The Twin Deficits of the U.S.

Economies that have both a fiscal deficit and a current account deficit are often referred to as having "twin deficits." The United States has been in this category for years. The opposite scenario—a fiscal surplus and a current account surplus—is generally viewed as preferable, but much depends on the circumstances. China is often cited as an example of a nation that has enjoyed long-term fiscal and current account surpluses.

The First Twin: Fiscal Deficit

A fiscal deficit, or budget deficit, occurs when a nation's spending exceeds its revenues. The U.S. has run fiscal deficits almost every year for decades.

Intuitively, a fiscal deficit doesn't sound like a good thing. But Keynesian economists argue that deficits aren't necessarily harmful, and deficit spending can be a useful tool for jump-starting a stalled economy. When a nation is experiencing a recession, deficit spending on infrastructure and other big projects can contribute to aggregate demand. Workers hired for the projects spend their money, fueling the economy and boosting corporate profits.

Governments often fund fiscal deficits by issuing bonds. Investors buy the bonds, in effect loaning money to the government and earning interest on the loan. When the government repays its debts, investors' principal is returned. Making a loan to a stable government is often viewed as a safe investment. Governments can generally be counted on to repay their debts because their ability to levy taxes gives them a reliable way to generate revenue.

The Second Twin: Current Account Deficit

A current account is a measure of a country’s trade and financial transactions with the rest of the world. This includes the difference between the value of its exports of goods and services and its imports, as well as net payments on foreign investments and other transfers from abroad.

In short, a country with a current account deficit is spending more overseas than it is taking in. Again, intuition suggests this isn't good. Those countries must continually borrow money to make up the shortfall, and interest must be paid to service that debt. For smaller, developing countries, especially, this can leave them exposed to international investors and markets.

A sustained deficit of exports versus imports may indicate a country has lost its competitiveness, or reflect an unsustainably low savings rate among the deficit-running country's people.

Current Account Deficit: It's Complicated

But like budget deficits, the truth about current accounts isn't that simple. In practice, a current account deficit can reflect that a country is an attractive destination for investment, as is the case with the U.S. Consider that advanced economies such as the U.S. often run current account deficits, while developing economies typically run surpluses.

Twin Deficit Hypothesis

Some economists believe a large budget deficit is correlated to a large current account deficit. This macroeconomic theory is known as the twin deficit hypothesis. The logic behind the theory is that government tax cuts, which reduce revenue and increase the deficit, result in increased consumption as taxpayers spend their new-found money. The increased spending reduces the national savings rate, causing the nation to increase the amount it borrows from abroad.

When a nation runs out of money to fund its fiscal spending, it often turns to foreign investors as a source of borrowing. At the same time, the nation is borrowing from abroad, its citizens are often using borrowed money to purchase imported goods. At times, economic data supports the twin deficit hypothesis. Other times, the data does not.