Discussion Paper No. 778

ADAM SMITH’S ANSWER
TO THE FELDSTEIN-HORIOKA PARADOX:THE INVISIBLE HAND REVISITED
Ayumu Yasutomi
Charles Yuji HoriokaMay 2010

The Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan

ADAM SMITH’S ANSWER TO THE FELDSTEIN-HORIOKA PARADOX:THE INVISIBLE HAND REVISITED*
Ayumu Yasutomi**
Institute for Advanced Studies on Asia, University of TokyoandCharles Yuji Horioka***
Institute of Social and Economic Research, Osaka University, andNational Bureau of Economic Research
Abstract
In this paper, we show that Adam Smith pointed out the existence of theFeldstein-Horioka Paradox or Puzzle and even gave an explanation for it more than 200years before the publication of Feldstein and Horioka (1980). Smith argues that it isthe pursuit of their own security that leads owners of capital to invest their capital intheir own country to as great an extent as possible and that it is the pursuit of security
rather than the pursuit of profit that leads individuals to promote the good of society as awhole via the “invisible hand.”Key words: Feldstein-Horioka paradox, Feldstein-Horioka puzzle, capital mobility,
capital flows, saving, investment, Adam Smith, invisible hand
Journal of Economic Literature classification numbers: B12, F21, F32*The authors are grateful to Yoko Fukao for introducing them to each other and for her
encouragement.
**Institute for Advanced Studies on Asia, The University of Tokyo, 7-3-1, Hongo,
Bunkyo-ku, Tokyo 113-0033, JAPAN.
E-mail: yasutomi@ioc.u-tokyo.ac.jp
Telephone: 81-(0)3-5841-5849 Facsimile: 81-(0)3-5841-5898***Institute of Social and Economic Research, Osaka University, 6-1, Mihogaoka,Ibaraki, Osaka 567-0047, JAPAN. E-mail: horioka@iser.osaka-u.ac.jp Telephone:81-6-6879-8586/8574. Facsimile: 81-(0)6-6879-8583.

I.

Introduction

Exactly thirty years ago, Feldstein and Horioka (1980) pointed out that the correlation
between domestic investment and saving is high even though the correlation between
the two should be zero (in the case of a small economy) and equal to the country’s sharein world capital (in the case of a large economy) if capital is perfectly mobile acrossnational borders. This paradox or puzzle has come to be called the “Feldstein-HoriokaParadox” or the “Feldstein-Horioka Puzzle,” but in this paper, we show that it is not aparadox or puzzle at all. In fact, more than two hundred years before the publicationof Feldstein and Horioka (1980), in his classic An Inquiry into the Nature and Causes ofthe Wealth of Nations (Smith, 1976), Adam Smith pointed out the existence of thisphenomenon and even gave an explanation for it.
To preview our main conclusions, Smith argues that it is the pursuit of their own
security that leads owners of capital to invest their capital in their own country to as
great an extent as possible and that it is the pursuit of security rather than the pursuit ofprofit that leads individuals to promote the good of society as a whole via the “invisiblehand.”II.

Smith’s Views on International Capital Mobility

In Chapter 2 of Book IV, which is entitled “Of Restraints upon the Importation fromForeign Countries of Such Goods As Can Be Produced at Home,” Smith tries todemonstrate that most of the capital of a nation is invested in that country. He writes
as follows: “First, every individual endeavours to employ his capital as near home as
he can, and consequently as much as he can in the support of domestic industry;
provided always that he can thereby obtain the ordinary, or not a great deal less than theordinary profits of stock (G.ed.p.454).” This is precisely the “Feldstein-Horioka
Paradox or Puzzle.”
The reason Smith gives for this tendency is the desire of merchants to reduce “risk andtrouble.” He writes:
Thus, upon equal or nearly equal profits, every wholesale merchant prefers naturally
prefers the home trade to the foreign trade of consumption, and the foreign trade of1

consumption to the carrying trade. In the home trade his capital is never so long out of
his sight as it frequently is in the foreign trade of consumption. He can know betterthe character and situation of the person whom he trusts, and if he should happen to bedeceived, he knows better the laws and of the country from which he must seek redress.
In the carrying trade, the capital of the merchant is, as it were, divided between two
foreign countries, and no part of it is ever necessarily brought home, or placed under hisown immediate view and command....The merchant, in order to save a second loading
and unloading, endeavors always to sell in the home market as much of the goods of all
those different countries as he can, and thus, so far as he can, to convert his carrying
trade into a foreign trade of consumption. A merchant, in the same manner, who isengaged in the foreign trade of consumption, when he collects goods for foreign
markets, will always be glad, upon equal or nearly equal profits, to sell as great a part ofthem at home as he can. He saves himself the risk and trouble of exportation, when, so
far as he can, he thus converts his foreign trade of consumption into a home trade.
Home is in this manner the centre, if I may say so, round which the capitals of theinhabitants of every country are continually circulating, and towards which they arealways tending, though by particular causes they may sometimes be driven off andrepelled from it towards more distant employments (G.ed.pp.454-55).”
And then the famous "invisible hand" emerges:
By preferring the support of domestic to that of foreign industry, [the merchant] intends
only his own security; and by directing that industry in such a manner as its produce
may be of the greatest value, he intends only his own gain, and he is in this, as in manyother cases, led by an invisible hand to promote an end which was no part of hisintention. Nor is it always the worse for the society that it was no part of it. By
pursuing his own interest he frequently promotes that of the society more effectuallythan when he really intends to promote it (G.ed. p.456).”
Thus, Smith argues that it is the owner of capital’s concern about her own security, nother concern about the rate of profit, that leads her to invest her capital domestically to as
great an extent as possible.
Note, moreover, that, contrary to common belief, this is the only usage the term
“invisible hand” in the entire book. Thus, Smith argues that what leads individuals to
promote the good of society as a whole is not the pursuit of profit but the pursuit of2

security! And it is this tendency toward risk-aversion and the dominance of thistendency vis-à-vis the tendency to pursue profits that causes capital to be immobile
between countries.
Granted, capital markets have become much more liberalized than during the days ofAdam Smith, but the higher than expected coefficient in Feldstein and Horioka-type
regressions shows that what Adam Smith wrote more than 200 years ago applies eventoday.
III. Conclusion
In this paper, we show that Adam Smith pointed out the existence of theFeldstein-Horioka Paradox or Puzzle and even gave an explanation for it more than 200years before the publication of Feldstein and Horioka (1980). Smith argues that it is
the pursuit of their own security that leads owners of capital to invest their capital intheir own country to as great an extent as possible and that it is the pursuit of security
rather than the pursuit of profit that leads individuals to promote the good of society as awhole via the “invisible hand.”3

References
Feldstein, Martin, and Horioka, Charles Yuji (1980), “Domestic Saving andInternational Capital Flows,” Economic Journal, vol. 90, no. 358 (June), pp. 314-329.
Smith, Adam (1976), An Inquiry into the Nature and Causes of the Wealth of Nations,volume 2 of Adam Smith, The Glasgow Edition of the Works and Correspondence ofAdam Smith (Oxford: Oxford University Press).

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