On the Fiscal Policy Implications of Low Capital Mobility: Some Further Evidence from Cross-Country, Time-Series Data

Abstract

In an attempt to determine whether an increase in a nation's private saving, stimulated (say) by tax policies, raises domestic investment or flows abroad, Feldstein and Horioka [4] and Feldstein [2] examined the relationship between the saving and investment of a sample of industrialized countries. Their results pointed to the existence of a strong, almost one-to-one relationship between investment and saving rates. They interpreted that finding as implying that the assumption of perfect capital mobility is invalid in that . . sustained increases in domestic saving induce approximately equal increases in domestic investment rates [2, 150]. The finding has farreaching implications. For instance, with low international capital mobility, a country's growth prospects are tied to its saving effort. If the saving effort is weak relative to investment opportunities, realized investment could fall short of their potential, and thus impact adversely on growth. It also implies that fiscal deficits lead to neoclassical crowding out of investment, so that both the Keynesian view as well as the Ricardian Equivalence proposition do not hold. Since the Feldstein and Horioka (henceforth denoted by FH) article, numerous papers have offered alternative explanations for the strong saving-investment correlations. Many of those explanations center on supposed weaknesses of the econometric methodology employed by FH and Feldstein. One of the arguments, initially proposed by Fieleke [5] and Tobin [19], is the policyresponse argument. According to that argument, if the government adjusts its policy instruments to offset current account imbalances, a strong positive correlation between saving and investment would result.' However, that correlation reflects the policy response and not low capital mobility. In a recent paper, Summers [16] proposed a direct test of that argument and his empirical results