Do budget deficits cause current account deficits? a re-evaluation utilizing military expenditures as an instrumental variable

The twin deficit hypothesis suggests that budget deficits are crucial factors leading to current account deficits, and substantial empirical evidence documents a significant positive statistical correlation between budget and current account deficits. However, such evidence generally suffers from endogeneity problems due to reverse causality, thereby making it difficult to provide solid evidence to support policy implementation. We use extensive cross-national panel data from developed and developing countries and military expenditure as an instrumental variable to reexamine the impact of budget deficits on the current account and test the validity of the twin deficit hypothesis. Our results demonstrate that budget deficits lead to current account deficits in both developed and developing countries, supporting the twin deficit hypothesis. After considering various factors that may affect the exogeneity of military expenditures, approximating the instrumental variable as exogenous, and performing multiple robustness tests, the hypothesis still holds. This study provides solid evidence supporting the use of fiscal policies to deal with current account imbalances.