The Feldstein-Horioka Paradox

It is one of the great conundrums of economics that major economic growth in developing countries, in Asia, Africa and Latin America, is happening now. For much of the post-World War Two period, there was much surprise that poorer countries were not growing faster than developed countries. Then suddenly, in the past 15 years growth rates for developing markets have increased dramatically.

Economic theory suggests that if capital is perfectly mobile investors would invest in countries with the most productive return on capital, which would consequently increase prices until the returns on capital were similar across different countries. In other words, capital flows should act to equalize marginal product of capital across different countries. According to this theory, for example, a saver in Germany will have no incentive to invest in his national economy, but would rather invest in a (most likely) developing economy where there is a higher productivity return on his capital. If this were true, then there should be no relationship between savings and investment within a single country and increased saving rates need not result in corresponding increased investment. Therefore, as developing countries are further away from the global technology frontier, investing in these countries would provide the most productive return on capital. These developing countries can take advantage of existing know-how, embodied in investment capital, and therefore grow quicker than developed countries (who can only grow by innovating – a more time-costly endeavour). However data has shown the opposite.

What a Paradox!

The Feldstein-Horioka Paradox revealed a positive correlation between national savings and national investments. This correlation is a paradox because, if capital truly is perfectly mobile, there should be low correlation between national savings and national investment as investors in one country do not need the funds from national savings and can borrow from international markets at international rates. Equally, savers can lend their entire national savings to foreign investors. In the absence of regulation in international financial markets, national savings would flow to the countries with the highest return per unit of investment. Therefore, national savings and national investments should be uncorrelated.

Adam Smith

The Feldstein-Horioka Paradox goes some way to explaining the conundrum of why major economic growth in developing countries, in Asia, Africa and Latin America, is happening now. The 2000s were the first time in which global GDP growth significantly surpassed the EU and USA. This growth was driven increasingly be emerging economies, a trend that is becoming ever more apparent. And what has helped the emerging economies? Massive amounts of investment capital and the know-how embodied with that capital has facilitated the generation of savings needed for the developing countries to industrialise and catch-up to the developed economies. Further along in the process, countries (particularly China and other Asian nations) have generated large savings which has helped to sustain strong investment.

So then what is the rationale behind the Feldstein-Horioka Paradox? Well Adam Smith postulated that the pursuit of security leads investors to invest at home, and that the pursuit of security (not profit) leads them to promote the good of their national society.