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Eureka: Feldstein-Horioka Puzzle Eureka: Feldstein-Horioka Puzzle
by Jay Gutman
2017-11-28 09:26:30
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The Feldstein-Horioka puzzle has it that savings rates are correlated with domestic investment rates. That is that what people and companies save, they tend to reinvest in the domestic market. The puzzle has it that this fact is abnormal, as in a relatively open international market, people should invest their savings around the world and not just domestically, and that domestic savings rates should not be correlated with domestic investment rates. Note that the correlation has been noted among OECD member states.

kario01_400There are two ways to solve this problem. First, we will look at the problem from a macro level, then from a micro level. Let's look at the macro level first. Most OECD countries having yearly income rates ranging from 10,000 dollars a year per capita to about 50,000 dollars a year per capita. Assuming that the average savings rate is anywhere from 5% to about 20%, that means the average per capita savings rate is about 500 dollars a year to 10,000 dollars a year. Where would the average person invest the money?

The average person invests the money in savings accounts, which sometimes provide decent interest rates, especially for those long-term savings accounts. People use the savings account to withdraw the money later on, say, to pay for their children's tuition fees among other expenses. Others invest the money in the form of rental property, that is they buy property that they rent out. Others speculate in the real estate market or in the stock market or buy government bonds. Why wouldn't they be tempted to invest their money internationally? Especially provided that could be done with a simple click by surfing the internet?


Let's say that would be possible if economics were an individual affair. As I've said before, economics are not about individual consumers and investors, they are about collective consumers and investors. Despite my international experience, it would be easier for me to convince my peers to invest in the domestic market than to invest in the international market. Psychology has something to do with it, as investing in the international market often comes out as pompous, arrogant, and to many people the suggestion comes out as showing off.


Second let's look at more practical reasons why investors choose the domestic market over the international market. Usually anyone who would invest in the international market would do so out of vested interests in the international market. Let's just say, as I've said before, that only those companies with a production surplus tend to be interested in the international market. That is they try to get their product to hit the local supermarket or real estate agent's shelves first, then, once they have a production and income surplus, and that they've basically saturated the local market, only then do they start aiming at the international market.


Now from a microeconomic perspective, most investors don't have enough money saved to have large choices of where to invest it. Two types of behavior tend to affect those who are investing their savings: herd behavior and proximity behavior. Herd behavior means they tend to invest where their friends, peers, colleagues or kins tend to invest. If their kins or friends invest locally they will invest locally. If their friends invest internationally they might try to invest internationally. That is people tend to try to get a first hand account of successful investment before they invest themselves. Of course some people invest after hearing ambiguous accounts of the possible return of the investment, but usually, the more detailed the account the more likely they are to invest in different places. Many don't talk with bankers or stock brokers on the possibilities of investment.


Another important, yet often omitted factor is, have you ever heard European, Asian or African investment brokers present their product? There are several jokes on that in trading circles. Like that Korean investment brokers who comes to you and says “you are my friend, so invest in this Korean stock!” Really? Is that a good enough reason to invest? Many other stories around the world echo this story.


Finally, there's the proximity factor. Someone in Kansas might start investing in Kansas, then in the Midwest, then in the coasts, then in Canada and perhaps Mexico, then in the rest of the world, probably in that order. The proximity factor is relative but often true. Koreans will tend to start investing in Japan and China, then South East Asia, then the Pacific, then perhaps the United States and Canada, and might save Africa, the Middle East and Europe for last. That is we tend to start investing in what is nearest to us.


Now I could pepper my articles with statistics, facts, quotes and other details, but I'll save that for my real job, the one that pays cash.

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