The Feldstein-Horioka puzzle and capital mobility: The role of the recent financial crisis
Introduction
Capital mobility is central to open-economy macroeconomics following the removal of capital controls in many countries during the 1970s and 1980s. Feldstein and Horioka (1980) (FH) investigated this phenomenon and found an unexpectedly high correlation between domestic saving and investment rates. These results led Feldstein and Horioka (1980) to conclude that there was low capital mobility among OECD economies. The paper soon became a puzzle as it contradicts the traditional wisdom of relatively high capital mobility among developed countries.
The voluminous literature that has sprung up as a result reflects, in part, the important implications that the puzzle has on government policy. First, if capital mobility is low, much of the increase in saving would be reinvested domestically (Feldstein, 1983, Schmidt-Hebbel et al., 1996, Coakley et al., 1998). So governments might provide more incentives to encourage saving. Second, in the absence of measurement errors, the difference between domestic saving and investment mirrors the current account balance. A high saving-retention coefficient may therefore reflect governments’ targeting of a current account balance (Obstfeld, 1986, Roubini, 1988, Summers, 1988, Coakley et al., 1996, Taylor, 2002). Third, since the onset of the recent financial crisis, there has been a repatriation of international capital back to domestic countries. This repatriation of finance may have affected the way in which saving and investment move across countries and, as a relatively new theme, this has not as yet become apparent in the literature.
This paper aims to contribute to the literature by investigating the role of the 2008 financial crisis in the puzzle’s development. Specifically, the paper asks the following questions: Is the FH puzzle still a puzzle? Did the recent financial crisis affect the puzzle’s validity in the OECD and are the effects asymmetric across OECD countries? The last two questions have not as far as we know been attempted in the literature yet. This paper argues that the answer to all of the above is yes, and that the puzzle has returned post crisis. This has important policy implications. The rest of this paper is structured as follows. Section 2 reviews the literature. Section 3 sets out the methodology. Section 4 discusses the results and Section 5 concludes with a policy discussion.
Section snippets
Literature review
In a world of perfect capital mobility, saving should be invested to ensure the highest return, regardless of geographical location. Hence, there should be a low correlation between domestic saving and investment rates. Feldstein and Horioka (1980) challenged this post-war consensus by estimating the equation:where , and respectively denote investment, saving, and GDP of country .
In this cross-sectional model, is the saving-retention coefficient. It measures how much
Methodology
This study first draws on the different crisis experiences among net capital-importing and net capital-exporting countries. It then investigates the time-varying saving-retention coefficients using recursive estimations. Three panel techniques – Pooled OLS, Fixed Effects (FE) and Random Effects (RE) – are subsequently employed to examine any asymmetry. There are two main advantages to using panel data. First, the crisis is not yet completely over, meaning the number of observations is limited.
Empirical results
This section discusses the cross-section averages and examines the net balance of capital exports/imports. The latter helps group countries according to their relative position of capital exporting/importing. This will play a key role in the subsequent panel estimations. The first two numerical columns in Table 1a show the averages of the investment and saving rates. Korea appears to have the highest average investment and saving rates in the sample, 31.77% and 32.99% respectively. Domestic
Conclusion
According to the panel results, the OECD’s saving-retention coefficient stands high post crisis. There is also a good level of agreement from the recursive estimates. The crisis substantially affected the puzzle’s validity. For the OECD and net capital-importing countries, the puzzle seems to have faded away in the build-up to the crisis, with some insignificant and negative saving-retention coefficients in 2004–08. But this has reversed since the crisis. The findings match the hypothesis of
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