Revisiting the Feldstein–Horioka puzzle with regime switching: New evidence from European countries

Abstract

Feldstein and Horioka (1980) propose assessing the degree of capital mobility by measuring the correlation between saving and investment. The high correlation between saving and investment is known as the Feldstein–Horioka puzzle (FHP). This study tests for the presence of the Feldstein–Horioka puzzle in nine European countries by employing the Markov switching model in order to characterize the time-varying behavior of the saving retention coefficient. The econometric methodology allows us to distinguish periods for which the FHP holds from those for which the FHP does not hold. It is found that, based on the results from the Markov switching regression, there is a shift in the saving retention coefficients from high to low values, meaning that regime switching has taken place from the high correlation regime (low capital mobility) to the low correlation regime (high capital mobility) for Denmark, Germany, Norway, and Sweden. This evidence suggests that the Feldstein–Horioka puzzle holds for a particular period of time and depends upon the regime shifts.