Twin Deficits: Evidence From Portugal, Italy, Spain and Greece

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DOI: 10.1007/s10272-020-0924-y

Konstantinos P. Panousis and Minoas Koukouritakis

Twin Deficits: Evidence From Portugal, Italy, Spain and Greece Since the mid-2000s, internal and external imbalances have increased in many EU countries. This contributed to the debate over whether government budget deficits affect current account deficits, known as twin deficits hypothesis. It implies that public debt is actually a burden for future taxpayers and thus a dangerous way for budget financing. Therefore, the fiscal measures implemented by policymakers may also affect the current account. This article tests the twin deficits hypothesis for Portugal, Italy, Spain and Greece for the period 1999-2017. The empirical analysis presented in the article finds evidence that strongly supports this hypothesis only for Italy and Greece. For Portugal and Spain, however, the evidence is quite weak. Since the 1980s, a debate has ensued over whether government budget deficits affect the current account deficits. This debate, known as the twin deficits hypothesis (TDH), is supported by Keynesian economists and implies that an increase in a government’s budget deficit (BD) will increase the current account deficit (CAD). On the other hand, the Ricardian Equivalence Hypothesis (REH), first introduced by Barro (1974), postulates that BD and CAD are not related: a BD will be totally offset by changes in savings and thus will not affect the current account. According to REH, the increase in government spending leads to more debt and therefore households increase their savings as they expect higher future taxes for offsetting this debt. However, empirical studies regarding REH provide mixed results. The relationship between BD and CAD is crucial as internal and external imbalances in many EU countries are increasing. If the TDH holds for a country, it implies that the REH is not valid and the public debt is actually a burden for future taxpayers. Consequently, it poses a problem for budget financing and may even lead to a future fiscal cri© The Author(s) 2020. Open Access: This article is distributed under the terms of the Creative Commons Attribution 4.0 International License (https://creativecommons.org/licenses/by/4.0/). Open Access funding provided by ZBW – Leibniz Information Centre for Economics.

Konstantinos P. Panousis, Cosmote Mobile Telecommunications S.A., Athens; and Hellenic Open University, Patra, Greece. Minoas Koukouritakis, University of Crete, Rethymnon; and Hellenic Open University, Patra, Greece.

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sis. This is, of course, quite crucial for policymakers, as the fiscal measures they implement for reducing BD may also affect the current account. This paper first provides an extensive literature review regarding the validity of the TDH, focusing on Portugal, Italy, Greece and Spain. Subsequently, the basic theoretical framework of the TDH and REH is presented, followed by the econometric methodology and the empirical results. There is no strong evidence to support the TDH for Portugal, which implies that an increase in BD will be to