Feldstein and Horioka (1980) controversially provide evidence of weak or low capital mobility among industrialized countries based on their FH condition of no correlation between domestic savings and investment. They conduct cross-country estimates of the regression of their basic equation (Eq. (5) in Section 3.1.3.) for a sample of 16 OECD countries for the period 1960 – 1974. This gives an estimate of β of 0.89 for the entire sample period.2 The coefficient proves statistically significantly different from one but is also incompatible with the hypothesis that the true value of β is zero. In their interpretation: “the evidence strongly contradicts the hypothesis of perfect world capital mobility and indicates that most of any
incremental savings tends to remain in the [domestic] country”. (1980, p 321). Feldstein (1993) repeats the same finding for an extended sample to the late 1970s, with an estimate for β of 0.865 for this latter period and 0.80 for the entire sample period. Though lower than for the initial sample, indicating a higher degree of capital flows among industrialized countries in the second half of the 1970s, their earlier finding seems to be confirmed. Given the importance of Feldstein and Horioka’s findings of savings-investment
correlations, they are listed in Table 2.2.
These results from Feldstein and Horioka fly in the face of findings from interest parity deviations and the general convention that financial markets in the 1980s are more open and integrated following widespread deregulation. This is known in the literature as the FH puzzle. To add to the puzzle,
2 This is in case where gross savings and investment are used. Feldstein and Horioka also provide results in case net savings and investment are used. In general, values of β tend to be even higher but also less reliable as net values are derived using an estimate of depreciation which tends to bias β upwards. I therefore only report values of β based on gross savings and investment.
Table 2.2
The relation between gross domestic savings and investment ratios
Sample period Constant FH coefficient (ββββ) R2
1960 – 1974 * 0.035 (0.018) 0.887 (0.074) 0.91
1975 – 1979 ** 0.046 (0.042) 0.865 (0.185) 0.57
1960 – 1979 ** 0.057 (0.028) 0.796 (0.112) 0.75
Standard errors are shown in parentheses.
* From Feldstein & Horioka 1980, Table 2, p 321
** From Feldstein 1993, Table 2, p 135
Feldstein and Horioka (1980) report that the finding of a high value for β remains valid when incorporating the rate of population as an exogenous variable in the basic equation to deal with the possible impact of a third variable when β is permitted to vary with a measure of the openness of the economy, or if indeed the basic equation is re-estimated using 2SLS to deal with the endogeneity of the savings ratio. Feldstein (1993) demonstrates that the result is consistent with a portfolio model. Furthermore, the main FH finding of high savings-investment correlations remains remarkably robust in many empirical studies that follow, both in cross-section and time-series studies (mainly of OECD countries) and has become one of those stylized facts of economics.
Feldstein and Horioka’s proposition is that their finding is compatible with international mobility of short-term capital, because “a small part of the total world capital stock is held in liquid form and is available to eliminate short-term interest rate differentials, [while] most capital is apparently not available for such arbitrage-type activity among long-term investments” (1980, p 328). This provides little comfort to other scholars in the field. A flood of articles follow in an attempt to resolve the FH puzzle. While it is impossible to review them all, I rely on Coakley et al. (1998) for a summary of the various reactions to the FH puzzle. They divide the line of enquiry in the FH puzzle into two: ones to do with measurements of the savings-investment correlation and others to do with providing alternative interpretations to its result.
Indeed the initial response is to target errors of measurement to explain the FH finding. As regards data errors, focus is on sample sensitivity. The FH finding proves to be pretty robust in many repeat tests that immediately follow, with the exception of three results clouding the FH finding. First, differences resulting from the inclusion of less developed countries. Dooley et al. (1987) are one of the first to report evidence of a statistically different effect when they examine 62 countries of which 48 are developing countries and 14 are OECD countries. They find in OLS regressions that relate the savings and investment ratios, that the coefficients are higher for the industrial countries than for the developing countries, although they also find that the difference in these coefficients is not statistically significant when the entire sample is pooled. Montiel (1994) provides what is widely regarded as the definitive proof of the development effect when he calculates estimates of β on the largest sample to that date, for 62 developing countries for the period 1970-1990, and finds a surprisingly high degree of capital mobility according to this
measure. The finding of higher FH capital mobility for many less developed countries than for industrial countries with more highly developed capital markets and fewer explicit capital controls, however, only adds to its controversy. Secondly, differences resulting from the inclusion of large countries or country blocs. This possible effect is alluded to by Feldstein and Horioka. When a country large enough to affect world financial market conditions experiences a fall in national savings, it might drive up interest rates and crowd out investment everywhere in the world. Dooley et al. (1987) attribute their development effect to a large country effect as they notice that their sample of developing countries contain small countries which cannot influence world interest rates. Coakley et al. (1998) report that several studies indeed find evidence of a country size effect, producing statistically significantly higher β values for large country groups than for small country groups. Jansen (1996) also finds such evidence with the estimation of his error correction model for 40 OECD countries over 40 years, namely that the large countries in his sample (USA, Japan), the EEC and the OECD have estimates of β close to one. Thirdly, differences resulting from regional effects.
Contrary to the previous two, these have been supportive of the FH finding. For example, Bayoumi and Rose (1993) use data for eleven regions in the UK for the period 1971-1985 and do not find a positive correlation between savings and investment in FH style regressions, which they deem consistent with the FH hypothesis. Coakley et al. (1998) report that other regional studies find similar results.
As regards econometric errors, the focus is on misspecification (common factors that can explain movements in savings and investment have been omitted), simultaneity bias (savings and investment are endogenous variables), financial and non-financial integration (the explanation is insufficiently integrated goods markets or markets of (non-traded) physical capital such that real interest rates are not equalized), cointegration (in the long run savings and investment are tied together, for example by the intertemporal budget constraint) and related to this, non-stationarity (the null of a unit root in national savings and investment rates cannot be rejected). Dooley et al. (1987) are one of the first to confront the endogeneity problem with an instrumental variables approach, including military expenditure over GNP and a
dependency ratio in the basic FH equation, but this does little to clear up the FH puzzle. They ultimately attribute the FH finding to the breakdown of real interest parity conditions. Indeed, Coakley et al. (1998) report that the employment of various instrumental variables does not seem to alter the thrust of the FH finding. Exploring evidence of cointegration is a more useful exercise. Kroll (1986) finds evidence that a country’s intertemporal budget constraint biases results against capital mobility when using time-averaged data as Feldstein and Horioka do. Using annual data for 1962 – 1990 for 21 OECD countries instead and controlling for country size and international business cycle effects, Kroll’s evidence suggests that capital is mobile internationally. Jansen (1996) also finds that savings and investment hold together in the long run by an intertemporal budget constraint in several countries, the EEC and the OECD as a whole. Correcting for this and for the notion that the current account converges to a constant in the long run, he finds a low β
value for eight countries and an average β value over the whole sample of 0.57, which is significantly below Feldstein and Horioka’s finding (see Table 2.2). Furthermore, Coakley et al. (1998) confirm that several studies find that time-series of savings and investment are non-stationary and the problem with this is, as Ghosh (1995) points out, that the correlation between them then becomes meaningless: “either savings and investments are integrated, in which case their asymptotic correlation is unity, or they are not co-integrated in which case their asymptotic correlation is zero.” (1995, p 108). De-trending the data or expressing it as fractions of GDP does not resolve this econometric problem.
Another major line of enquiry is to provide an alternative interpretation to the FH finding and to reconcile it within specific economic models. Here, several authors construct theoretical models that simultaneously incorporate savings-investment correlations and perfect or high capital mobility. Coakley et al. (1998) state that these include general equilibrium models, real business cycle models and
intertemporal models of the current account. Obstfeld (1986) is an example of the first, developing a life-cycle model of consumption and growth in the world economy in which countries’ savings and investment are correlated though capital is perfectly mobile. It is demonstrated through simulated regression analysis that this theoretical model is capable of producing results similar to those reported by Feldstein and Horioka. This particular line of enquiry subsequently produces its very own measure of international financial integration based on cross-country consumption growth correlations (see Section 3.1.4.). Ghosh (1995) provides an example of the latter when he compares the variance of an optimal consumption smoothing current account assuming perfect capital mobility with the consumption smoothing component of the actual current account to determine capital mobility. He finds that for five major industrialized countries between 1960 and 1988, for all apart from the US this variance is higher, pointing to excess capital flows. Coakley et al. (1998) report that the general results of these contributions are actually opposing the FH finding with the one exception of Barro-style modified neoclassical growth models in which human capital is immobile.
Taken together, this barrage of literature forms a pretty damning criticism of the
savings-investment correlation strand as an appropriate measure for international financial integration. Coakley et al. (1998, p 171) sum the whole discussion up perfectly when they note that “despite the apparent
robustness of the FH result of a high savings-investment association, the FH view or interpretation that the FH coefficient (β) can be identified as a measure of international capital mobility has been widely
challenged since it is not obvious what structural parameters this equation measures.”