Weak links in twin deficit chains
Recently, there’s been discussion about President Trump’s tax cuts potentially enlarging the trade deficit. This notion stems from what is known in economic circles as the “Twin deficit” hypothesis, which suggests that the fiscal deficit and trade deficit are closely linked, rising and falling together.
The reasoning appears straightforward. Tax cuts could heighten the fiscal deficit, lead to increased interest rates, bolster the dollar, and thereby reduce imports, causing the trade gap to widen. This sequence of events has been labeled the Feldstein Chain after Martin Feldstein, who articulated this view back in the 1980s.
Furman points out that cutting taxes, as Trump did, will consequently drive both fiscal and trade deficits. This may seem counterintuitive, yet it’s something economists largely agree upon.
However, upon closer examination, the theory has its flaws. While it sounds intuitive, real-world data often suggests otherwise, indicating that the connections within the Feldstein chain are precarious. Numerous economists have pointed out that budget deficits don’t necessarily lead to increased trade deficits.
This marks the beginning of a two-part exploration of the shortcomings in Furman’s argument. Critics argue that tax cuts don’t always result in higher interest rates, won’t necessarily strengthen the dollar, and don’t guarantee a worsening of trade balances. In fact, the link between the fiscal and trade deficits can be conditional, variable, and often weak, with instances where they even move in opposing directions.
A fiscal deficit does not cause a trade deficit
In a 2006 study, economists Leonardo Bartorini and Amartia Rahiri posited that eliminating the entire federal deficit—even at 2% of GDP back then—would only slightly improve the current account deficit by about 0.6% of GDP. Given the current account deficit exceeds 4% of GDP, this implies that the fiscal deficit isn’t a significant driver of trade imbalances.
Moreover, during the Biden administration, while the fiscal deficit as a share of GDP increased, it didn’t result in a widening trade deficit. In 2022, the trade deficit peaked around 3.7% of GDP, and by 2023, the fiscal deficit decreased to about 2.8% of GDP, despite the trade deficit expanding from 5.3% to 6.3%. Thus, historical data contradicts Furman’s stance.
Is it crowded or crowded?
Let’s temporarily sidestep the contentious debate over the likelihood of tax cuts. If we assume higher budget deficits do boost interest rates—a notion taken from macroeconomic textbooks—the evidence backing this hasn’t been convincingly demonstrated. Former Reagan Economic Advisor William Niskanen cautioned in 1988 that this supposed link was at best inconsistent, and at worst, non-existent. Budget deficits do not automatically elevate private investments or interest rates. In today’s open global economy, capital flows freely.
He summarized that while the theory of the fiscal-to-trade deficit relationship is plausible, the supporting evidence for each connection is surprisingly weak. Thus, it shouldn’t be shocking that a direct link between these two deficits appears tenuous. Economists often claim that government deficits “crowd out” private investments by soaking up available capital and raising interest rates, but there’s a valid argument that a government deficit might actually reduce interest rates.
This notion is encapsulated in Ricardo’s view. Notably, economist Robert Barro argued that tax cuts could prompt borrowing through new debt issuance, enabling the public to save and invest in anticipation of future tax obligations tied to increased debt. In such a scenario, a budget deficit might lower interest rates by boosting demand for Treasury securities.
Historically, periods marked by significant, persistent budget deficits have aligned with a long-term decline in interest rates. Furthermore, when the economy is experiencing a deficit mainly due to excessive imports, people might spend less domestically, which could dampen private sector income. An increase in the fiscal deficit can actually stimulate private investments by driving up demand for domestically produced goods and services, enhancing business confidence and projected revenues.
When companies witness rising sales and economic momentum, they’re less inclined to invest. In a world of abundant liquidity in global capital markets, government borrowing often complements rather than displaces private sector activities; it can even encourage them.
Tomorrow, Part II will delve into the flawed assertion that tax cuts will trigger a surge in imports, alongside evidence suggesting that a strong dollar does not necessarily elevate interest rates.
