Discuss the effects of government deficits on

A hard and difficult issue.

During the Reagan administration, the creation of twin deficits, whereby slashing taxes, government deficits increased, which was accompanied with increased current account deficits. Using the identity CA = Private Saving – I – (G – T), one can see that if private savings and I are constants, an increase in the deficit, namely an increase in (G – T), necessarily increases the CA deficits by the same magnitude. However, government budget deficit may change both private savings and investment, thus avoiding a creation of the twin deficits.

An example is the European countries reducing their budget deficits just prior to the introduction of the euro in January 1999. Now, under the “twin deficits: theory,” one would have expected the EU’s current account surpluses to increase. This has never happened. The main reason was sharp reduction in private saving rates.

A good answer should discuss Ricardian equivalence, which argues that when the government cut taxes and raises its deficit, consumers anticipate that they will face higher taxes later to pay for the resulting government debt. In anticipation, they raise their own private saving to offset the fall in government saving. In addition, one should mention wealth effect in anticipation of one Europe, assets prices increased, lowering private saving rates.