The twin deficits in OECD countries: cointegration analysis with regime shifts

We investigate whether government budget deficits and real interest rates have a long-run relationship with the current account of the balance of payments in 23 OECD countries. Such an investigation is of interest since large and persistent budget deficits may impose strains on the foreign exchange markets and are considered by some to be one of the main causes of crises in international financial markets. We permit regime shifts in the cointegration analysis, which extends empirical modelling relative to existing studies. We find that the admission of regime shifts substantially influences the empirical conclusions: we find a long run relationship between budget deficits, real interest rate and current account deficit in 13 out of 23 countries whereas the number of countries with apparent long-run relationships is dramatically reduced when regime shifts are not permitted. We argue that, when structural breaks are taken into account, it seems to be the countries with a more extensive financial infrastructure in which the twin deficits are less likely to be conjoined.