Does economic cycle ingluence twin deficits in Europe? A threshold model.

Abstract

The aim of the paper is to test the impact of output gap on twin deficits existence in euro-area countries and three non-euro area countries (Sweden, Denmark and United Kingdom) over the time 1995 – 2015. The idea is motivated by the fact that certain European countries succeeded to adjust their current account deficits during recession and a principal motor of this adjustment was a decrease in their domestic demand. A panel data threshold model estimated two thresholds of output gap and divided the relation between budget balance and current account into three intervals. If an output gap is slightly negative or positive, the model confirms twin deficits, whereby a “twin relation” is stronger if an output is above its potential level. If an output is importantly below its potential level during recession, we conclude to twin divergence (e.g. in Greece, Portugal and Spain): even though a country increases its budget deficit during recession, it can succeed to adjust its current account deficit. We recommend taking into account an output gap when testing twin deficits as neglecting this effect could potentially lead to spurious rejection of twin deficit hypothesis.