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Twin Deficits and Twin Decades

Twin Deficits and Twin Decades. Jeffrey Frankel Harpel Professor of Capital Formation and Growth Kennedy School of Government Harvard University conference on the Macroeconomics of Fiscal Policy sponsored by the Federal Reserve Bank of Boston, at Wequasett, June 14-16, 2004.

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Twin Deficits and Twin Decades

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  1. Twin Deficits and Twin Decades Jeffrey Frankel Harpel Professor of Capital Formation and Growth Kennedy School of Government Harvard University conference on the Macroeconomics of Fiscal Policy sponsored by the Federal Reserve Bank of Boston, at Wequasett, June 14-16, 2004

  2. Three propositions were put to the test by fiscal expansion of 1980s

  3. tax cuts => big deficits (despite claims to long-run fiscal probity) (Figure 1) part of the problem: overly optimistic forecasts(Figure 4) incl. the Lafferhypothesis: “US tax rate cuts => growth up => tax receipts up” optimistic forecasts soon shattered, although Administration still blames deficits on recession and claims they will go away soon(Figure 5) failure of budget outcomes to follow script => switch to “Starve the Beast” claim “Starve the Beast” claim rings hollow <= WH increases spending(Figure 6) Private saving does not offset deficits => national savingfalls. (Figure 2 or 2b) Economists debate if deficits affect interest rates Fall in national saving reflected in current account deficit. (Figure 3)Twin deficits. (Admittedly, cyclical factors responsible for exaggerating decline in budget, NS, & I at the beginning of decade, but not for overall pattern.) Remarkably close parallels between fiscal expansion of the 1980s and the current decade

  4. Fig.1: US Federal Deficit as Share of GDPby Presidential Term

  5. Fig. 4: Three years of budget forecasts that soon proved too optimistic

  6. Fig. 5: As of 2004, official budget forecasts are still too optimistic Source: Alice Rivlin & Isabel Sawhill, Brookings, 1/13/2004

  7. Fig. 6: US Federal Spending as a Share of GDP, by Presidential Term

  8. Fig. 2b: Private Saving Fails to Rise to Offset Budget Deficits; Rather National Saving Falls (shares of GDP 1980-2002)

  9. Fig. 2: Budget Balances, Private Saving, & National Saving, as Shares of GDP

  10. Fig. 3: National Saving, Investment, % Current Account, as Shares of GDP

  11. Table 2: Feldstein-Horioka Regressions for US -- 1964-2003 • Dependent Variable: Current Account / GDP, Cyclically Adjusted • Coefficient is about 1/2 • Some evidence of upward trend in capital mobility

  12. Differences between the two decades • Differences between early 00s and early 80s: • Interest rates have been low, 2001-2004 • The dollar began to depreciate in 2003 • Not surprising: • The Fed has been very accommodating, so far • Asian central banks, too, have bought US Treasury securities • People are apparently not yet fully aware of the likely magnitude of coming deficits. • Likely to change: i trend will be up

  13. Interest Rates & Expected Budget DeficitsSource: Menzie Chinn and Jeffrey Frankel, October 15, 2003OLS regression using annual data, in levels (Newey-West robust standard errors in parentheses). % variables defined in decimal form. *(**)[***] denotes significance at the 10%(5%)[1%] level.

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