Discussion Paper No. 962

THE 'REAL' EXPLANATION
OF THE FELDSTEIN-HORIOKA PUZZLE

Nicholas FordCharles Yuji Horioka

March. 2016

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

The ‘Real’ Explanation of the Feldstein-Horioka Puzzle
Nicholas Ford
Wolfson College, Cambridge University, Cambridge, U.K.
Charles Yuji Horioka
Asian Growth Research Institute, 11-4, Ohtemachi, Kokurakita-ku, Kitakyushu,Fukuoka, Japan; National Bureau of Economic Research, Cambridge, MA, UnitedStates; Institute of Social and Economic Research, Osaka University, Ibaraki, Osaka,JapanMarch 7, 2016
Abstract
This paper shows that global capital markets cannot, by themselves, achieve net transfersof financial capital between countries and that both the integration of global financial
markets as well as the integration of global goods markets are needed to achieve net
transfers of capital between countries. Frictions (barriers to mobility) in one or both ofthese markets can impede net transfers of capital between countries, produce the Feldsteinand Horioka (1980) results, and prevent real interest rates from being equalized acrosscountries. Moreover, there is empirical evidence that barriers to the mobility of goods
and services are an important obstacle to international capital mobility.
JEL classification codes: F21, F32, F36, G15
Keywords: Barriers to capital mobility, Feldstein-Horioka paradox, Feldstein-Horioka
puzzle, financial market integration, goods market integration, international capital flows,international capital mobility, net transfers of capital, real interest rate equalization, realinterest rate parity, saving-investment correlations, trade frictions
Corresponding author: Charles Yuji Horioka, Asian Growth Research Institute, 11-4,Ohtemachi, Kokurakita-ku, Kitakyushu, Fukuoka 803-0814, Japan. Tel.: +81 93 583
6202; fax: +81 93 583 6576. E-mail address: horioka@iser.osaka-u.ac.jp (C. Y.
Horioka).
Forthcoming in Applied Economics Letters (accepted March 2, 2016).

1. Introduction
Most academic economists presume that net transfers of capital between countries arepossible as long as global financial markets are integrated and gauge the extent to which
there are barriers to capital mobility by the extent to which net transfers of capital occur
between countries.

For example, Feldstein and Horioka (1980) and the subsequent

research they spawned find high cross-country correlations between domestic saving anddomestic investment, which imply that the vast majority of incremental domestic saving
is invested at home rather than abroad, and conclude from this finding that there must be
considerable barriers to international capital mobility (see Apergis and Tsoumas (2009)
for a useful survey of this literature).
Another oft-used gauge of barriers to capital mobility is the extent to which real interest
rates are equalized across countries, and the finding of Mishkin (1984) and others that
real interest rates are not equalized across countries is cited as further evidence of theexistence of barriers to capital mobility.
In reality, however, global financial markets cannot, by themselves, achieve net transfersof financial capital, and the integration of global financial markets is a necessary but not
sufficient condition for achieving net transfers of capital between countries.

It is truethat gross transfers of financial capital can and will take place in both directions if global
financial markets are integrated, but net transfers of financial capital can occur only if, inaddition, global goods markets are also integrated. Consequently, although frictionlessfinancial markets may allow an individual agent’s financial capital to be “perfectly mobile”
between countries, this does not correspond to capital being “perfectly mobile” in thesense of rapid net transfers of financial capital between countries occurring.

This wouldadditionally require the absence of frictions in goods markets (e.g., transport, marketingand distribution costs, technical standards, certification procedures, tariffs and non-tariff
trade barriers, etc.).
To the best of our knowledge, Niehans (1986) is the first economist to have made the1point that global financial markets cannot by themselves achieve net transfers of capital
between countries, but he does not explain why this is the case and he does not seem torealize that it is frictions in global goods markets that impede net transfers of bothfinancial and real capital between countries.
By contrast, Obstfeld and Rogoff (2000) do point out that barriers to the mobility of goodand services may impede net transfers of capital between countries from being achieved
but fail to point out that global financial markets cannot, by themselves, achieve net
transfers of financial capital between countries.
To the best of our knowledge, this is the first paper to synthesize the views of Niehans(1986) and Obstfeld and Rogoff (2000) and to show that global capital markets cannot,
by themselves, achieve net transfers of financial capital between countries and that boththe integration of global financial markets as well as the integration of global goods
markets are needed to achieve net transfers of capital between countries.

Frictions(barriers to mobility) in either of these markets can impede net transfers of both real andfinancial capital between countries, produce the Feldstein and Horioka (1980) results, andprevent real interest rates from being equalized across countries.

Moreover, there isempirical evidence that barriers to the mobility of goods and services are an importantobstacle to international capital mobility (see, for example, Eaton, Kortum, and Nieman(2015)).
2. An Anecdotal Example
A more rigorous formulation of the line of argumentation presented in this paper can befound in Ford (2015), but a simple anecdotal example will suffice to illustrate our point.
In scenario 1, let us assume that there are no barriers to capital mobility or to the mobilityof goods and services. Let’s further assume that Ms. Tanaka, a Japanese investor, wants
to purchase the dollar equivalent of 100,000 yen worth of corporate bonds from Ford
Motor Company.

She will be able to do so because we assume that there are no barriers

to capital mobility.

Ms. Tanaka will simply convert 100,000 of her Japanese yen to U.S.

2dollars and use these dollars to buy Ford bonds.

This means that 100,000 yen worth offinancial capital has moved from Japan to the U.S.
But the story does not end there.

Let us assume that Mr. Smith, an American consumer,

is the one who sold the U.S. dollars to Ms. Tanaka in exchange for her Japanese yen. Mr.
Smith now has 100,000 yen in Japanese currency.

Let’s further assume that Mr. Smithis an avid manga fan and wants to buy 100,000 yen worth of Japanese comic books.
Since we assume that there are no barriers to the mobility of goods and services including
comic books, Mr. Smith will be able to import a 100,000 yen stock of comic books fromJapan and pay for them using the 100,000 yen he received from Ms. Tanaka.

Thanks toboth financial and goods markets being fully integrated, the end result is that there has
been a 100,000 yen net transfer of financial capital from Japan to the U.S. as a result ofMs. Tanaka transferring her 100,000 yen from Japan to the U.S. to purchase Ford bonds
and that there has simultaneously been a net transfer of real capital from Japan to the U.S.
as a result of Mr. Smith transferring a 100,000 yen stock of comic books from Japan tothe U.S.
By contrast, in scenario 2, let us assume that there are no barriers to the mobility offinancial capital but that there are prohibitive barriers to the mobility of goods andservices including comic books.

As in the case of scenario 1, Ms. Tanaka will be able

to convert 100,000 of her Japanese yen to U.S. dollars and uses these dollars to buy thecorporate bonds of Ford Motor Company.

However, the behavior of Mr. Smith willchange relative to scenario 1 because he will no longer be able to import comic books
from Japan.

Let us further assume that Mr. Smith reluctantly decides instead to purchasethe corporate bonds of Toyota Motor Corporation using his Japanese yen, which he cando since we assume that there are no barriers to the mobility of financial capital.

In thiscase, there will be gross transfers of financial capital in both directions between Japanand the U.S. but no net transfers of financial capital between the two countries because
Ms. Tanaka’s purchases of Ford bonds will be exactly offset by Mr. Smith’s purchase ofToyota bonds.

This result arises not because there are barriers to the mobility offinancial capital but because there are barriers to the mobility of goods and services.

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In scenario 3, let us assume that there are no barriers to the mobility of goods and services
including comic books but that there are barriers to the mobility of financial capital. As
in the case of scenario 1, Mr. Smith will be able to buy 100,000 yen worth of Japanesecomic books (say from Ms. Tanaka).

However, Ms. Tanaka will not be able to purchasethe corporate bonds of Ford Motor Company using the U.S. dollars she receives from Mr.
Smith.

If she instead chooses to buy American comic books using her U.S. dollars, there

will be not be any net or gross transfers of financial capital between the two countries.
Finally, in scenario 4, let us assume that there are barriers to the mobility of financial
capital as well as to the mobility of goods and services including comic books.

Undersuch circumstances, Ms. Tanaka will not be able to buy the corporate bonds of Ford Motor
Company so she will have to settle for buying the corporate bonds of Toyota Motor
Corporation. Similarly, Mr. Smith will not be able to buy Japanese comic books so hewill have to settle for buying American comic books.

Thus, there will not be any grossor net transfers of capital (or of goods and services) between the two countries.
In scenario 2, the transactions cost of purchasing foreign assets might be so low that, fromtheir own perspectives, both Ms. Tanaka and Mr. Smith might regard their own capital as
being “perfectly mobile” between countries.

However, this still does not lead to any net

mobility of capital, either real or financial, between countries. Net capital transfers will
occur only when there is a net transfer of goods and services between the two countries(scenario 1). There will be no net transfers of capital between the two countries if there
are barriers to the mobility of either financial capital and/or goods and services between
the two countries (scenarios 2, 3, and 4).

Thus, it is presumably a combination of

scenario 2 (which assumes barriers to the mobility of good and services) and scenario 3(which assumes barriers to the mobility of financial capital) that leads to the Feldsteinand Horioka (1980) finding of high saving-investment correlations and prevents realinterest rates from being equalized across countries.
Furthermore, there is empirical evidence suggesting that scenario 2 is an important4

explanation of the Feldstein and Horioka (1980) results. For example, Eaton, Kortum,and Neiman (2015) find that the Feldstein and Horioka (1980) puzzle is greatly attenuated
if trade frictions are assumed not to exist.
3. Summary and Conclusion
This paper has shown that global capital markets cannot, by themselves, achieve net
transfers of financial capital between countries and that both the integration of global
financial markets as well as the integration of global goods markets are needed to achieve
net transfers of both real and financial capital between countries.

Frictions (barriers tomobility) in one or both of these markets can impede net transfers of capital between
countries, produce the Feldstein and Horioka (1980) results, and prevent real interest rates
from being equalized across countries.

Moreover, there is empirical evidence thatbarriers to the mobility of goods and services are an important obstacle to international
capital mobility.
Acknowledgements
The authors are indebted to Chris Dillow and Graeme Roy for their valuable advice andcomments. This work was supported by JSPS (Japan Society for the Promotion ofScience) KAKENHI Grant Number 15H01950, an Asian Growth Research Instituteproject grant, and a grant from the MEXT Joint Usage/Research Center for Behavioral
Economics, Institute of Social and Economic Research, Osaka University.

Anyremaining errors are the authors’.
References
Apergis, Nicholas, and Tsoumas, Chris (2009), “A Survey of the Feldstein-Horioka
Puzzle: What Has Been Done and Where We Stand,” Research in Economics, vol. 63, no.
2 (June), pp. 64-76.

5Eaton, Jonathan; Kortum, Samuel S.; and Neiman, Brent (2015), “Obstfeld and Rogoff’sInternational Macro Puzzles: A Quantitative Assessment,” NBER Working Paper No.
21774, National Bureau of Economic Research, Cambridge, Massachusetts, USA(December).
Feldstein, Martin S., and Horioka, Charles Yuji (1980), “Domestic Saving andInternational Capital Flows,” Economic Journal, vol. 90, no. 358 (June), pp. 314-329.
Ford, Nicholas (2015), “A Solution to the Feldstein-Horioka Puzzle, and an Exchange
Rate Model that Works,” mimeo., Wolfson College, Cambridge University, Cambridge,U.K.
Mishkin, Frederic S. (1984), “Are Real Interest Rates Equal Across Countries: An
Empirical Investigation of International Parity Conditions,” Journal of Finance, vol. 39,no. 5 (December), pp. 1345-1357.
Niehans, Jurg (1986), International Monetary Economics. Baltimore, Maryland, USA:Johns Hopkins University Press.
Obstfeld, Maurice, and Rogoff, Kenneth (2000), “The Six Major Puzzles inMacroeconomics: Is There a Common Cause?” in Ben S. Bernanke and Kenneth Rogoff,eds., NBER Macroeconomics Annual 2000, vol. 15 (Cambridge, Massachusetts, USA:MIT Press), pp. 339-412.

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