Fiscal Rules and Twin Deficits: The Link between Fiscal and External Balances

• DOI: http://doi.org/10.1111/twec.12427
• Date: 01 January 2017
• Published date: 01 January 2017
• Author: Wolf Heinrich Reuter,Aurélien Fichet de Clairfontaine,Harald Badinger

Fiscal Rules and Twin Deficits: The Link

between Fiscal and External Balances

Harald Badinger

1,2

, Aur

elien Fichet de Clairfontaine

1

and Wolf Heinrich

Reuter

1

1

Department of Economics, Vienna University of Economics and Business (WU), Vienna, Austria and

2

Austrian Institute of Economic Research (WIFO), Vienna, Austria

1. INTRODUCTION

THERE is a large number of studies investigating the twin deficit hypothesis on the link

between fiscal and external balances. Recently, this topic has received additional atten-

tion, given the need of many countries for adjustments of both the fiscal and external balance

in the wake of the financial and economic crisis. The standard rationale for the twin deficit

hypothesis is that a government’s fiscal deficit occurs together with a current account deficit

through demand, interest rate and real exchange rate effects. Numerous empirical studies on

the determinants of the current account have confirmed the positive relation between fiscal

balances and current accounts.

1

Most studies so far have assumed the relationship between fiscal and external balances to

be homogeneous across countries; to the best of our knowledge, none of the previous studies

has considered the role of fiscal rules, which can affect both fiscal and external balances and

the relationship between them. The public finance literature (see, e.g. Poterba, 1994; Perotti

and Kontopoulos, 2002; Canova and Pappa, 2006; Fabrozio and Mody, 2006) shows that

fiscal frameworks, characterised, for example by stringent budget and efficient auditing

processes, can help to reduce fiscal deficits. And as outlined in more detail below, fiscal rules

may have further effects on the current account operating through channels other than the

fiscal balance (such as interest rates and savings). Against this background, fiscal rules may

be an important variable to be considered in empirical studies on the twin deficit hypothesis,

or more generally, the relation between fiscal and external balances.

This study builds on standard empirical models on the determinants of the current account

(Lee et al., 2008; Prat et al., 2010; Lane and Milesi-Ferretti, 2012) and augments these mod-

els by considering the role of fiscal rules. Based on a theoretical discussion of the potential

linkages between fiscal rules, fiscal balances and current accounts, we use a panel of 73 coun-

tries over the period 1985–2012 to test for both direct effects of fiscal rules on the current

account and also consider, whether more stringent fiscal rules affect the relationship between

the fiscal balance and the current account. Thereby, we make use of a novel data set on the

stringency of fiscal rules developed in Badinger and Reuter (2014).

There are three main results: (i) confirming the results of previous studies, we find a posi-

tive relationship between the fiscal balance and the current account; (ii) there is no significant

direct effect of fiscal rules on the current account; and (iii) the magnitude of the effect of the

Financial Support by the Austrian Central Bank (OeNB, Anniversary Fund, project number: 15469) is

gratefully acknowledged.

1

‘Current account’ and ‘external balance’ are used interchangeably throughout this paper.

©2016 John Wiley & Sons Ltd 21

The World Economy (2017)

doi: 10.1111/twec.12427

The World Economy