Tuesday, May 10, 2016

When Investment Isn’t Investment

From VoxEU (excerpt):

The ‘real’ explanation of the Feldstein-Horioka puzzle – and what it means
Nicholas Ford, Charles Yuji Horioka

…The nature of the Feldstein-Horioka puzzle concerns the mobility of the world’s supply of capital. There is a presumption amongst economists that financial markets can rapidly, and nearly without cost, divert ‘financial capital’ from one country to another. This being the case, it would be expected that savings should be diverted from wherever they occur to where the best investment opportunities are by agents seeking to maximise returns. There is no reason the best investment opportunities should be in a savers’ home country; as a consequence, according to this reasoning, the levels of investment and saving should not be correlated across countries. However, Feldstein and Horioka (1980) found that this is not the case and that most incremental saving is in fact invested in the country in which it occurs. The puzzle is to try to understand why this should be the case….

…The principal insight of our paper is to appreciate that although international financial markets may allow individual agents to move their own ‘financial capital’ between countries, international financial markets cannot, by themselves, achieve net transfers of capital between countries…Suppose an agent such as the hypothetical Ms Tanaka chooses to move her capital from Japan to the US by selling a Japanese bond, buying US dollars with the Japanese yen raised, and then buying a US bond. There must be counterparties to the transactions. Suppose Mr Smith is the counterparty who sold Ms Tanaka the dollars and uses the yen to buy a Japanese bond. Ms Tanaka has moved her capital from Japan to the US, but Mr Smith has moved his capital in the reverse direction, so there is no net transfer of capital between the countries. The same rationale applies to all transactions that involve only financial assets – they do not involve a net transfer of capital between countries regardless of how large or numerous they are.

A net transfer of capital between countries requires one of the parties (Ms Tanaka or Mr Smith) to buy a financial asset and the other to buy goods or services. In that case the transfer of ‘financial capital’ by one party is not netted off by the counterparty’s transaction. Thus, a net transfer of ‘financial capital’ can only occur between countries as a result of a goods market transaction, and the aggregate net transfer of ‘financial capital’ between countries occurs as the result of an aggregated net transfer of goods and services in the same direction. The transfer of goods between countries involves additional frictions and costs compared to their use in their country of origin (e.g., transport, marketing and distribution costs, technical standards, certification procedures, tariffs and non-tariff barriers, etc.). These frictions in goods markets therefore inhibit the net transfer of financial capital as well as real capital between countries, and so make it likely that national saving and domestic investment are highly correlated. In other words, net transfers of capital require the integration of not only financial markets but also goods markets, and frictions in one or both of these markets can impede net transfers of capital and cause high saving-investment correlations. Moreover, there is empirical evidence (e.g. Eaton et al. 2015) that barriers to the mobility of goods and services are an important obstacle to international capital mobility.

Aren’t we economists stupid for not figuring this out all this time? Actually, it’s hardly economists alone who fall into the trap of thinking of only one side of the transaction. Take for example the common fallacy of thinking of the government budget as if it were the same as a household’s.

Here’s another one: people think FDI is “good” because it involves inflows of capital into a country. But consider that FDI falls under three categories:

  1. Greenfield investment
  2. Mergers and acquisitions
  3. Retained earnings

Greenfield investment involves purchases of land, equipment and services to start up a “new” business. But land purchases are an asset transfer (someone has to sell that land, a divestment), so there’s no net change in investment. M&A involves purchases of more than 10% of the value of a company – but again, someone has to be on the other side of that transaction i.e. there is no net gain in investment. Retained earnings are the amount of profit made by a foreign entity that is not repatriated. In other words, it does not involve an actual inflow of funds, although FDI has “risen”.

Try this thought experiment. Ali owns a piece of land, and wants to sell it for RM1 million. Ahmad agrees to buy it because he thinks he can build some houses on it, but then changes his mind and turns around and sells it to Ah Chong for RM2 million, who wants to build some shop houses. Ali then offers to buy it for RM5 million, because he plans to build an office bloc instead. Ahmad then buys it for RM10 million, because he has plans for a skyscraper. At each stage, there’s an investment and a divestment, such that net investment doesn’t change (though presumably debt does). The land doesn’t change, though its apparent value does.

All prices are in the end social constructs, dependent on the percieved usefulness of an asset to each successive buyer and seller, and the social norms that govern our interactions.

Lastly, consider the case for gold as the underlying basis of all “money”. Gold bugs think of fiat money as somehow “artifical” and think that a return to gold-backed currencies would provide a more solid foundation for the global monetary system. But the “value” of gold (whether as currency or jewellery or investment asset) is itself subject to the vagaries of social perception. Gold only holds its value for someone if other people value it, and doesn’t if it does not. In that sense, the value of gold is as “artificial” as paper money.

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