The twin deficits in OECD countries: cointegration analysis with regime shifts

Abstract

We investigate the question of whether or not government budget deficits and real interest rates have a long–run relationship with the current account of the balance of payments in 23 Organization for Economic cooperation and Development (OECD) countries. Such an investigation is important, since large and persistent budget deficits may impose strains on the foreign exchange markets and are considered by some to be one of the main causes of crises in international financial markets. We permit regime shifts in the cointegration analysis, which extends empirical modelling relative to existing studies. We find that the admission of regime shifts substantially influences the empirical conclusions: we find a long-run relationship between budget deficits, real interest rate and current account deficit in 13 out of 23 countries, whereas the number of countries with apparent long-run relationships is dramatically reduced when regime shifts are not permitted. We argue that, when structural breaks are taken into account, it seems to be the countries with a more extensive financial infrastructure in which the twin deficits are less likely to be conjoined.

Notes

¹ However, the relationship between fiscal and external deficits may be weakened if increases in government expenditures are associated with reductions of private investment (crowding out effect). This happens when economic agents can anticipate that a current increase in public debt is associated with a future tax increase.

² Appendix B contains details of the estimation results.

³ Dates too close to the beginning or end of the estimation period are excluded from consideration; see Equation 4.2.

⁴ We use an ADF t-statistic. GH also provide tables for the Z _α and Z _t tests of Phillips (1987).