The ‘real’ explanation of the Feldstein-Horioka puzzle – and what it means

Nicholas Ford, Charles Yuji Horioka 05 May 2016



In a well-known paper, Obstfeld and Rogoff (2000) identified six major unsolved puzzles in international macroeconomics. These include the Feldstein-Horioka puzzle (Feldstein and Horioka 1980), which has not been satisfactorily explained even though more than 35 years have passed since it was first proposed. The longstanding existence of these puzzles implies that despite intensive research, academic economists still do not fully understand how the international economy works regarding basic issues such as why exchange rates move and how international financial markets impact individual countries’ economies. Senior economists are consequently left in the unenviable position of having to make policy recommendations even though they are aware of clear gaps in their knowledge and understanding.

The nature of the Feldstein-Horioka puzzle concerns the mobility of the world’s supply of capital. There is a presumption amongst economists that financial markets can rapidly, and nearly without cost, divert ‘financial capital’ from one country to another. This being the case, it would be expected that savings should be diverted from wherever they occur to where the best investment opportunities are by agents seeking to maximise returns. There is no reason the best investment opportunities should be in a savers’ home country; as a consequence, according to this reasoning, the levels of investment and saving should not be correlated across countries. However, Feldstein and Horioka (1980) found that this is not the case and that most incremental saving is in fact invested in the country in which it occurs. The puzzle is to try to understand why this should be the case.

Many authors have tried to explain this puzzle but without complete success (for a useful survey of this literature, see Aspergis and Tsoumas 2009). However, in a recent paper, we propose a solution to the puzzle that is disarmingly simple (Ford and Horioka 2016a).

The solution to the puzzle

The principal insight of our paper is to appreciate that although international financial markets may allow individual agents to move their own ‘financial capital’ between countries, international financial markets cannot, by themselves, achieve net transfers of capital between countries. The issue is most easily appreciated when countries have different currencies and the exchange rate is allowed to freely float. Suppose an agent such as the hypothetical Ms Tanaka chooses to move her capital from Japan to the US by selling a Japanese bond, buying US dollars with the Japanese yen raised, and then buying a US bond. There must be counterparties to the transactions. Suppose Mr Smith is the counterparty who sold Ms Tanaka the dollars and uses the yen to buy a Japanese bond. Ms Tanaka has moved her capital from Japan to the US, but Mr Smith has moved his capital in the reverse direction, so there is no net transfer of capital between the countries. The same rationale applies to all transactions that involve only financial assets – they do not involve a net transfer of capital between countries regardless of how large or numerous they are.

A net transfer of capital between countries requires one of the parties (Ms Tanaka or Mr Smith) to buy a financial asset and the other to buy goods or services. In that case the transfer of ‘financial capital’ by one party is not netted off by the counterparty’s transaction. Thus, a net transfer of ‘financial capital’ can only occur between countries as a result of a goods market transaction, and the aggregate net transfer of ‘financial capital’ between countries occurs as the result of an aggregated net transfer of goods and services in the same direction. The transfer of goods between countries involves additional frictions and costs compared to their use in their country of origin (e.g., transport, marketing and distribution costs, technical standards, certification procedures, tariffs and non-tariff barriers, etc.). These frictions in goods markets therefore inhibit the net transfer of financial capital as well as real capital between countries, and so make it likely that national saving and domestic investment are highly correlated. In other words, net transfers of capital require the integration of not only financial markets but also goods markets, and frictions in one or both of these markets can impede net transfers of capital and cause high saving-investment correlations. Moreover, there is empirical evidence (e.g. Eaton et al. 2015) that barriers to the mobility of goods and services are an important obstacle to international capital mobility.

We now turn to the implications of our solution to the Feldstein-Horioka puzzle for real interest rates, exchange rates, and current account imbalances (for more details, see Ford and Horioka 2016b).

Implications for interest rates

Much economic research and modelling supposes that international financial markets equalise real interest rates across countries by themselves (e.g. Obstfeld and Rogoff 1996). However, once it is appreciated that international financial markets cannot by themselves divert capital between countries, nor alter the total supply of loans or loan equivalents in a country, and that the net transfer of capital between countries is impeded by frictions in goods markets, we should not expect financial markets by themselves to be able to instantaneously equalise real interest rates across countries. This allows us to make sense of findings that real interest rates are not in practice equalised across countries (e.g. Mishkin 1984). Instead, we might better understand the real interest rate in every country as being determined by the local supply of, and demand for, loans.

Implications for exchange rates

If international financial markets cannot by themselves make net transfers of capital between countries and cannot by themselves equalise real interest rates across countries, then it might be expected that the effect of arbitrage in international financial markets should be primarily on the exchange rate. In other words, if the real interest rate is higher in one country than another, agents will bid up the real value of the currency of the high interest rate country until they judge that the expectation of a future fall in the value of that currency, or the risk of a fall in its value, offsets the expected gain from the interest rate differential. Of course, expected interest rate differentials are what many forex traders regard as a primary factor driving exchange rates, so this insight, if correct, would bring economic theory into line with practitioners’ views.

Possible implications for interest rate equalisation and global imbalances

Given that the net transfer of financial capital between countries requires transactions in both international goods and financial markets, it would be natural to expect the equalisation of real interest rates across countries to require the interactions of both of these markets. We suggest one way in which this interaction might be modelled:

  • If a country has higher real interest rates than its trading partners, agents in international financial markets will bid up the value of its currency. The appreciation of its currency will cause that country to incur a trade deficit. Because it allows domestic investment to exceed domestic saving, the trade deficit will cause the stock of real capital in this country to accumulate more quickly; this, in turn, will cause the marginal productivity of capital to fall and so will cause real interest rates to fall. In financial terms, we might regard the trade deficit as resulting in an inflow of additional financial capital (i.e. an additional supply of loans) that allows local investment opportunities to be used up more quickly, eventually pulling down local interest rates of the high interest rate country towards that of its trading partners, with the exchange rate adjusting correspondingly.

It can be recognised that this process is very gradual. Capital stocks are large compared to trade deficits (several times GDP compared with a few percentage points of GDP) so it takes a long time to make a significant change in a country’s capital stock. Clearly, in reality, local risk-free real interest rates are subject to many factors, including demand shocks and changing risk premiums. Similarly, exchange rates are influenced by changes in the terms of trade resulting from such things as commodity price changes. These other influences on interest rates and exchange rates may have made this capital transfer process difficult to identify. However, we submit that the process we describe may be behind persistent current account imbalances often described as ‘global imbalances.’ For the last 30 years, the UK and the US have had relatively low saving rates, relatively low capital stocks, and reasonable growth rates. Arguably as a consequence, rates of return on capital have been relatively high. By contrast, Japan and Germany have had high saving rates, higher capital stocks, and lower returns on capital. We might regard the persistent trade deficits of the UK and the US and the persistent trade surpluses of Germany and Japan over this period as reflecting the diversion by the market of capital to where returns on that capital were expected to be higher.

In summary, the solution to the Feldstein-Horioka puzzle is significant in its own right. However, the implications of the solution for related issues such as the interaction of interest rates, exchange rates, and current account imbalances may be even more interesting.


Apergis, N and C Tsoumas (2009) “A survey of the Feldstein-Horioka Puzzle: What has been done and where we stand,” Research in Economics, 63: 64-76.

Eaton, J, S S Kortum and B Neiman (2015) “Obstfeld and Rogoff’s international macro puzzles: A quantitative assessment,” NBER Working Paper No 21774, National Bureau of Economic Research, Cambridge, MA.

Feldstein, M S, and C Y Horioka (1980) “Domestic saving and international capital flows,” Economic Journal, 90: 314-329.

Ford, N and C Y Horioka (2016a) “The ‘real’ explanation of the Feldstein-Horioka puzzle,” Applied Economics Letters, forthcoming.

Ford, N and C Y Horioka (2016b) “The ‘real’ explanation of the PPP puzzle”, Institute of Social and Economic Research, Discussion Paper No 969, Osaka University, Ibaraki, Osaka, Japan.

Mishkin, F S (1984) “Are real interest rates equal across countries: An empirical investigation of international parity conditions”, Journal of Finance, 39: 1345-1357.

Obstfeld, M and K Rogoff (1996) Foundations of International Macroeconomics, MIT Press, Cambridge, MA.

Obstfeld, M and K Rogoff (2000) “The six major puzzles in macroeconomics: Is there a common cause?” in B S Bernanke and K Rogoff (eds), NBER Macroeconomics Annual 2000, 15: 339-412.



Topics:  Financial markets Global economy

Tags:  Feldstein-Horioka puzzle, investment rates, saving rates, macroeconomic puzzle, solution, capital transfer

Director, In-Line Consulting

Vice-President and Professor, Asian Growth Research Institute (AGI), Kitakyushu City, Japan; Invited Professor, Osaka University