The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?

Home bias in trade, Feldstein-Horioka, home bias in equity portfolios, low international consumption correlations, the purchasing-power-parity puzzle, and the exchange-rate disconnect puzzle – grouped because the authors think one friction explains all six. The opening paragraph poses each as a question: “Why do people seem to have such a strong preference for consumption of their home goods (the home-bias-in-trade puzzle)? Why do observed OECD current-account imbalances tend to be so small relative to saving and investment when measured over any sustained period (the Feldstein-Horioka puzzle)? Why do home investors overwhelmingly prefer to hold home equity assets (the home-bias portfolio puzzle)? Why isn’t consumption more highly correlated across OECD countries (the consumption correlations puzzle)? How is it possible that the half-life of real exchange-rate innovations can be three to four years (the purchasing-power-parity puzzle)? Why are exchange rates so volatile and so apparently disconnected from fundamentals [the exchange-rate disconnect puzzle, of which the Meese-Rogoff (1983) forecasting puzzle and the Baxter-Stockman (1989) neutrality-of-exchange-rate-regime puzzle are manifestations]?” (Section 1). The proposed common cause is “a (significant but plausible) level of international trade costs in goods markets,” where “these trade costs may include transport costs but also tariffs, nontariff barriers, and possibly other broader factors that impede trade.”

It refuses to pick a capital market imperfection per puzzle, and asks instead how much can be explained with a goods market friction alone. The contrast with standard practice is stated directly: “Typically, an author chooses from a menu of plausible capital-market imperfections the one best suited to explain a particular puzzle. We do not deny the importance of a variety of imperfections peculiar to international asset markets. Our goal here, however, is to show how far one can go in elucidating major empirical riddles without appealing to intrinsically international capital-market imperfections. Remarkably, we find that once one allows for trade costs in goods markets, many of the main empirical objections to the canonical models of international macroeconomics disappear” (Section 1). The authors also disclaim priority: Samuelson (1954) “argued that the existence of an international transfer problem depends critically on whether there is a home bias in consumption, and he showed explicitly how a home bias could be derived from transport costs,” but “in subsequent research, however, Samuelson’s straightforward approach has generally been abandoned in favor of a more stylized paradigm based on breaking up a country’s products into two dichotomous categories, traded and nontraded goods.”

Because the dividing line is arbitrary and endogenous, and because trade costs are easier to think about concretely and quantitatively. The authors state the general judgment early – “for many purposes, this dichotomous grouping is far less helpful than the natural alternative of simply introducing trade costs” (Section 1) – and give the specific reasons in the portfolio section: “the sharp dichotomy between traded and nontraded goods is a contrived one, since in reality transport costs differ across goods, and a particular good may or may not enter trade under different market conditions. For most goods, tradability is not absolute and tradedness is endogenous” (Section 4). Notably, they concede that the dichotomous model can reproduce the qualitative shape of their central Feldstein-Horioka result: “for a pure endowment case, the standard traded-nontraded model does produce a graph very much like Figure 1. … We prefer our formulation largely because it is much easier to think concretely about trade costs than about the arbitrary dividing line between traded and nontraded goods. Perhaps the ideal model would be a richer one incorporating a range of transport costs in which the degree of tradability is endogenous and some goods are consistently produced exclusively for the home market” (Section 3.6.4).

Considerable, but well short of McCallum’s original factor of twenty. McCallum’s gravity estimate “found that trade among individual Canadian provinces was twenty times greater than trade between individual Canadian provinces and individual U.S. states,” on 1988 data, “still at the dawn of the U.S.-Canada free-trade agreement, and before trade patterns had time to adjust fully.” Helliwell, using 1993-1996 data, “found that the unexplained home bias had fallen to a factor of 12, which remains a surprisingly large number.” Indirect methods for other OECD pairs give lower numbers: “Wei suggests that the average bias may be as low as 2.5, while Evans finds values intermediate between Wei’s and Helliwell’s.” Van Wincoop’s critique is that McCallum’s measure “gives an exaggerated impression of home bias in global trade because it calculates the bias from the perspective of the small country, Canada, rather than from the perspective of the large country, the United States,” and using US interstate data “estimates that the U.S.-Canada border reduces trade between the two countries by at most 30%.” The authors’ own summary: “a balanced interpretation of the literature is that countries do exhibit a considerable degree of home bias in trade, but the bias is not as extreme as McCallum’s original estimates suggested” (Section 2).

Through the interaction with the substitution elasticity: with an elasticity of 6 and trade costs of 25 percent, home goods outweigh imports in home spending by a factor of 4.2. The model is a two-country endowment economy with CES preferences over home and foreign goods and iceberg costs, so competitive arbitrage puts the home price of the imported good above and the exported good below the foreign price, and in the symmetric case the expenditure ratio is a simple power function of the trade cost (Section 2.1). The illustration: “if there were no trade costs then [the ratio equals] 1. If τ = 0.25 (a large number just for goods actually traded but conservative when applied to all of GNP) and θ = 6, then CH/pCF = 4.2. This ratio is consistent with those we observe for many OECD countries, and the degree of home bias can easily be made larger by raising τ, raising θ, or assuming that the home country is a small one trading with many like-sized foreign partners.” The relationship is nonlinear – “the higher trade costs …, the greater the impact of a 1% reduction” – with a baseline elasticity of home bias with respect to trade costs of 1.67. The authors flag the model’s crudeness: “Obviously, this example is wildly oversimplified. It implicitly assumes a common substitution elasticity across any individual pair of home and foreign goods, and similarly lumps all goods together as having common trade costs. It ignores the potential importance of substitution between domestic and foreign inputs in production. Nevertheless, it neatly illustrates how a high elasticity of substitution can explain a large observed home trade bias even with low trade costs.”

Estimates for traded goods cluster around 5 to 6, with wide industry dispersion, and the authors argue the economy-wide value should be higher still. Trefler and Lai’s panel of 28 industries across 36 countries over 1972-1992 gives “a preferred estimate [of] 5.3. That average number reflects estimated disaggregated substitution elasticities as high as 21.4 (for industrial chemicals) and 18.9 (for electrical machinery and electronics) but as low as 1.2 (for printing and publishing).” Harrigan, using three-digit 1983 SITC data for 13 OECD countries representing 90 percent of OECD output, “finds elasticities in the range of 5 to 12.” Markup-based inference gives somewhat lower numbers: Cheung, Chinn and Fujii “impute elasticities typically in the range of 3.5 to 4,” while Hummels “comes up with an average markup of 22%, translating into a θ of 5.6, although other of his estimates of θ are higher.” Berry, Levinsohn and Pakes find automobile price elasticities “between 3.1 and 6.4,” and domestic markup studies imply values in the same neighbourhood, with Rotemberg and Woodford favouring “estimates in the range of 20% to 40%, that is, θ between about 3.5 and 6.” The upward adjustment: “these studies refer to goods actually traded. As Hummels emphasizes, one would expect that elasticities of substitution would be higher on average for goods that are not traded. In this case, an estimate of θ = 20, as Wei proposes, does not seem so wild-eyed” (Section 2.3).

Much less settled, with measured tariffs and freight rates in the single digits but substantial reasons to think the true economy-wide figure is far larger. For 1993, “average tariffs, on a domestic-production-weighted basis, were 4.9% for the United States, 7.7% for the European Union, 3.5% for Japan, and 8.9% for Canada.” Nontariff barriers can only be inferred from a model, and Anderson and Neary “typically find estimates on the same order of magnitude as for tariffs, larger of course for some countries (such as Japan) than for others (such as the United States).” On freight: “freight and insurance charges for U.S. imports averaged 3.6% in 1995, and 3.3% in 1996 and 1997,” but “these numbers considerably understate average costs in international shipping” because the United States has unusual geography, because they omit customs paperwork and “the costs of delays either in transit or at port of entry,” and because they exclude inland shipping. Disaggregated 10-digit data show that “shipping costs for many categories of goods are quite a bit larger than the average (trade-weighted) shipping costs – and this table excludes goods that are not traded at all.” Additional components canvassed include currency-related costs, with Rose’s finding that “countries with currency unions trade two to three times as much with each other as countries with separate currencies,” informational costs, and differences in legal and payments systems (Section 2.4).

Yes, formally – the authors show it is isomorphic to trade costs for the trade and portfolio puzzles – but they argue deriving the bias from a friction is more illuminating and better supported. “One can easily show that the effects of home bias in preferences (w < 1) can be isomorphic to the effects of trade costs τ. Helpman (1999) argues that once one controls for income, there is no clear evidence of home bias in preferences. Indeed, it is more illuminating to derive trade biases from other frictions. Nevertheless, it is important to recognize that a home bias in demand for goods can work similarly to trade costs, at least for the trade and portfolio-bias puzzles” (Section 2.4). The qualification matters later: in discussing pricing puzzles the authors note that “whereas the home bias in trade could, in principle, be explained simply by a home bias in preferences, the failure of markets to arbitrage international price differentials for seemingly identical goods cannot” (Section 6.4).

Less than in 1980 but still a great deal: the OECD slope has fallen from 0.89 to 0.60, which remains far above what integrated capital markets would imply. The authors first restate what the original result was: “across OECD countries, long-period averages of national saving rates are highly correlated with similar averages of domestic investment rates. Indeed, in the original data sample examined by Feldstein and Horioka, covering 1960 through the mid-1970s, cross-section regressions of investment on saving yielded slope coefficients near unity.” Their own regressions on eight-year averages for 1990-1997 give, for 24 OECD countries, “the coefficient (0.60) is a good deal smaller than the 0.89 found in Feldstein and Horioka’s original work, but it is still larger than one might expect in a world of fully integrated capital markets where global savings should flow to the regions with the highest rates of return.” The coefficient falls as poorer countries are added – 0.70 for countries with GNP per capita above 2000, 0.48 above 1000, 0.41 for all 56 – “although the extended results must be viewed with extreme caution given the poor quality of national income and product data for most non-OECD countries” (Section 3.1). Sample sensitivity is disclosed: Israel is excluded throughout, and “if one adds Korea to the OECD sample, the estimate for β rises to 0.76.”

Because they rest on special assumptions, create new puzzles, or imply regional patterns that the data do not show. “A fair summary of the literature is that there are at least five or six leading explanations (and ten or so close seconds). All are unconvincing because they are based on very special assumptions empirically – some about the nature of the exogenous shocks …, others because they raise collateral empirical contradictions. For example, in the asymmetric information model of Gordon and Bovenberg (1996), a ’lemons’ problem is invoked to explain why foreigners finance so little domestic investment, yet departures from covered interest parity must also be assumed if there is to be any foreign equity inflow at all. Explanations that try to maintain the assumption of perfect capital mobility often have the strong implication that one should also observe high saving-investment correlations across states or regions within a given country. But the partial evidence available on saving and investment by subnational regions simply does not produce the Feldstein-Horioka regularity” (Section 3.1). The authors include themselves in the indictment: “none of the explanations advanced to date (including our own attempts) has been terribly convincing. Most explanations tend to be clever but empirically inadequate and, more troublesome still, tend to fix one puzzle at the expense of creating others.” The intranational evidence is also their reason for looking at an international friction in the first place: “The fact that the Feldstein-Horioka regularity does not seem to characterize intranational regional data suggests that factors intrinsic to trade between different nations are at work.”

A current account imbalance large enough to reverse the direction of trade in a good changes that good’s home price between periods, which changes the consumption-based real interest rate – and the effect is a step function, flat in the middle and steep at the edges. The intuition, in a two-period two-good small-country endowment model with iceberg costs: “Suppose, for example, that the country’s endowment pattern and rate of time preference are such that in the first period, net exports of good H are negative (in which case intertemporal solvency dictates they must be positive in period 2). Then … the relative price of good H will be higher in period 1 than in period 2. There will be expected deflation, and the home real interest rate will be above r*. The situation is reversed when the country is initially running a sufficiently large current-account surplus, so that its real consumption-based lending rate must lie below r*” (Section 3.2). The formal analysis gives a five-segment schedule. In the middle segment – “the country is running a sufficiently small current-account surplus or deficit that there is never any reversal of the pattern of trade in either good … It is precisely in this region that trade costs have no effect on the real interest rate.” Outside it, the rate moves. The authors also stress what the model does not require: “whereas our model includes trade costs for goods, it is consistent with free and costless trade in securities. Thus, it is perfectly consistent with the observation that gross international flows of securities are substantial even though net flows are small.”

With a world rate of 5 percent, trade costs of 10 percent and an elasticity of 6, domestic real rates can range from 20 percent to −8 percent – and the authors argue the fact that we never see this is the point. “For example, with r* = 0.05, τ = 0.1, θ = 6, and prices normalized to one, we find that the highest possible real interest rate is 20% (15% above the world level) while the lowest is −8% (13% below the world level).” The elasticity amplifies: “As θ rises, the maximum and minimum real domestic interest rates move apart – with higher substitutability, the price-level impacts of changes in P are more pronounced. In the limiting case as θ → ∞ the two goods are asymptotically perfect substitutes, in which case the country’s effective real borrowing rate will be 30%, and its lending rate, −15%!” And then the interpretive move: “Of course, the range of real domestic interest rates encompassed by Figure 1 is far greater than what we usually observe in practice, especially for OECD countries. But this simply reflects the fact that incipient real interest differentials put a sharp check on a country’s incentives to run large current-account deficits or surpluses” (Section 3.5). The authors also note what earlier literature lacked: real-interest-rate explanations had been “touched upon” before, “[but] no one has taken the idea very seriously, since earlier models could not give any reason why the real interest rate might be so important quantitatively. Nor could they really explain the durability of the Feldstein-Horioka relationship across different time periods and regimes” (fn. 15).

The authors work through five and judge each to leave the main point intact, while flagging where the argument is a conjecture. A continuum of goods with a distribution of transport costs turns the step function into “to the naked eye, a smoothly upward-sloping curve,” and “with a rich enough range of goods, transport costs, and elasticities of substitution, even small current-account deficits may produce trade reversals in a small number of goods, thereby resulting in an interest-rate effect” – although the authors mark this as unproved: “We conjecture, though it remains to be proved, that one would obtain…” On long-term borrowing: “Though a more careful analysis is required than we can provide here, it seems unlikely that this consideration would overturn our basic point; there would still be a big price swing between the big deficit periods and surplus periods – which is precisely why a country would seek to avoid such swings.” On investment, the extension produces the Feldstein-Horioka correlation directly: “that very mechanism dictates that reductions in national saving will be accompanied by reductions in domestic investment. In segments I and II, the country could channel some of its higher savings into higher investment, again tempering the fall in the effective real interest rate but creating the positive Feldstein-Horioka correlation between increases in saving and increases in investment.” On nominal rigidity: adding monopoly pricing and price stickiness “would enrich the model without overturning the main points,” and in any case “the most troubling manifestations of the Feldstein-Horioka puzzle are at medium-term horizons of five to fifteen years, when price flexibility is much greater and firms’ ability to preserve monopoly power is less” (Section 3.6).

Yes, on OECD panel data for 1975-1998, and the sign and significance come out as predicted, with a magnitude the authors put at 20 to 30 basis points per percent of GDP. “The model does contain one simple prediction that can easily be checked. Countries running current-account surpluses should have lower real interest rates than countries running deficits” (Section 3.7). The sample covers “all OECD countries except Iceland, Korea, Mexico, and Turkey,” with the real rate built as a three-month nominal rate less lagged annual CPI inflation (specification 1) or less contemporaneous inflation (specification 2), each estimated by OLS, with country fixed effects, and with fixed effects plus time dummies, and with an autoregressive correction. All six coefficients on the current account to GDP ratio are negative and significant at conventional levels, but the two specifications differ substantially in magnitude – specification 1 gives coefficients of −36.9, −46.3 and −32.3, specification 2 gives −17.9, −19.4 and −18.9. The authors pick their preferred number transparently: “Taking the regressions with country fixed effects and time dummies as likely to be most reliable, we see that a 1% of GDP rise in an OECD country’s current-account surplus is associated with roughly a 20- to 30-basis-point decline in its real interest rate.” They also report robustness informally – “We experimented with a number of other specifications, expected inflation proxies, and time periods, almost always finding results similar to those reported” – and distinguish their test from Gordon and Bovenberg’s, who establish a similar relationship “but their test and their specification are motivated by a model that is very different than ours.”

French and Poterba found 94 percent of American and 98 percent of Japanese equity wealth held at home; the traded/nontraded story gets to a bit over half, short of the observed 80 to 90 percent. By the mid-1990s “about 10% of U.S. equity wealth was invested abroad,” and home bias “is muted for smaller countries and has shown some tendency to decline over time,” yet “standard models of optimal international portfolio diversification imply, however, that equity investors still have not diversified internationally nearly as much as they should, and so the puzzle remains” (Section 4). The leading explanation rests on the Salter-Swan dichotomy: since payments must be made in traded goods and utility is separable, “investors hold a globally diversified portfolio of traded-goods industries. But nontraded-goods industries are held entirely domestically,” so with nontradables at 50 percent of output “agents will (loosely speaking) hold more than half their equity in home assets.” The authors’ objection is quantitative as well as conceptual: “although it goes some way toward explaining home bias, it falls short of explaining the 80% to 90% domestic equity shares we actually observe.”

A home equity share of 81 percent with an elasticity of 6 and trade costs of 25 percent, and 72 percent with an elasticity of 10 and trade costs of only 10 percent. The setup adds uncertainty to the two-country model, with free and costless trade in a complete set of Arrow-Debreu securities alongside costly goods trade. In the tractable case where relative risk aversion equals the inverse of the substitution elasticity – where “the Arrow-Debreu allocation is then identical to the one in which people can trade only straight equity shares” – closed-form portfolio shares follow: “For θ = 6 and trade costs of τ = 0.25 (again, a seemingly reasonable number when applied to all of output, especially compared to the usual assumption that fully half of output is nontraded), one obtains XH = 0.81, X*H = 0.19. Since share prices will be equal due to symmetry, this implies a home equity share of 81%. If θ = 10, then the home portfolio share of home equities is 72% even with trade costs of just 10%” (Section 4.3). Relaxing the risk-aversion restriction breaks the exact equivalence, but numerical simulation shows “how insensitive the portfolio shares are even to large changes in ρ,” a robustness the authors connect to Cole and Obstfeld’s conjecture “that, for moderate uncertainty, the gains from global risk sharing may be so low as to be mostly offset by costs of trade.” They also justify working with complete markets on three grounds, the third being empirical: “for realistic parameters, trade in equities alone can come quite close to attaining the complete-markets consumption allocation, so that the home bias evident under complete markets is a good guide to the home bias in an equities-only model” (Section 4.2).

That trade costs are not the whole story, that a dynamic model would reduce the bias somewhat, and that complete markets is a calibration device rather than a belief. “We do not believe that trade costs in goods markets are necessarily the whole story in explaining observed portfolio biases, and we certainly expect that the kinds of information asymmetries and legal restrictions emphasized in earlier work also play a role” – though they note these “can be viewed as trade costs in a broader sense.” The dynamic caveat is stated as an open question: “transaction costs, and the resulting home bias, would be reduced somewhat in a fully dynamic model. Investors could then reinvest dividends abroad rather than repatriating them immediately. As is true for a tax-deferred asset, they could earn dividends on wealth that would otherwise be burned up as shipping costs. The question deserves further research. … Our guess is that trade costs will remain an important determinant of home bias even in a realistic dynamic setting” (Section 4.4). On complete markets: “By taking that modeling approach, however, we certainly do not intend to endorse an empirical view that real-world asset markets are complete or nearly complete, either domestically or internationally. The complete-markets assumption is not essential, and our arguments would go through in a fully articulated incomplete-markets model.” Supporting evidence is cited from Portes and Rey, whose gravity model with informational distance explains trade in both equities and goods, which the authors read as “in accord with our model’s prediction that equity biases in large measure reflect goods-market biases.”

G7 per capita consumption growth correlations average 0.40 against a frictionless benchmark prediction of almost 0.9; the authors argue the puzzle is largely a corollary of the previous two, and separately propose a better benchmark. Using Penn World Table data for 1973-1992, “the simple average of correlation coefficients is 0.40,” while “the benchmark frictionless world economy model of Backus, Kehoe, and Kydland (1992) still predicts a cross-country consumption correlation of almost 0.9, far above the correlations we see in the table” (Section 5.1). The authors’ first point is that this should not be surprising: “in some sense, the consumption correlations puzzle is almost a corollary of the Feldstein-Horioka and home-equity-bias puzzles. Given that the most transparent market means of consumption smoothing – debt and equity trade – are far less operative across borders than within them, it should not come as any great surprise that international consumption correlations are low.” Their second point addresses the Backus-Kehoe-Kydland subpuzzle that consumption correlations are lower than output correlations (0.40 against 0.53 in this sample): “only the output remaining after investment and government consumption can be shared by private consumers. Thus, a more appropriate comparison … is that between growth rates of output net of investment and government consumption,” and “the average international correlation in the growth of Y − I − G is 0.17, far below the average correlation 0.40 of international consumption growth rates. For six of the 21 country pairs that ranking is reversed, but in most of these cases the discrepancy is not significant” (Section 5.4). The conclusion they draw is carefully limited: “the puzzle concerning the relative variability of output and consumption is not necessarily incompatible with a high level of international asset market integration.”

They accept that it is decisively rejected but attribute the failure to incomplete asset markets rather than to trade costs. The Backus-Smith condition generalizes consumption-growth equalization to the case where national price levels differ, and “given the high volatility of real exchange rates under floating together with the low volatility of consumption, it is perhaps not surprising that Backus and Smith’s empirical work forcefully rejects the optimal risk-sharing condition. In fact, the empirical rejection … is even more devastating, since even very high values of ρ cannot reconcile that condition with the data.” Their own diagnosis: “In our view, however, incompleteness of asset markets is the major reason why condition (15) fails so miserably in practice. Indeed, given the volatility of exchange rates, the size of transfers required for (15) to hold would require a level of risk sharing even greater than we observe in domestic markets.” They then concede the implication for their own model: “a version of the Backus-Smith condition will hold in a dynamic extension of our earlier model of the home-equity-bias puzzle. That model implicitly assumed flexible nominal prices, and would not produce nearly the level of real-exchange-rate volatility one sees in the data. We do not take this as damning, since for us the complete-markets assumption was only a useful device for calibration, and not a conviction” (Section 5.2). The question they regard as the real one is comparative: “the really interesting issue is not why international consumption correlations are difficult to replicate in a complete-markets model, but the extent to which consumption risk sharing is less prevalent across distinct countries than within countries” – for which they marshal evidence from Atkeson and Bayoumi, Asdrubali-Sorensen-Yosha against Sorensen-Yosha, Crucini, and Bayoumi and Klein.

That real exchange rate deviations die out with half-lives of three to four years, which is hard to square with exchange rate volatility that seems to be driven by monetary and financial shocks. Using monthly 1973-1995 data for Canada, France, Germany, Japan and the United States, and all ten bilateral real exchange rates, the authors find autoregressive coefficients “ranging from 0.99 (U.S.-Canada, implying a half-life of 69 months) to 0.97 (Germany-Japan, implying a half-life of 21 months). The mean half-life across these real exchange rates is around 39 months, or 3¼ years” (Section 6.1). The puzzle is the combination: “Such long half-lives would not necessarily be a puzzle but for the remarkable volatility of real and nominal exchange rates, volatility that seems hard to explain without assigning a major role to monetary and financial shocks. If monetary and financial shocks are the predominant source of volatility, however, it is hard to imagine what source of nominal rigidity could be so persistent as to explain the prolongation of real-exchange-rate deviations.” Following Engel, they show the slowness is not confined to nontradables: “the data reveal no significant difference between short-term and long-term correlations, indicating extremely slow mean reversion in shocks to the relative prices of tradables. Interestingly, it seems to make rather little difference whether we use tradables or nontradables prices to compute real exchange rates: all the price ratios are highly correlated with each other even out to horizons of five years.” Their reading: “even over the medium term, the consumer prices of supposedly tradable goods are nearly as insulated from the forces of international arbitrage as are the consumer prices of nontradables” (Section 6.2).

Because adjustment is much faster at the importer level, which both rescues the assumption of high trade elasticities and locates the friction at the consumer end. “There seems to be considerably more adjustment of prices to exchange-rate changes at the importer level than at the consumer level. In their excellent survey …, Goldberg and Knetter (1997) conclude that the passthrough of exchange rates to relative international prices is about 50% after one year, much faster than what we have just seen in the consumer-price data. Thus, relatively large elasticities in international trade between exporters and importers can be consistent with exceedingly sluggish adjustment in the relative consumer prices of tradables” (Section 6.3). The authors add that the fast wholesale adjustment is also needed for the terms of trade to behave as observed: if importer prices moved as sluggishly as consumer prices, “a country’s terms of trade would actually improve, rather than worsen, after a depreciation of the exchange rate,” which they find is not what the data show. On why wholesale arbitrage does not equalize prices anyway, the answer is legal and contractual control of distribution: “Exclusive national marketing licenses are extremely common. For example, to protect its ability to price-discriminate across home and foreign markets, the Coca-Cola company sued a couple of small American wholesalers who, during the late 1990s, were trying to arbitrage the difference between Coca-Cola’s $11.50-per-case wholesale price in Japan (as of January 2000) and its wholesale $5.50-per-case price in the United States – a differential far in excess of bulk shipping costs” (Section 6.5). For small firms unable to bear the legal costs, price discrimination can still work “either by exploiting long-term relationships with their downstream wholesalers or even by taking over more portions of their wholesale distribution network.”

No, and the authors say so repeatedly: monopoly and nominal rigidity are needed as well, and they do not build the required model here. The limitation is stated in the introduction – “To explain adequately the various pricing puzzles, we would need to develop a much richer framework featuring imperfect competition plus sticky prices and/or wages, as in the extensive recent literature on the ’new open-economy macroeconomics.’ Although we do not present such a model here, we do demonstrate why trade costs must constitute an essential element, implicitly if not explicitly” – and again at the start of Section 6: “Any realistic attempt to address these pricing puzzles formally would require a much more elaborate framework than the one we have used thus far. … Unfortunately, we do not have nearly enough space remaining here to present a fully articulated model.” They also explain why the earlier leverage is unavailable: “A critical difference between the (relatively short-term) pricing puzzles and the (longer-term) quantity puzzles is that we can no longer appeal to high elasticities of substitution to lever up the effects of modest-sized trade costs. … If there are only modest obstacles to short-term price arbitrage across borders, there can be only modest short-term price differentials.” On existing models: Dumas shows trade costs alone can generate real exchange rate persistence under flexible prices, but “the Dumas model cannot simultaneously generate anywhere near the volatility and persistence needed to match the data. Monopoly and nominal rigidities appear to be essential elements of any resolution of the PPP puzzle” (Section 6.6). One methodological caution is added: with trade costs, “econometric estimates of the half-life of real-exchange-rate movements may be exaggerated. Price differentials dissipate very slowly within transaction-cost bands, but more quickly outside them, and proper econometric estimation should take these nonlinearities into account.”

That segmentation plus local-currency price stickiness insulate real variables from the exchange rate, so the exchange rate must move a lot to clear financial markets. “In the type of model we described earlier in this section, a financial-market shock that moves the exchange rate may have little economic effect even over a fairly long horizon. With pervasive pricing to market at the retail level, consumers will be largely insulated from exchange-rate effects until these have had the time to feed through to wholesale import prices and, from there, to retailers. The magnitude of the PPP puzzle suggests how long that process might take. Thus, interacting with the segmentation caused by trade costs, nominal price rigidities can produce a disconnect in which the exchange rate responds wildly to shocks. With the prices of most goods preset in local currency and real variables such as aggregate consumption largely insulated from exchange rates in the short run, exchange-rate adjustments have minimal short-run economic effects and therefore must be huge to clear financial markets. Only gradually will the responses of importers and exporters feed through to the retail level – and the adjustments might well be too slow to be picked up in the kinds of tests performed by Baxter and Stockman (1989)” (Section 6.7). The authors also confront an obvious analogy: “one may well ask why the exchange-rate disconnect puzzle should be any different from the stock-price disconnect puzzle” – and answer that “the links between the exchange rate and the real economy are much more direct than for stock prices. In most economies, the exchange rate is the single most important relative price, one that potentially feeds back immediately into a large range of transactions. Because the potential links are so direct, it is surprising indeed that they are not stronger.” They raise but do not resolve a possible amplification loop: “Can heightened exchange-rate volatility due to transport costs act to further segment markets internationally, with a resulting multiplier effect on volatility?”

Substantial resolution of the four quantity puzzles, a weaker but still substantive claim for the two pricing puzzles, and an explicit omission. “We find that introducing plausible proportional (iceberg) trade costs into the most standard international macroeconomics models substantially resolves many of the core empirical puzzles in the field, including especially the (seemingly intractable) Feldstein-Horioka puzzle, the home-bias-in-equities puzzle, the home-bias-in-trade puzzle, and the low-consumption-correlations puzzle. We cannot claim the same degree of success in elucidating pricing puzzles as in the case of quantity puzzles, at least not with the kind of very simple models we have featured here.” For the pricing puzzles the claim is necessity, not sufficiency: “We have argued, however, that introducing trade costs (implicitly or explicitly) must be an essential ingredient in resolving the international pricing puzzles as well.” They also note that their approach “does not rely on the assumption that [international capital markets’] performance is intrinsically inferior to that of domestic capital markets (at least not in analyzing data for OECD countries)” and that it “is entirely consistent with the observation that gross flows in international capital markets are much larger than the small net flows.” The omission is acknowledged directly: “a small apology to readers who were expecting us also to address the forward-premium puzzle. We simply have not yet tackled this particular pricing puzzle, which we regard as much more of a pure finance question than a macroeconomic puzzle (and hence this paper’s title)” (Section 7).

The authors treat this as the leading objection and answer that the quantity puzzles have indeed eased, while net trade costs may not have fallen as much as one would assume. “An obvious potential criticism of our central theme is that transport technology has been steadily improving over the past half century, and tariffs have fallen dramatically, especially among the OECD countries. Has the home bias in trade and equities lessened, and are the consumption-correlations and Feldstein-Horioka puzzles less acute than they were half a century ago? The short answer is that trade, capital movements, and equity flows all have expanded sharply since 1950, so the major quantity puzzles are less acute.” The supporting numbers: the trade-to-GDP ratio “has roughly doubled across the OECD between 1950 and 1995; for the United States, it has risen from 9% in 1950 to 24% in 1995”; OECD saving-investment correlations fell “from 0.89 for 1960-1974 to 0.60 for 1990-1997”; and US foreign equity holdings rose “from a 4% share in 1987 to a 10% share in 1996.” On the cost side the picture is genuinely ambiguous: “while transport technology has steadily improved, labor costs have risen sharply, so there is actually some debate about whether net transport costs have fallen. Hummels (1999b) argues that, until recently, the overall effect has been relatively small, with shipping costs falling sharply for bulk commodities but actually rising for manufactures, which account for over 70% of OECD trade,” while Greenspan “emphasizes that trade is getting lighter.” Their verdict is appropriately hedged: “Overall, the data for the past half century certainly do not provide any prima facie case against our approach.” They also suggest the natural extension, citing Williamson’s calculation that “transport costs for internationally traded goods fell by 1.5% per annum in real terms from 1850 to 1913,” while noting that prewar data “are much thinner” and there are “many other factors to control for” (Section 7).