"Twin Deficits" Won't Tank the Dollar

Many analysts have been thinking and writing about the "twin deficits" and whether the record-breaking size of those two deficits, combined, mean the US dollar is about to plummet versus other currencies.

Before we get into the weeds, a little background is necessary. When people talk about the twin deficits they are talking about the budget deficit plus the trade deficit. Combined, these two deficits were 22.8% of GDP in the year ending in the first quarter, easily the highest on record. Before the pandemic, the record high was 12.8% of GDP back in 2009. Before the Financial Crisis, previous peaks included 8.7% in 2004-05 and 8.0% back in 1985-86.

The reason they are called the "twin" deficits is that superficial Keynesian theory suggest they should go together. The idea is that if a country runs a larger budget deficit, it should have higher interest rates, which should drive up the value of the dollar. In turn, a higher dollar means more imports (we can buy more stuff!) and lower exports (foreigners buy less because it costs them more to get dollars).

This theory seemed to work in the 1980s. Budget deficits grew under President Reagan, mostly because of more defense spending, and so did the trade deficit.

However, the theory fell apart in the 1990s, when the budget deficit fell (and even turned into surpluses). If the theory held, you'd expect the trade deficit to shrink, too. But that didn't happen. In fact, the current account deficit, which is the most comprehensive measure of the trade deficit, hit a new peak at 3.9% of GDP in 2000, even higher than the peak of 3.3% in the late 1980s.

What this showed was that the old Keynesian theory behind the twin deficits was too superficial and the two deficits don't have to move in tandem. What really matters isn't whether the government runs a larger or smaller budget deficit; what matters is the set of policies the government is implementing.

In the 1980s, the Reagan Administration cut tax rates, deregulated, and got inflation under control. All of these policies made the US a better place to invest. Those policies attracted capital from the rest of the world, which pushed up the dollar and also increased the trade deficit.

In the 1990s, a large combination of factors helped the economy and also reduced the budget deficit. These include lower inflation (which reduced the effective capital gains tax rate), the "peace dividend" (which allowed for less military spending), President Clinton holding to the federal spending caps inherited from President Bush, the failure of Clinton-care, enacting welfare reform and Medicare reform, free trade pacts, and the natural aging of Baby Boomers into their peak earning years.