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THE TWIN DEFICITS HYPOTHESIS: EMPIRICAL EVIDENCE FROM CROATIA

Large and persistent budget deficits have occurred together with current account deficits in many (industrial) countries over the past two decades. This important issue known as the “twin deficits” has intrigued many researchers, economists and policy- makers. A large body of literature examines this crucial relationship for developed and developing economies, and yet the most pertinent conclusion from all this work remains the heterogeneity of its findings. Our empirical results concludes more in favour of the Ricardian equivalence because there is not a strong link between budget deficits and current account deficits in Croatia. This paper shows that there is no Granger causality amid the trade and budget deficit in Croatia in both directions. Moreover, changes in the budget deficit do not affect the trade deficit at all, while the influence of the latter on the budget deficit is around 5%. A stronger interest rate channel of monetary transmission would perhaps enhance the self- correction among the twins, but qualitative (and needed) structural reforms both in the government sector as well as in export would in the long run enhance the trade and budget balance and improve the overall economic framework in Croatia. We believe that a real solution to the problem of fiscal deficits and current account imbalances lies in a coherent package consisting of both fiscal and monetary policies. Appropriate policy measures focusing on productivity improvement, improvment of terms of trade, fiscal consolidation to raise public saving, exchange rate and monetary stance will complement the budget-cut policy. It seems prudent to reduce budget (and trade) deficit and remember Keynes’ famous quote “in the long run we all are dead!”

fiscal deficit, current account deficit, twin deficit, Croatia, VAR model

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