting that many authors (see among others, Gourinchas (2002)) have stressedthat the widening of current account deficits due to financial integration might cause internationalfinancial markets to take fright over the sustainability of the net foreign asset position of countrieswith widening current account deficits. This might require some insurance, or buffer. Smallergovernment deficits (or larger government surpluses) provide such an insurance. Hence it mightbe argued that the limits imposed by the Stability and Growth Pact on government deficits arejustified not only on the grounds of fiscal and monetary stability, but also on grounds related tocurrent account adjustment as a result of financial integration.In any case, general government net lending cannot be ignored in models analyzing the effectsof financial integration. Since financial integration and, in particular, the convergence of interestrates, affect the balance between private savings and private investment, general government netlending could either reinforce this effect or move the balance between national saving and nationalinvestment (and, therefore, the current account balance) to the opposite direction.An important question that is usually asked in this context is the following: To what extent isa change in the net lending of general government matched by an opposite change in the privatesavingsinvestment gap (and through which transmission mechanisms) and, therefore, to whatextent does a change in the net lending of general government affect the current account balance?This leads us to test the following equation:[Sp IpGDP]= a0 + a1[(NLGGDP)]i+ ui (1)1 NLG is equal to government savings minus government investment. Government savings is equal to current governmentrevenue minus current expenditure.598 T. Papadogonas, Y. Stournaras / Journal of Policy Modeling 28 (2006) 595602Table 1Estimation results for Eq. (1)a0 a1 Adj. R2 a1 = 1aAustria 0.04 (0.88) 1.19*** (4.73) 0.45 0.76Belgium 0.02 (0.09) 0.71*** (6.87) 0.59 2.81**Denmark 0.16 (0.09) 0.12 (0.44) 0.02 5.82***Finland 0.53 (1.40) 0.82*** (5.31) 0.50 1.15France 0.08 (0.41) 1.01*** (5.04) 0.52 0.07Greece 0.08 (0.26) 0.75*** (4.95) 0.42 1.66Ireland 0.11 (0.24) 0.74** (2.87) 0.31 1.02Italy 0.10 (0.42) 0.89*** (5.72) 0.59 0.73Netherlands 0.08 (0.31) 0.41*** (3.26) 0.24 4.64***Portugal 0.03 (0.06) 0.93*** (3.44) 0.31 0.28United Kingdom 0.08 (0.38) 1.01*** (6.94) 0.60 0.05t ratios are in parentheses. ** Significant at the 5% level, *** significant at the 1% level (two-tailed tests). Results forGermany, Luxembourg, Spain and Sweden are not reliable due to insufficient observations.a t-tests for the hypothesis H0: a1 = 1. ** Denotes rejection at the 5% level, and *** denotes rejection at the 1% level.Table 1 presents results for 11 EU member-states for this equation.2 These imply a negative andstatistically significant coefficient a1 for all member-states except Denmark with a value close to1. Actually the hypothesis a1 = 1 cannot be rejected for most of these 11 member-states. Also,the constant a0 appears to be statistically insignificant in all member-states. These results implythat changes in the net lending of general government are matched to a large extent by oppositechanges in the private sector savings/investment gap implying a negligible association betweenpublic sector and current accounts balances.This surprisingly strong result might be explained in many ways and has strong policy impli-cations. We will not attempt to present all relevant theories here, since this is outside the scope ofthe present study, nor the full transmission mechanism. However, we will indicate certain possibleexplanations:(A) It might be argued very strongly that these results are consistent with the debt neutralityor Ricardian hypothesis presented earlier, since a stylized fact that would emerge from aRicardian model is precisely the fact that the coefficient a1 in the above equation would be1. An objection to this explanation could be the following: The precise Ricardian positiondoes not refer to the relationship between government net lending and the private sectorsavingsinvestment gap. It refers to the relationship between private savings and governmentsavings in a frictionless and fully rational world, where the private sector, in full anticipationof the future implications of increases in government current expenditure, increases its currentsavings. Moreover, earlier tests by McCallum (1993) for OECD countries reject this Ricardianrelationship between private savings and government savings.(B) MundellFlemingDornbusch models suggest that a reduction in government net lending(that is, an increase in general government deficit) leads to higher output, an increase inreal interest rates and an appreciation of the real exchange rate. These imply higher pri-vate savings and, perhaps, lower private investment (depending on interest rate and income2 All data used in this study come from OECD, National Accounts and cover the period 19702003.T. Papadogonas, Y. Stournaras / Journal of Policy Modeling 28 (2006) 595602 599elasticities). Therefore, they imply a higher private savingsinvestment gap. However, thecorrelation between the increase in general government deficit and the increase in the pri-vate savingsinvestment gap is generally less than unity. A correlation coefficient equal tounity might be derived in models with product real wage rigidity, capital controls and creditrationing (see among others, Gibson, Stournaras, & Tsakalotos, 1992, 1994).(C) The result might be due to a combination of conjunctural factors and financial integration:Maastricht Treaty fiscal criteria promoted fiscal contraction (an increase in government netlending) for member-states with large government deficits and, at the same time, financialintegration affected the private savingsinvestment gap: for borrowing countries the privatesavingsinvestment gap shrank as a result of interest rate convergence, which reduced privatesavings and increased private investment.Although we do not examine empirically the transmission mechanism and the full implications ofthis surprisingly strong result (which definitely requires further investigation), we can draw threeconclusions. Firstly, we should expect a rather small association between changes in the currentaccount deficit and changes in the public sector deficit, as there is strong evidence that changes inthe public sector deficit are matched by opposite changes in the private sector savingsinvestmentgap.3 Secondly, empirical efforts to analyze the effects of financial integration, especially on thecurrent account should not ignore the contribution of government surpluses or deficits. Thirdly,a reduction in public sector deficits is not sufficient to reduce external imbalances: additionalmeasures or incentives to affect the private savingsinvestment gap are also required if it isdeemed that a current account deficit is a cause for concern.3. The determinants of the current account balance in GreeceIn this section we will use the model proposed by Blanchard and Giavazzi (2002) in orderto explain the current account balance in one of the EU member-states, Greece, making use offactors related to economic and financial integration as well as the public sector deficit. Themodel includes n countries, trading goods and assets among themselves. Each country producesits own good, but households in each country consume the same composite good. Householdslive for two periods and maximize logarithmic utility under an intertemporal budget constraint.The optimization problem is:Max{log(Ct) + log(Ct+1)} (2)Subject toCt + [(1 + X)R]1Ct+1 = PtYt + [(1 + X)R]1Pt+1Yt+1 (3)WhereC =[1nni=1C(1)/i]/(1)(4)C is the composite consumption good defined in Eq. (4), which is consumed by all countries, the elasticity of substitution ( > 1), Y the domestic output, P the price of domestic output in terms3 In a model in the tradition of new open economy macroeconomics, Erceg, Guerrieri, and Gust (2005) derive the sameresult for the US.600 T. Papadogonas, Y. Stournaras / Journal of Policy Modeling 28 (2006) 595602of consumption, R the world interest rate in terms of consumption, t the current period, t + 1 thefuture period, and X is the spread at which the representative borrowing country borrows abovethe world interest rate R (this spread is affected by factors such as risk premia).Solving the above optimisation problem, and under various assumptions Blanchard andGiavazzi (2002) obtain the current account balance as a percent of output (1 C/Y) for a borrowingrepresentative country as:CAB = 12[1 11 + X(1 + g1 + g)1(1/)](5)Where CAB is the current account surplus as a percent of output, g* the world rate of outputgrowth and g is the rate of output growth for the country under consideration.4Although Blanchard and Giavazzi (2002) have used Eq. (5) in a heuristic way to explain certainstylized facts, they did not actually estimate it in the empirical part of their paper. In the presentpaper, we estimate Eq. (6), which is derived directly from Eq. (5), in which we have added afiscal variable, the net lending of general government, to capture the contribution of the generalgovernment to national savings:5CAB = a0 + a1NLG + a2X + a3G (6)where the variables are described as follows: CAB, current account surplus (% of GDP); NLG, netlending (surplus) of general government (% of GDP); X, interest rate spread, ideally the differencein interest rates between Greek and German long-term bonds;6 G, difference between the realGDP growth rate of Greece and that of OECD.According to the augmented DickeyFuller test, all variables in Eq. (7) appear to be integratedof order one or lower. We then used Johansens Maximum Likelihood procedure to test for thepresence of cointegration among the variables CAB, NLG, X and G.The maximum likelihood and trace statistics (Lmax and Ltrace) both reject the null hypothesisof no cointegration in favour of one cointegrating relationship at the 5% level. Further, a lagof order k = 3 was chosen for the VAR of the Johansen procedure by the application of theHannanQuinn and Akaike criteria.The results of the econometric analysis are (t-ratios are in parentheses):7CAB = a0 + 0.33NLG(6.35) + 0.52X(11.06) 0.38G(2.36)(7)where ** denotes the significant at the 5% level (two-tailed test) and *** denotes significant atthe 1% level (two-tailed test).In the above equation, the explanatory variables are statistically significant and their coeffi-cients have the expected signs: (a) an increase in the net general government lending (surplus) to4 In the model (1 + g)Yt = Yt+1, where Y* is output aggregated over all n countries (world output). Also(1 + g)Yt = Yt+1, where Y is domestic output. In Eq. (6) the world interest rate R and the price of domestic output interms of consumption, P (which may be called the real exchange rate) do not appear because they are eliminated in thesolution process. Indeed, Pt = (Yt/Yt )1/ and 1/R = Yt /Yt+1 = 1/(1 + g).5 In Blanchard and Giavazzi (2002) there is no public sector. It is straightforward to include it in the model.6 Due to lack of data on long-term bond interest rates in Greece for a sufficiently long period, we estimate X (the interestrate spread) by the inflation differential between Greece and Germany.7 In the information set of the model world oil prices were included to achieve a more correct specification. This variableappeared in the short-run dynamics of the model.T. Papadogonas, Y. Stournaras / Journal of Policy Modeling 28 (2006) 595602 601GDP ratio of one percentage point increases the current account surplus to GDP ratio (or reducesthe current account deficit to GDP ratio) by one-third of a percentage point; (b) a reductionin the interest rate spread (difference between the interest rate at which the domestic countrycan borrow and the world interest rate) of 100 basis points reduces the current account surplusto GDP ratio (or, increases the current account deficit) by one-half of a percentage point; (c)a widening of the growth differential (in favour of the home country) of one percentage pointreduces the current account surplus (or increases the current account deficit) to GDP ratio byover a third (0.38) of a percentage point.As indicated in Section 1, there are many similarities between the findings of this modeland the findings of more traditional ones (MundellFlemingDornbusch models) regardingthe current account balance. First, output growth differentials between the home country andthe world economy affect exports and imports in more traditional models: a high domesticoutput growth and a low output growth of the world economy affect imports of the homecountry more than its exports, depending, of course, on the relative income elasticities. Sec-ond, a reduction in interest rate spreads in more traditional models shift the aggregate demandschedule to the right. With a positively sloped aggregate supply curve, output increases andthe real exchange rate appreciates. As a result, the current account balance deteriorates (see,among others, Stournaras, 2004). Third, an increase in government net lending (that is, areduction in the government deficit) shifts the aggregate demand schedule to the left, domes-tic output falls and the real exchange rate depreciates. As a result the current account balanceimproves.Blanchard and Giavazzi (2002) treat output as exogenous (their model does not specify asupply side). This prevents them from considering important effects on the current account balanceemanating from shifts in total factor productivity, the product and labour market structure, or fromexogenous shocks affecting the cost of domestic output (e.g. an oil price shock). In Stournaras(2004) a positive total factor productivity shock shifts the aggregate supply schedule to the right,domestic output increases and the real exchange rate depreciates. Hence the effect on the currentaccount balance is ambiguous, depending on relative elasticities.4. Summary and conclusionsThe two main findings of this paper are (a) changes in the net lending of general governmentare matched to a large extent by opposite changes in the private sector savingsinvestment gap,in almost all EU member-states and (b) current account developments in Greece are explained, assuggested by intertemporal models of the current account using a utilitarian framework, by factorsrelated to economic and financial integration, such as the growth differential between Greece andOECD and interest rate spreads (as approximated by inflation differentials between Greece andGermany) as well as by the public sector (general government) deficit.The findings imply that an improvement in the general government balance has a positiveimpact on the current account balance, although the effect is rather small as changes in generalgovernment balances are found to be strongly associated with opposite changes in the privatesector savingsinvestment gap. Further research is needed, however, to investigate in more depththe causal links between these factors. The above findings also imply that we should treat changesin the current account balance with care. It is by no means the case that an increase in the currentaccount deficit should always be a source for concern as this could simply reflect the forces offinancial integration and real convergence. Finally, the findings suggest that the public sectordeficit is not a sufficient instrument to affect the current account deficit; if it is deemed that the602 T. Papadogonas, Y. Stournaras / Journal of Policy Modeling 28 (2006) 595602current account is a source for concern, measures or incentives are also needed in order to affectthe private sector savings/investment gap.AcknowledgementsThe authors gratefully acknowledge helpful discussions and comments with VassilisDroucopoulos, Heather Gibson and Ioanna Mpardaka. The usual disclaimer applies; remainingerrors are, of course, our own.ReferencesBarro, R. (1988). The Ricardian Approach to Budget Deficits, NBER Working Paper, no. 2685.Blanchard, O., & Giavazzi, F. (2002). Current account deficits in the Euro area: The end of the FeldsteinHorioka puzzle?Brookings Papers on Economic Activity, 2, 147209.Erceg, C., Guerrieri, L., & Gust, C. (2005). Expansionary fiscal shocks and the trade deficit, Board of Governors of theFederal Reserve System, International Finance Discussion Paper, 25.Fetherston, M., & Godley, W. (1978). New Cambridge macroeconomics and global monetarism. In A. Brunner & A.Meltzer (Eds.), Public policies in open-economies. North Holland.Gibson, H., Stournaras, Y., & Tsakalotos, E. (1992). Twin deficits in credit rationed economies, Studies in Economics,no. 92/9, University of Kent.Gibson, H., Stournaras, Y., & Tsakalotos, E. (1994). Investment and credit-rationing in four European economies. GreekEconomic Review, 16(2), 6581.Gourinchas, P. O. (2002). Current account deficits in the Euro area: The end of the FeldsteinHorioka puzzle? BrookingsPapers on Economic Activity, 2, 147209.Lane, P. (2001). The new, open-economy macroeconomics: A survey. Journal of International Economics, 54, 235266.McCallum, J. (1993). Government spending and national saving. In M. Baldassari, R. Mundell, & J. McCallum (Eds.),Debt, decit and economic performance. MacMillan/St. Martins.Obstfeld, M., & Rogoff, K. (1996). Foundations of international macroeconomics. MIT Press.Stournaras, Y. (2004). Aggregate supply and demand, the real exchange rate and the denomination of oil prices, WorkingPaper 55, University of Athens.Vines, D. (2003). John Maynard Keynes 19371946: The creation of international macroeconomics. The EconomicJournal, 113, F338F361.Twin deficits and financial integration in EU member-statesIntroductionGovernment savings and investment and the private sector savings-investment gapThe determinants of the current account balance in GreeceSummary and conclusionsAcknowledgementsReferences


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