THE TWIN DEFICITS HYPOTHESIS: NEW EVIDENCE FROM GIIPS ACCOUNTING FOR STRUCTURAL SHIFTS IN CAUSAL LINKAGES

Abstract

This study re-examines the dynamic causal link between government budget and current account deficits for five highly indebted European countries: Greece, Ireland, Italy, Portugal and Spain (GIIPS) with newly developed econometric techniques. Utilizing first Toda – Yamamoto causality analysis and then its Fourier approximation to consider structural shifts, this study asks whether accounting structural shifts plays a role on these causal linkages. The results reveal that considering structural shifts is important for the relationship between fiscal and current account imbalances of the GIIPS. The findings of analysis that does not consider structural changes indicate that the twin deficit hypothesis is supported through Keynesian Hypothesis (for Spain) or Current Account Targeting Hypothesis (for Greece and Portugal) but also Barro-Ricardo Equivalence Theorem is acknowledged for Ireland and Italy. On the other hand, the causality analysis that account for structural changes show that current account targeting hypothesis is supported by all countries, except Ireland.