Why the Feldstein-Horioka “Puzzle” Remains Unsolved

Levy Economics Institute, Working Papers Series

36 Pages Posted: 5 May 2022

See all articles by Jesus Felipe

Jesus Felipe

De La Salle University

Scott Fullwiler

University of Missouri at Kansas City

Al-Habbyel Yusoph

Bocconi University - Department of Accounting

Multiple version iconThere are 2 versions of this paper

Date Written: April 29, 2022

Abstract

This paper argues that the 40-year-old Feldstein-Horioka “puzzle” (i.e., that in a regression of the domestic investment rate on the domestic saving rate, the estimated coefficient is significantly larger than what would be expected in a world characterized by high capital mobility) should have never been labeled as such. First, we show that the investment and saving series typically used in empirical exercises to test the Feldstein-Horioka 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, i.e., 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 one. Since the omitted variable is known, we call it “pseudo bias.” Given that this (pseudo) bias is known to be negative and less than one in absolute terms, it should come as no surprise that the Feldstein-Horioka regression yields a coefficient between zero and one.

Keywords: Accounting Identity, Feldstein-Horioka Paradox, Investment, Pseudo Bias, Saving

JEL Classification: E01, F21, F32, F36, F41, G15

Suggested Citation

Felipe, Jesus and Fullwiler, Scott and Yusoph, Al-Habbyel, Why the Feldstein-Horioka “Puzzle” Remains Unsolved (April 29, 2022). Levy Economics Institute, Working Papers Series, Available at SSRN: https://ssrn.com/abstract=4097136 or http://dx.doi.org/10.2139/ssrn.4097136

Jesus Felipe (Contact Author)

De La Salle University ( email )

2401 Taft Avenue
Manila, Metro Manila 1004
Philippines

Scott Fullwiler

University of Missouri at Kansas City ( email )

5100 Rockhill Road
Kansas City, MO 64110-2499
United States

Al-Habbyel Yusoph

Bocconi University - Department of Accounting ( email )

Via Roentgen 1
Milan, 20136
Italy

HOME PAGE: http://alyusoph.com

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