European Integration and the Feldstein–Horioka Puzzle

AuthorGylfi Zoega,Margarita Katsimi
DOIhttp://doi.org/10.1111/obes.12130
Date01 December 2016
Published date01 December 2016
834
©2016 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 78, 6 (2016) 0305–9049
doi: 10.1111/obes.12130
European Integration and the Feldstein–Horioka
Puzzle*
Margarita Katsimi†,‡ and Gylfi Zoega‡,§,¶
Department of International and European Economic Studies, Athens University of
Economics and Business, 76 Patision Avenue, 10434 Athens, Greece (e-mail:
mkatsimi@aueb.gr)
CESifo, Munich, Germany
§Department of Economics, University of Iceland, 2 Saemundargata, 101 Reykjavik, Iceland
(e-mail: gz@hi.is)
Department of Economics, Mathematics and Statistics, Birkbeck College, University of
London, Malet St, London WC1E 7HX, UK
Abstract
We apply the differences-in-differences method to study the effect of the European single
market in 1993 and the euro in 1999 on the Feldstein–Horioka equation where countries
outside the single market serve as a control group and those within as a treatment group.
We find structural breaks that coincide with both events, in addition to the financial crisis
in 2008. The results suggest that the correlation between investment and savings depends
on institutions, exchange rate risk and credit risk. Furthermore, the pattern of capital flows
within the single market leaves a significant part of the flowsunexplained by fundamentals.
I. Introduction
A large and growing literature has attempted to explain the findings of Feldstein and
Horioka (1980) that savings and investment are correlated across countries. In this paper
we take advantage of a natural experiment to test whether the beginning of the European
single market in 1993 and the introduction of the euro in 1999 coincided with a structural
break in the savings–investment relationship in the European countries but not in the
rest of our sample of 30 countries. We use the differences-in-differences method by using
countries that are outside the single market as a control group and assuming that the saving–
investment relationship would have evolved in the same manner in countries currently
within and outside the single market if these steps towards European integration had not
been taken. We can then show how the single market and the euro affected the relationship
JEL Classification numbers: E2
*Weare grateful to two anonymous referees for their comments on an earlier draft. Wealso acknowledge comments
by Ron Smith and Jerry Coakley and seminar participants at Athens University of Economics and Business and the
Central Bank of Turkey on an earlier draft. This work was supported by the Icelandic Research Fund (IRF – grant
number 130551-052) and the University of Iceland Research Fund.
Capital mobility in Europe 835
for various groups of European countries, such as those within and outside the euro zone,
the northern part of the euro zone and its southern periphery.
The Feldstein–Horioka (FH) equation is the following
I
Yjt
=a+bS
Yjt
+ujt (1)
where Idenotes gross capital formation, Sis savings, Ydenotes GDP, uis an error term
and jis a country index. If capital was perfectly mobile across countries we would find
the coefficient bto be close to zero because a fall in savings in one country would not
affect domestic interest rates or investment. However, Feldstein and Horioka found that
the estimated coefficient of the saving rate was 0.887 in a cross section of industrialized
countries for the period 1960 to 1974. In a world of capital mobility the finding appears
puzzling since a fall in savings in one country should not affect domestic interest rates or
investment. The authors attributed their finding to barriers to capital mobility.1
This paper makes two contributions in the Feldstein–Horioka literature: First, it shows
that capital mobility as measured by the coefficient of savings in the FH equation is both
time-varying and not unidirectional and then uses the Frankel (1992) theoretical framework
for interpreting changes in the coefficient taking place in Europe in the past two decades.
Frankel points out that a zero saving retention coefficient (the FH perfect capital null)
requires both real parity to hold and national saving to be uncorrelated with the error term
in the FH regression.
The second contribution is that the paper attempts to explain factors affecting capital
flows in Europe by exploring the pattern of capital mobility before the financial crisis of
2008. The results suggest that a large part of the pattern is unexplained by fundamentals,
suggesting that one of the unintended consequences of European integration may have
been a flow of capital from core to peripheral economies that led to asset price bubbles and
financial instability in the periphery.
We will estimate the FH equation 1960–2014 for a sample of 19 EU Single marketand
11 non-single-market countries to test for structural breaks in the equation coinciding with
steps towards European integration and the recent financial crisis. We first use a rolling
10-year panel regression, which is novel in the FH literature in showing the variability of
capital mobility over time, especially in Europe.This stands in contrast to the conventional
treatment of using time-averaged cross-sectional regressions. Next, weperfor m panel esti-
mation for the whole sample period and test for structural breaks in the FH coefficient. By
not confining our sample to the EU countries we can compare and contrast structural breaks
between the euro zone, member countries of the single market that do not use the euro
and countries that do not belong to the single market. Using the differences-in-differences
method allows us to find the effect of the single market and the euro on the FH coeffi-
1Several authors haveprovided explanations for the FH puzzle. Coakley, Kulasi and Smith (1996) use the fact that
the difference between saving and investment equals the current account surplus in the national accounts to focus
their explanation on current account imbalances. According to these authors, excessivecur rent account deficits may
raise the interest rate faced by a country in international capital markets making further borrowing difficult. Similarly,
as argued by Tobin (1983) and Summers (1988), governments may dislike deficits for financial stability reasons and
surpluses since they indicate room for expansionary policies. Katsimi and Moutos (2009) find that the FH result is
impervious to the use of a broader view (i.e., including human capital) of investment and saving. Bai and Zhang
(2010) show that financial frictions can explain the FH puzzle.
©2016 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd

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