TERRIBLE TWINS

A Reagan-era economic trend is making a worrisome comeback

Economists are afraid of twins.

The twin deficits, to be exact—a phenomenon wherein both the federal government’s balance and that country’s trade balance nosedive into negative territory. Since appearing in the US in the 1980s, save for a brief cameo in the early 2000s, they haven’t been around much of late.

Now the twins are back. Big time. And some economists say it’s a sign of vulnerability that the US can’t afford to ignore.

The twin deficit hypothesis

The US trade deficit continues to grow, hitting $57.6 billion in February. And thanks to the Trump administration’s massive stimulus, courtesy of a huge new spending bill and last year’s tax cuts, the US government is set to spend way more than the revenue it brings in. The resulting budget deficit is now on track to blow past $1 trillion in just two years, according to the latest Congressional Budget Office report. By 2028, it will balloon to $1.5 trillion.

The “twin deficit hypothesis” holds that a growing budget deficit drives a widening trade deficit: The government’s debt-fueled spending revs up consumption, which increases imports. Twin deficits are sometimes also seen less through a causal lens, and instead as a sign of perilous glitches in a country’s economy.

Mind you, neither a trade deficit—sometimes known as a current account deficit—nor a budget deficit is inherently “bad.” A budget deficit indicates the government is spending more than the revenue it brings in. A trade deficit means that a country is consuming more than it’s producing, borrowing from abroad to cover the difference.

Whether it’s appropriate to run a trade deficit depends in large part on how that credit is being spent. For fast-growing developing countries, running a big trade deficit is totally fine. They lack the domestic wealth to pay for infrastructure and factories, so they need to import. But the US is in a very different position, which suggests that its trade deficit is a symptom of critical sickliness.

The wisdom of running chronic budget deficits is much harder to evaluate. It’s well understood that during recessions—when an economy isn’t producing as much as it should be—budget deficits are essential for cushioning an economy. The increased fiscal spending offsets the slump in demand, spurring businesses to hire more and, as incomes rise, to make more stuff. This is, for instance, one reason why the US has fared so much better than Europe in the wake of the global financial crisis.

But you probably don’t want to run big fiscal deficits when the economy is already at full capacity, and pretty much everyone who wants to work has a decent job. In an economy that’s already using all its labor and capital—meaning, there aren’t extra people to hire or idle factories to whir into action—pumping in a bunch of money isn’t going to help it produce more. In this situation, running a fiscal deficit raises two bad possibilities.

First, as the government borrows to fund the stimulus, it could push up interest rates, “crowding out” business investment. There’s no real evidence of that happening in the US.

Second, the budget deficit could widen the trade deficit: Since the economy is already operating at full tilt, extra spending can only be satisfied with imports.

That’s what seems to happening in the US right now.

Rising interest rates

The budget deficit will mushroom to around 4.5% of GDP over the next two years, according to Oren Klachkin, lead economist at Oxford Economics, a research firm associated with the eponymous university. And that will force an increase in the current account deficit to more than 3%—the first time it’s hit that level in a decade.

“The twin deficits signal there are rising macro fundamental vulnerabilities” that “are set to become more glaring,” says Klachkin.

Like what?

A chief concern about the terrible twins is what they imply about America’s need to borrow more from foreigners, says Menzie Chinn, an economics professor at the University of Wisconsin who worked on the White House Council of Economic Advisers from 2000 to 2001.

“If the rest of the world says, ‘We don’t want to finance your current account deficit and budget deficit,’ then something has to give,” he says. A weaker dollar would likely help narrow the trade deficit, though its effects wouldn’t show up for a couple of years. However, it’s unlikely to weaken much given that the US is outperforming most other economies, as well as the US’s safe-haven status and the fact that the dollar is the predominant world reserve currency.

A sharp rise in interest rates, however, could douse growth by slowing business activity.

“Given we have massive tax cuts, that’s going to put pressure on interest rates,” says Chinn, who worked on the White House Council of Economic Advisers from 2000 to 2001. “If we hadn’t passed this tax cut I wouldn’t be so worried.”

Of course, all this is happening as the US Federal Reserve begins selling down the bond portfolio amassed through quantitative easing. Meanwhile, as the budget deficit deepens, the US Treasury will need to sell much more debt than it had been doing—about 4% of GDP on net, versus the 2% of GDP it currently does, according to the Council on Foreign Relation’s Brad Setser.

In the early 2000s, the last time twin deficits appeared, the US avoided a spike in interest rates. That’s because oil exporters and currency-manipulating countries were propping up demand for US government debt, which suppressed rates. But the US can’t count on that anymore, notes Chinn. And the more interest the US Treasury has to pay on its bonds, the larger the current account deficit. That’s another reason why the twins seem here to stay.

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