The Tale of Twin Deficits: Which Comes First?

This paper is aimed at contributing to the ongoing debate on the possible bi-directional relationship between government budget deficit and current account deficit in the European Union. While there is a bulk of empirical papers addressing the underlined question this paper takes the most recent time series covering longer time paper (2004Q1-2014Q4) and fairly large number of countries and shows that twin deficits still poised a problem with no clear evidence whether the causality goes from budget deficit to current account or vice versa. This study based on a Pairwise Granger test for all EU countries and indicates that the direction of the causality goes from current account deficit to budget deficit and not vice versa. Splitting the sample into "new EU" and "old EU" members, however, the results seem to suggest that the relationship turns bidirectional. The estimates based the VAR model and corresponding response functions seem to suggest fairly week relationship between budget and current account deficits.