Feldstein–Horioka puzzle

The Feldstein–Horioka puzzle is a widely discussed problem in macroeconomics and international finance, which was first documented by Martin Feldstein and Charles Horioka in an 1980 paper. Economic theory assumes that if investors can easily invest anywhere in the world, acting rationally they would invest in countries offering the highest return per unit of investment. This would drive up the price of the investment until the return across different countries is similar.

The discussion stems from the economic theory that capital flows act to equalize marginal product of capital across nations. In other words, money flows from lower to higher marginal products until the increased investment equalises the return with that obtainable elsewhere. According to standard economic theory, in the absence of regulation in international financial markets, the savings of any country would flow to countries with the most productive investment opportunities. Therefore, domestic saving rates would be uncorrelated with domestic investment rates. This is the same fundamental insight which underlies several other results in economics like the Fisher separation theorem.

Feldstein and Horioka argued that if the assumption is true and there is perfect capital mobility, we should observe low correlation between domestic investment and savings. Borrowers in a country would not need the funds from domestic savers if they could borrow from international markets at world rates. Similarly, savers as savers would show no preference for investing within their own country, but would lend to foreign investors and would not need to lend domestically. For example, a saver in France would have no incentive to invest in the French economy, but would invest in the economy which offers the highest return on capital. Therefore, increased saving rates within one country need not result in increased investment. However, statistical data does not bear this out.

For example, if the capital flows between OECD countries are reasonably free, this should hold true in those countries. But Feldstein and Horioka observed that domestic savings rates and domestic investment rates are highly correlated, in contrast to standard economic theory.

Maurice Obstfeld and Kenneth Rogoff identify this as one of the six major puzzles in international economics. The others are the home bias in trade puzzle, the equity home bias puzzle, the consumption correlations puzzle, the purchasing power and exchange rate disconnect puzzle, and the Baxter–Stockman neutrality of exchange rate regime puzzle.

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