The Fighting Deficit Twins
Henry C.K. Liu

This article appeared in NewDeal2.0 on July 1, 2010 and in AToL on July 15.2010
In monetary economics, the trade deficit and the fiscal deficit are referred to as the “Twin Deficits” as if they were genetically related twins merely because they both contribute to increases in the public debt. Yet these two deficits are genetically opposite and can act like fighting twins to neutralize each other in their adverse economic effects.
A fiscal deficit is created by government spending in excess of revenue in the domestic economy. The external penalty of a persistent fiscal deficit is the devaluation of the exchange rate of the domestic currency in foreign trade.  
A trade deficit is created by excess imports over exports in foreign trade. One of the curative measures for a persistent trade deficit has been conventionally identified in trade economics as a devaluation of the domestic currency against those of its trading partners, or in multilateral trade, against a reserve currency. Currency devaluation is expected to make exports less costly and more competitive in price. It is also expected to make imports more costly in local currency terms.
Therefore, there is logic in viewing a fiscal deficit as a solution to a trade deficit through its function in devaluing the domestic currency.
Under the Bretton Woods regime of fixed exchange rate pegged to a gold-backed dollar, it was considered normal that an economy that ran persistent trade deficits would see its foreign trade decline unless the currency was devalued officially, since at that time, foreign exchange markets were not allowed to operate beyond currency settlement at the central bank of the reserve currency – the US Federal Reserve.
A deficit in foreign trade for an open economy is equivalent to a corporation running a loss in domestic market operation due to imbalance between cost of production and sales revenue derived from the market price of its products. The solution to operational losses in a corporation is to either lower the unit cost of its products without reducing quality, or to increase the unit price without affecting sale volume, or an optimum mixture of both.
Increasing the volume of trade would cut operational losses only if the greater sale volume reduces the unit cost of production, and provided that greater sale volume is not achieved through price discounts. If the unit cost in sales is fixed independent of production volume, increasing the trade volume will only exacerbate the losses.
This happened to General Motors at a time when its labor cost per car remained independent of volume of production to result in a negative unit profit margin. Under such circumstances, the more cars GM sold, the higher its losses. The solution then was to shut down production even if that would lead to losing market share.
The monetary regime of an open economy allows the exchange rate of its currency to be determined by market forces. The central bank can still and does intervene in open market operations to keep the exchange rate of its currency at the level targeted by monetary policy. This is done by selling its own currency in the open market for foreign reserves to keep the currency from rising in exchange value, or buying its own currency with foreign reserves to keep it from falling in exchange value.
Depreciating a currency in an open economy without capital control and with full currency convertibility can be achieved by a central bank accumulating foreign reserves through selling its own currency. Or it can be achieved by government running a persistent fiscal deficit to signal market forces to push down the exchange rate of its currency. Thus a controlled persistent fiscal deficit is a form of soft intervention that can produce the same result as a hard intervention of conducting open market operations through selling or buying the currency to accumulate or drain foreign reserves.
Even for countries that have accumulated excessive foreign reserves from trade surpluses, such as China and Japan, the option of soft intervention with a persistent fiscal deficit serves as a way to absorb the excess accumulation of foreign reserves not usable in the domestic economy, through high domestic spending from a fiscal deficit.
For countries that have insufficient foreign reserves and trade deficits, such as the Baltic states in recent years, the option of soft intervention with a persistent fiscal deficit serves as a relatively less painful way to reduce the trade deficit by lowering the exchange value of its currency to stimulate more export.
However, if the trade deficit failed to be reduced or eliminated by currency depreciation alone, as frequently the case, the trade deficit then can only be reduced by lowering the trade volume or in extreme cases, stopped completely. In such a case, a fiscal deficit can still act as a stimulus on the domestic economy to create needed domestic production to replace the reliance on imports and to develop import substitutions.
Of course, the fiscal deficit must be used constructively and not for wasteful indulgence. Furthermore, a perpetual fiscal deficit is unsustainable and will lead to hyperinflation independent of foreign trade. But a controlled fiscal deficit can be an effective measure to wean economies from excess dependence on foreign trade, both for those with trade deficits or those with trade surpluses.    
June 29, 2010