The Feldstein-Horioka Puzzle and Spurious Ratio Correlation

This study shows that the Feldstein-Horioka puzzle resembles a spurious ratio correlation due to a common deflator (Pearson 1896/7). Empirically, the Feldstein-Horioka specification and its counterpart with an arbitrary deflator - final domestic - demand give similar results. Monte Carlo results also indicates that the slope beta and R-2 of the ratio regression are upward biased. Theoretically, assuming each of the original undeflated variables are linear homogeneous functions of the deflator and random disturbances, formulas for beta and le are derived. As saving and investment rates are numerically small relative to the disturbances, both beta and R-2 are predominantly determined by the disturbances and they tend towards unity when the disturbances are close in magnitude. The Feldstein-Horioka results are therefore noisy, though not entirely spurious, and do not necessarily reflect a strong correlation between investment and savings. (C) 2011 Elsevier Ltd. All rights reserved.