Academic journal article Economic Inquiry

Theory-Based Measurement of the Saving-Investment Correlation with an Application to Norway

Academic journal article Economic Inquiry

Theory-Based Measurement of the Saving-Investment Correlation with an Application to Norway

Article excerpt


The findings of Feldstein and Horioka [19c,0] have led to numerous theoretical and empirical papers on the close correlation between domestic saving and domestic investment and its supposed implications for international capital mobility. Feldstein and Horioka [1980, 317] state that "with perfect world capital mobility, there should be no relation between domestic saving and domestic investment: saving in each country responds to the worldwide opportunities for investment while investment in that country is financed by the worldwide pool of capital." However, in a cross-country regression using period-averaged saving and investment figures for sixteen OECD countries, they obtain a significant coefficient close to unity and conclude that capital is rather immobile. This result constitutes the "Feldstein-Horicka puzzle," as it contradicts the widely held perception that capital is highly mobile across countries. Subsequent empirical work confirmed the close correlation, though its implication for the degree of capital mobility is a moot point (see Tesar [1991]).

This paper contributes to the understanding of the puzzle on both theoretical and empirical counts. First, we present a theory-based econometric specification for estimating saving investment correlations. Second, we discuss the possible usefulness of the estimates for detecting capital mobility. Third, we provide empirical results for the interesting case of Norway. We argue that Feldstein and Horioka's basic idea that the saving-investment correlation contains information about international capital mobility is correct, but that the interpretation of the estimated correlation value must be altered substantially in view of the results derived from modern macroeconomic models.

Our research is motivated by the observation that various regression equations have been used to measure the saving-investment correlation, but that none of them has a firm theoretical foundation. This in turn raises questions about the interpretation and comparability of the existing empirical results. We propose an econometric specification that is founded in intertemporal general equilibrium models, in which agents optimize under intertemporal budget constraints. We show that time-series studies have estimated misspecified equations and that cross-section studies are seriously flawed because they neglect dynamics. As a result the puzzle may turn out to be an artifact caused by measurement errors. However, the significance of reliable measurement of saving-investment correlations goes beyond solving the "Feldstein-Horioka puzzle," because they represent stylized facts open economy models should explain.

Norway serves as a suitable example to cement our methodological arguments with empirical evidence, thanks to its system of capital controls, which were phased out during the 1970s and 1980s, the oil discoveries and its small size. We demonstrate that the failure to take structural breaks into account seriously distorts the picture, making a strong case for careful diagnostic testing. Our main empirical result is that the "Feldstein-Horioka puzzle" does not exist for Norway.

The paper proceeds as follows. In section II we briefly summarize the state of the discussion regarding Feldstein and Horioka's findings. In section III we derive our specification from the theory, compare it to the previous specifications, and discuss how to make inferences about capital mobility. In section IV we sketch major developments in the post-war Norwegian economy, notably the abolition of capital controls and the emergence of the important oil sector. Section V presents the empirical results. Section VI summarizes and concludes.


Many authors have confirmed Feldstein and Horioka's result of a high and stable correlation of saving and investment for OECD countries, both in cross-country studies and in time-series studies. …

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