The savings-investment puzzle is one of the most important regularities in international finance, which originally identified by Feldstein and Horioka (1980). Feldstein and Horioka find that a cross-country regression of average investment rates on average savings rates results in a regression coefficient close to one. They argue that this regression coefficient should be close to zero in a frictionless open economy world and suggest that this large regression coefficient indicates a high degree of financial frictions in the world economy. Their finding and claims about substantial financial frictions in international financial markets raise a huge debate in the literature. The profession has responded to the Feldstein-Horioka finding from two different approaches.
Most of the capital structure literature focuses on demand-side factors, assuming implicitly that supply-side constraints have little effect on capital structure decisions. For example, the trade off theory states that each firm chooses its optimal capital structure by comparing its costs and benefits of issuing new debt, assuming that the supply of capital is infinitely elastic.
Faulkender and Petersen (2006) argue that this is a strong assumption because market frictions, such as asymmetric information and agency costs, that make capital structure relevant could also be associated with a firm’s source of capital. They show that U.S. firms with public bond market access, as measured by having a credit rating, have about six to eight percentage points higher debt ratios than firms without access, after controlling for demand-side factors.
Productivity shocks and government budget deficits are considered to be two key determinants of the current account. This follows from basic accounting, which equalizes the current account and the difference between saving and investment. On the one hand, innovations to the government budget deficit will lower overall saving and the current account (to the extent that private saving and investment do not fully off-set the fall in public saving); on the other hand, productivity innovations, will have a positive impact on consumption and investment and lower the current account (to the extent that the effects on consumption and investment exceed the immediate effect of productivity on income).
Not surprisingly, productivity shocks and budget deficits have figured prominently in the policy debate on the secular decline of the current account in the U.S. In the mid-1980s, as a result of record current account and budget deficits the notion of ‘twin deficits’ became popular. In the mid-1990s, by contrast, the current account and the budget balance were moving in opposite directions. Consequently, general attention turned to productivity gains as the prime suspect responsible for the current account deficit. The early 2000s have again witnessed a strong deterioration in the U.S. fiscal position associated with a further decline in the current account such that the ‘twin deficits’ gained renewed attention. In sum, the informed analysis of current account developments during specific episodes seem to suggest an important role for productivity shocks and budget deficits.
