And the twin deficits

This is for you mom -

The fiscal and capital deficit were first called the "twin deficits" because from 1980 to 86 they increased by the same amount and they are derived from the same economic fundamentals. Why are they dangerous though? First, the capital deficit means more money was being sent away rather than reinvested in the national economy. seccond, an increasing fiscal deficit ment that the goverment was become more and more reliant on outside funding. This increasing foreign indebtedness could eventually lead to concerns about the strength of the American dollar and precipitate a sudden exchange rate "readjustment". Let's take a closer look at this relationship shall we?

Twin Deficit Hypothesis is embodied in the National Income and product accounts frame work or NIPA for short. Basically the equations for the capital account and budget deficit are derived from the national income (or gross domestic product, GDP) equations. First to define the variables,

Y = GDP or national income

The total market value of all final goods and services produced within a country.

C= consumer or consumption spending

This is regular consumer spending on hard and soft goods. Hard goods are defined as goods that last more than one year so they could include washing machines or cars for example. Soft goods, goods that last less than one year, could be daily necessities like food or school supplies.

I = Capital investments

This is business investment expenditures or capital (in the economic sense, goods as a factor of production to produce other goods) acquirement expenditures. These good could be warehouses, machines, or similar things.

G = government spending

Government spending is exactly what it sounds like

X = exports of goods and services

Spending by foreigners on domestically produced goods. Essentially the foreign capital coming in from abroad to purchase domestically produced goods and services

M = imports of goods and services

The opposite from X, the domestic spending on foreign produced goods.

Therefore ultimately,

GDP = C + I + G + (X –M)

This is fairly simple except for the (X-M)

(X-M) = the balance on the current account and it actually includes several other items. However these are small and really just complicate things so for our purposes we will ignore them.

(for those who care X-M includes )

1. Net exports on goods and services.

2. Net imports on goods and services

3. Net income (confusing)

4. Current transfers, settlements associated with the change in ownership of real resources or financial items)

Items 3 and 4 make up a very small part of the current account so you can pretty much not worry about them. After all, what is the US's non reciprocal aid to Rwanda compared to our trade imbalance with china… nothing.

Anyways, you are still probably wondering why we include (X-M) into the GDP equation at all.

X is included because foreigner's purchasing of domestically made products is not included anywhere else in the equation, foreigners aren't C, domestic consumers, G, the government, or I, investments. Therefore the GDP would be undervalued if we did not include their purchases. M, purchases of imported goods or services, on the other hand IS included in C + I + G. these would be the foreign made items consumers purchase from Wal-mart. Remember GDP is the DOMESTIC product, only things produced inside the US therefore we need to strip out any expenditures on foreign products from our GDP equation.

So now we have two equations

GDP = C + I + G + (X-M)

Capital account = (X-M)

This is where things get very cool, watch this now.

In any economy, I (investments) = S (total savings)

When a business wants to make an investment they have to RAISE CAPITAL (in the accounting sense, debt or equity). This capital has three sources,

Savings from the private sector

The consumer's disposable income less tax and consumption spending

Sp = Y – T – C

Y = disposable income

T = tax

C = consumption spending

Savings from the public sector (government)

The difference between tax revenues and government spending. It is important to remember that this is NEGITIVE in the US. The government Spends (G) MORE then it collects (T). (this is the fiscal deficit)

Sg = T – G

T = Tax (review)

G = Government spending (review)

Savings from forgers and invested into the national economy (the US)

Careful now, the amount of extra imports the national economy can buy (M) above the value of exports (X)

Sf = M -X

Ok math time. Let's recombine everything using the Savings- Investment equilibrium and sources of savings

I=S

I=Sp + Sg +Sf

(it's interesting to note that if we can get back to our original GDP equation from here.)

I=( Y – T – C) + (T – G) + (M –X)

OK now recombine

I=Y-C-G+M-X

Y= C+I+G+(X-M) TADAAA our equation for GDP!

But continuing on,

I=Sp +Sg + Sf

I – Sp = Sg +Sf

I – (personal savings) = (fiscal deficit) – (capital deficit)

From here, things get murky, but there seems to be a general trend between the movement of I –Sp and the twin deficits. The movement of one seems to mimic the other. In my next post, I'll take about some of the rational for this movement. However at this point it's important to recognize the connection between personal savings, the fiscal, deficit, and the capital deficit and that historically they have moved together.