High Net Stocks of Foreign Liabilities and Sluggish Productivity Growth - the Key to the Resurgence of the Feldstein-Horioka Puzzle in Europe

This paper discusses the resurgence of the Feldstein-Horioka puzzle after the global financial crisis within the European space. Using an intertemporal choice model, I start by describing the optimal investment-saving schedules of small open economies, showing that investment and savings can correlate even without frictions to capital mobility when macroeconomic determinants that favor capital flow from richer to poorer economies deteriorate. I then test the model predictions against a data set of 12 European economies spanning since the inception of the Maastricht treaty and ending immediately before the start of the Covid-19 pandemic. I find that the I-S correlation is generally low both across and within open economies in accordance with the theoretical stylized fact. However, this can be jeopardized when economies accumulate large net stocks of foreign liabilities on top of sluggish productivity growth. Ultimately, if investment and savings are not rationally managed according to productivity growth, and because foreign investors eventually rise a premium on the new liabilities, therefore raising the cost of financing investment with foreign funds, this leads investment and savings to correlate across and within countries, therefore explaining the resurgence of the puzzle in Europe after the global financial crisis, when it had already been declared as extinguished