Published Mar 22, 2024 The Feldstein–Horioka puzzle is an economic phenomenon first identified by economists Martin Feldstein and Charles Horioka in 1980. This puzzle questions the widely held assumption of perfect capital mobility across borders by presenting empirical evidence that suggests a strong correlation between saving and investment within national economies. According to the classical economic theory, with perfect capital mobility, a country’s investment should not be limited by its own saving, as it can borrow from or lend to the international capital market. However, the Feldstein–Horioka puzzle showed that, in practice, countries tend to invest mostly what they save domestically, implying that international capital mobility is not as perfect as theorized. To understand the Feldstein–Horioka puzzle, consider two countries with different savings rates. According to the theory of perfect capital mobility, a country with a higher savings rate (Country A) should be able to lend its excess savings to a country with a lower savings rate (Country B), which requires funds for investment. This process should occur until the return on investments is equalized across countries. However, the puzzle points out that in reality, Country A’s high savings rate closely matches its high investment rate, and Country B’s low savings rate mirrors its low investment rate, indicating that countries generally use their domestic savings to finance their domestic investments, rather than engaging extensively in international borrowing or lending. The significance of the Feldstein–Horioka puzzle lies in its challenge to the notion of global financial integration. It suggests that international financial markets may not be as efficient in allocating global savings to the most productive investments worldwide. This has profound implications for economic policy and theory, including: 1. It suggests that governmental policies affecting national savings rates can significantly influence domestic investment levels, contrary to what would be expected if capital were perfectly mobile internationally. While various explanations and interpretations have been proposed, the Feldstein–Horioka puzzle remains a subject of debate and research in international economics. Some economists argue that the observed correlation between savings and investments decreases when accounting for factors not initially considered by Feldstein and Horioka, such as differences in countries’ stages of development, financial market maturity, or adjustment costs. Others propose that the correlation reflects non-financial constraints, such as informational asymmetries or institutional factors, rather than limited capital mobility. However, no consensus has been reached, making the puzzle an ongoing area of inquiry. The Feldstein–Horioka puzzle suggests that countries might benefit from policies that encourage domestic saving, as these savings appear to have a direct impact on domestic investment levels. It also implies that liberalizing capital markets could enhance global savings’ allocation to investments, although the degree of improvement depends on overcoming the constraints implied by the puzzle. Furthermore, understanding the mechanics behind this phenomenon can help policymakers tailor their strategies to either harness or mitigate the effects of the implied relationship between savings and investment. Modern economists recognize that while capital mobility is higher than ever before in history, it is not perfect, and various frictions exist. These include transaction costs, tax differentials, political risks, and regulatory barriers, all of which can affect the flow of capital across borders. The Feldstein–Horioka puzzle serves as a reminder of these limitations, encouraging economists to explore the nuanced mechanics of international finance. Moreover, contemporary research often focuses on dissecting these frictions to understand better how capital mobility operates in practice and how it can be further optimized to facilitate global economic development.Definition of Feldstein–Horioka Puzzle
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Why the Feldstein–Horioka Puzzle Matters
2. It implies that countries may have more control over their economic destiny than global financial integration theory suggests, since they are not as dependent on foreign savings for investment.
3. The puzzle also raises questions about the effectiveness of international capital controls and the potential for countries to protect themselves from global financial shocks.Frequently Asked Questions (FAQ)
Has the Feldstein–Horioka puzzle been resolved?
What are the policy implications of the Feldstein–Horioka puzzle?
How do modern economists view capital mobility in light of the Feldstein–Horioka puzzle?
Economics