As the federal budget deficit came down as a fraction of gross domestic product (GDP), the trade deficit rose as a fraction of GDP. With the onset of the recession in 2001 and subsequent move to expansion, the coincident shift back to budget deficit, the two deficits began to move together again. The data on Table 2 show a very different pattern in the last half of the 1990s from the twin deficits of the 1980s. Upward pressure on U.S. interest rates was the proximate cause of the inflow of capital, and resulting trade deficit, in both the 1980s and late 1990s. In the 1990s, it came from the increased productivity and related rise in the profitability of private investment. These trade deficits have not hampered the overall creation of jobs. Beginning in 1995, real gross domestic investment rose as a fraction of real GDP reflecting the increase in productivity and related increase in the real rate of return on American capital. Thus, the trade deficit rose even as the budget deficit fell. If the twin deficits theory is correct, it has an adverse implication for the efficacy of fiscal policy as a stimulus tool. It suggests that when international capital flows are highly mobile, the effect of policy induced increases in the structural budget deficit (through tax cuts or increases in government spending) on short-run output growth and employment would be largely offset by increases in the trade deficit.
In the 1980s expansion, the trade deficit and budget deficit moved together. This pattern re-emerged in the recession and subsequent expansion beginning in 2001. This is the opposite of what happened in the last half of the 1990s, when the budget deficit fell as a fraction of gross domestic product (GDP) and the trade deficit rose sharply as a fraction of GDP. From this experience it is clear that international capital flows, which drive the net balance of trade, do not depend solely on movements in the budget deficit. During the last half of the 1990s, real gross domestic investment rose as a fraction of real GDP. This resulted from the rise in U.S. productivity and the related rise in the real yield on U.S. assets. This drew in additional private capital from abroad. If the twin deficits theory is correct, it has an adverse implication for the efficacy of fiscal policy as a stimulus tool. It suggests that in an environment of highly mobile international capital, the effect of policy induced increases in the structural budget deficit (e.g., tax cuts) on short-run economic growth would be largely offset by increases in the trade deficit. The experience during both the 1980s and 1990s demonstrates that a large and growing trade deficit need not be an impediment to overall job creation even though it may have had an effect on the type of jobs that were created since it affected the composition of U.S. output. This report will be updated periodically.