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 β and R2 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 β and R2 are derived. As saving and investment rates are numerically small relative to the disturbances, both β and R2 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.