Twin Deficits in Greece: Theory and Evidence from the Last Drachma Journey

Abstract

Global macroeconomic imbalances have been, perhaps, one of the most contentious issues with magnificent implications for policymakers. Over the last decades, there has been an adherence to the view that public saving causes national saving and as such may sequentially represent macro-policy stabilisation targets towards both internal and external (dis)equilibria; hence, the twin deficits phenomenon emerged. In principle, the coexistence of large and unsustainable budget deficits combined with huge and continuous trade deficits is detrimental not only for the rate of economic growth but, worse, it is responsible for reducing the living standards of future generations implying a transfer of wealth to foreigners. In this paper, we consider the adjustment dynamics of trade (im)balances by concentrating on the malign effects of governmental deficits while assessing the role of the national currency within this triangular mechanism in the current account characterisation. The analysis is distinguished from the non-linear strand of the literature by not imposing a priori any identifying assumptions thus reaching unvitiated conclusions. Budget deficits critically affect trade deficits both in the short-run and the long-run analysis. A prominent role is assigned to the accommodative nature of monetary policy which acts, circumstantially, as a complement to the stance of fiscal policy in explaining the secular current account value. Consistent with theoretical models, temporary shocks reflected in monetary and income innovations exert a crucial impact on the trade position. Contrary to conventional priors of relying on currency depreciation in correcting various trade anomalies, the analysis reveals that an improvement of the transitional current account pattern enhances the value of the real exchange rate, exhibiting a rather peculiarly exogenous behaviour, towards smoothing its equilibrium determination.