Why the Feldstein-Horioka “Puzzle” Remains Unsolved

• Main Authors: Felipe, Jesus, Fullwiler, Scott, Yusoph, Al-Habbyel
• Format: text
• Published: Animo Repository 2022
• Subjects: accounting identity; Feldstein-Horioka paradox (puzzle); investment; pseudo bias; saving
• Online Access: https://animorepository.dlsu.edu.ph/res_aki/3; https://animorepository.dlsu.edu.ph/context/res_aki/article/1002/viewcontent/dlsu_aki_working_paper_series_2022_06_084.pdf
• Institution: De La Salle University

This paper argues that the 40-year-old Feldstein-Horioka “puzzle” (i.e., in a regression of the domestic investment rate on the domestic saving rate, the estimated coefficient is significantly larger than expected in a world with high capital mobility) should have never been labeled as such. First, we show that the series of investments and savings typically used in empirical exercises to test the FeldsteinHorioka thesis are not appropriate for testing capital mobility. Second, and complementary to the first point, we show that the Feldstein-Horioka regression is not a model in the econometric sense, that is, an equation with a proper error term (a random variable). The reason is that by adding the capital account to their regression, one gets the accounting identity that relates the capital account, domestic investment, and domestic saving. This implies that the estimate of the coefficient of the saving rate in the Feldstein-Horioka regression can be thought of as a biased estimate of the same coefficient in the accounting identity, where it has a value of 1. Because the omitted variable is known, we call it pseudo bias. Given that this (pseudo) bias is known to be negative and less than 1 in absolute terms, it should come as no surprise that the Feldstein-Horioka regression yields a coefficient between 0 and 1