Investopedia 1/27/2015 James E. McWhinney

Economies that have both a fiscal deficit and a current account deficit are often referred to as having twin deficits. The United States has fallen firmly into this category for years. The opposite scenario, featuring a fiscal surplus and a current account surplus, is generally viewed as a much better financial position. China is often cited as an example of a nation that has enjoyed long-term fiscal and current surpluses.

The First Twin: Fiscal Deficit

Despite being referred to as twins, each half of the duo of debt is actually quite different. Fiscal deficit is the terminology used to describe the scenario when a nation’s expenses exceed its revenues. This situation is also referred to as having a budget deficit.

Intuitively, running a deficit doesn’t sound like positive development, and most conservative investors and many politicians would agree that it isn’t. On the other side of the argument, more than few economists and politicians would point out that deficit spending can be a useful tool for jumpstarting a stalled economy. When a nation is experiencing a recession, deficit spending often helps to finance infrastructure projects, which result in the purchase of material and the hiring of workers. Those workers spend money, fueling the economy and boosting corporate profits, causing stock prices to rise.

Governments often fund fiscal deficits by issuing bonds. Investors buy the bonds, in effect loaning money to the government, and earning interest on the loan. When the governments repay their debts, investors’ principal is returned. Making a loan to a stable government is often viewed as a safe investment. Governments can generally be counted on to repay their debts because their ability to levy taxes gives them a relatively predictable way to generate revenue. (For a closer look at the components of a nation’s fiscal deficit and some additional insight on why deficits gets so much attention from the media and investors, read Breaking Down The U.S. Budget Deficit .)

The Second Twin: Current Account Deficit

A nation is said to be running a current account deficit when its imports more goods and services than it exports. Again, intuition suggests that running a current account deficit isn’t good news.

Not only does running a deficit cost money, as interest must be paid to service the debt, but nations that run a current account deficit are beholden to their suppliers. The exporting nations have the ability to apply financial and political pressure on the importers. This can have significant fiscal, political and even national security implications.

Of course, there are two sides to every argument. A country’s trade balance or international trade balance can be looked as being relative to the business cycle and economy. In a recession, exports create jobs. In a strong expansion, imports provide price competition, which can keep inflation in check. Arguably, a trade deficit is bad during a recession but may help during an expansion.

Also, a country could run a short-term deficit as it imports unfinished goods. Once those goods are transformed into finished goods, they can be exported, and the deficit turned into a surplus. (Read In Praise Of Trade Deficits and Current Account Deficits: Government Investment Or Irresponsibility? to learn ways in which a current account deficit can be a sign of trouble for some countries, and of health for others.)

Twin Deficit Hypothesis

Some economists believe that a large budget deficit is correlated to a large current account deficit. This macroeconomic theory is known as the twin deficit hypothesis. The logic behind the theory is that government tax cuts, which reduce revenue and increase the deficit, result in increased consumption as taxpayers spend their new-found money. The increased spending reduces the national savings rate, causing the nation to increase the amount it borrows from abroad.

Consider that when a nation runs out of money to fund its spending, it often turns to foreign investors as a source of borrowing. At the same time the nation is borrowing from abroad, its citizens are often using borrowed money to purchase imported goods. At times, economic data supports the twin deficit hypothesis. Other times, the data does not. Interest in the theory rises and wanes with the status of a nation’s deficits.

Other Pieces of the Puzzle

The fiscal deficit and current account deficit are just two of the many inputs used to determine a nation’s fiscal situation. In fact, the current account itself is just one of three main categories found within a nation’s balance of payments (BOP). The BOP tracks money coming in and going out of a country. (To learn more, read What Is The Balance Of Payments? and Understanding The Current Account In The Balance Of Payments . )

Investors and policymakers often use trade balance data in their efforts to determine the health of the U.S. economy.