Saturday, December 22, 2007

U.K. "Twin" Deficits Grow

The link between budget deficits and current account deficits is a highly disputed topic. The truth on this matter is that they are related. Not in the sense that budget balances are the only thing affecting current account balances, or even that a change in the budget deficit will ceteris paribus affect the current account balance equally. Instead it is true in the sense that an increase in the budget deficit will simply make the current account deficit larger than it otherwise would have been. How much larger depends on the circumstances and so differ between different countries and different periods of time, but it is probably usually something like a 20 to 40 cent increase in the current account deficit for every $1 increase in the budget deficit.

So, while being related, these two deficits aren't identical twins. Indeed, they're arguably not even fraternal twins, but more like half siblings. Half siblings reared in different environments, as there is one key economic factor which moves them in opposite directíon: the business cycle. An inflationary boom tends to reduce the budget deficit, while increasing the current account deficit. It is therefore rare to see them move empirically in the same direction.

However, sometimes we do see that. That is usually during times of moderate growth when the budget deficit increases. This is what we saw in America 2002-2004 and this is what we see now in Britain.

The budget deficit in Britain have so far this budget year (April-November) been £36.2 billion, up from £26.0 billion the same period last year. Thus we have seen an average monthly increase of £1.3 billion compared to last year. As a result, the forecast from The Economist's Intelligence Unit of a budget deficit of 3.1% of GDP looks set to be exceeded. And even that forecast would have made Britain's deficit the largest in the G7, even larger than in Japan, Italy and France.

At the same time, Britain's current account deficit is reaching new highs,with the third quarter deficit rising to £20.0 billion, 5.7% of GDP. Britain's deficit thus actually exceeded America's deficit as a share of GDP during the third quarter. The increase in the current account deficit reflect in part the increase in the budget deficit but also an overvalued pound.

With expanding "twin" deficits and a weakening economy, the pound seems likely to be one of the weaker currencies in the near future, along with the U.S. and Canadian dollars.


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