Domestic Saving and International Capital Flows

How much of the saving generated inside a country actually stays there? Feldstein and Horioka set two extreme answers against each other – a world capital market in which capital flows until net-of-tax yields are equalised, so that a nation’s saving joins a common pool and its domestic investment is financed from that pool, versus a world in which portfolio preferences and institutional rigidities keep long-term capital where it originates – and note that under the first view the cross-country association between a country’s saving rate and its investment rate should be close to zero (the authors put the implied coefficient at “less than 0.10” on average across their sample, and at zero for an infinitesimally small country), while under the second it should be close to one. They then regress the ratio of gross domestic investment to GDP on the ratio of gross domestic saving to GDP across 16 OECD countries, using averages over 1960-74 so that the estimate reflects long-run rather than cyclical variation. The coefficient is 0.887 with a standard error of 0.074 for gross flows and 0.938 (0.091) for net flows – neither significantly different from one, both plainly incompatible with zero – and the five-year subperiods give 0.909, 0.872 and 0.871. The result survives the checks the authors run: a quadratic term is insignificant, adding population growth barely moves the coefficient, and letting the slope vary with trade openness or with the logarithm of GDP produces interaction terms that are negative but very small. Disaggregating saving for the nine countries with sectoral data, total gross investment responds with a coefficient of 0.957 to aggregate saving, and the household (1.17), government (1.12) and corporate (0.55) coefficients cannot be shown to differ (F = 4.5 against a 5 percent critical value of 5.8). Annual time-series regressions country by country give a much lower average coefficient, 0.64, which the authors are careful to call a short-run response “not comparable” to the cross-section estimate. Their conclusion is stated as a comparative judgement rather than a structural estimate – “the truth lies closer to the second view than to the first” – and they explicitly acknowledge that a high coefficient could in principle reflect some third factor moving saving and investment together, arguing only that the burden of naming such a factor now falls on defenders of perfect mobility. They also insist the finding is compatible with the obvious rapid arbitrage of short-term liquid capital and with large flows of direct investment undertaken to serve markets or exploit production knowledge rather than to chase yield.

Martin Feldstein | Macro Paper Warehouse

Domestic Saving and International Capital Flows