Published Mar 22, 2024 The Backus–Smith puzzle, named after economists Backus and Smith who identified it, relates to an anomaly observed in international economics, especially within the context of real business cycle models. It suggests that, contrary to what one might expect, countries with high consumption volatility compared to output volatility tend to have lower correlations between domestic consumption and output than countries with low consumption volatility. This observation contradicts the theoretical predictions of standard international financial models, which suggest that open financial markets should allow for international risk sharing, enabling countries to smooth consumption more effectively than output. Consider two countries: Country A and Country B. Country A has a relatively closed financial market, which limits the ability of its residents to invest in foreign assets or borrow from abroad. As a result, its citizens’ consumption is highly dependent on the domestic output; when the country’s economy is booming, consumption rises, and when the economy falters, consumption falls sharply. This leads to high volatility in consumption relative to output. Country B, on the other hand, has open financial markets that allow its citizens to invest in foreign assets and borrow from abroad. This international financial integration should, in theory, enable Country B’s residents to smooth their consumption over time, insulating it from fluctuations in the domestic economy. However, the Backus–Smith puzzle points out that, in practice, even countries like Country B often exhibit a weaker correlation between consumption and domestic output than expected, despite their lower volatility in consumption relative to output. The significance of the Backus–Smith puzzle lies in its challenge to the conventional wisdom regarding the benefits of financial globalization. It raises questions about the efficacy of international markets in facilitating risk sharing and consumption smoothing across countries. Addressing this puzzle is crucial for understanding the complexities of international financial markets and for the formulation of policies aimed at enhancing economic stability and welfare. Several explanations have been proposed to solve the Backus–Smith puzzle. These include imperfections in international financial markets, such as transaction costs and barriers to cross-border investments, which may limit risk sharing. Other explanations focus on non-financial factors like differences in consumption preferences across countries, the role of non-tradable goods, and informational frictions that might inhibit optimal international risk sharing. Understanding the Backus–Smith puzzle is important for policymakers because it highlights limitations in the current international financial system’s ability to facilitate risk sharing and consumption smoothing. If financial markets are not perfectly efficient in this regard, policies aimed at improving market access and reducing transaction costs could potentially enhance economic stability. Moreover, identifying the underlying causes of the puzzle could help in designing more effective macroeconomic and financial regulations. Technological advancements and increased globalization have the potential to mitigate some aspects of the Backus–Smith puzzle by reducing transaction costs and barriers to international financial activities. However, as long as there are imperfections in the market and non-financial factors affecting consumption and investment decisions, the puzzle may persist. Continuous research and policy adjustments are necessary to address the ongoing challenges in international risk sharing.Definition of Backus–Smith Puzzle
Example
Why the Backus–Smith Puzzle Matters
Frequently Asked Questions (FAQ)
What are the potential explanations for the Backus–Smith puzzle?
How does the Backus–Smith puzzle affect international economic policy?
Can technological advancements and globalization resolve the Backus–Smith puzzle?
Economics