It is causal: revisiting the savings and investment nexus¹

ABSTRACT

Domestic savings and investment are positively correlated across countries and through time, as first suggested by Feldstein and Horioka (1980). However, whether this long-lasting correlation implies causation is still an open question. In this paper, we use instrumental variables in a panel setting and show that domestic savings do cause investment in developing economies. In contrast, for advanced countries the statistically significant correlation found in the data seems to result from endogeneity bias. Our identification strategy relies on the idea that age structure influences savings, but not total investment directly. Time-series data patterns for the United States and the theory of Direct Technological Change lend credence to our exclusion restriction.

KEYWORDS:

• Investment
• savings
• causality

JEL CLASSIFICATION:

• E21
• E22
• F40

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ All usual disclaimers apply. The views expressed in this paper are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

² The list of these oil-exporting countries is the following: Angola, United Arab Emirates, Azerbaijan, Republic of Congo, Equatorial Guinea, Iran, Iraq, Kuwait, Libya, Oman, Qatar, Saudi Arabia, South Sudan, Timor-Leste and Venezuela.

³ This variable presents enough variation not only across countries, but also through time. If, instead, we employ the broader [15:64]-age bracket, all results carry through roughly unchanged.

⁴ We thank an anonymous referee for this suggestion..

⁵ We exclude Sweden, Romania, Liberia, and Mongolia from the sample because the country-specific coefficient estimates for these economies are clear outliers.

⁶ Several alternative explanations have been put forward for a high correlation between savings and investment observed in the data. Baxter and Crucini (1993) show that even in a stochastic growth model with perfect capital mobility, national saving and investment rates are positively correlated if technology shocks in large countries have non-trivial effects on world interest rates. Global productivity shocks (common across countries) are also put forward as a possible explanation for the puzzle: driving the co-movement between savings and investment rates (Glick and Rogoff 1995). Barro, Mankiw, and Sala-i-Martin (1995) point to differences in tax rates, broadly interpreted as distortions to the returns on physical and human capital, as an explanation for the puzzle. The underlying idea is simple: in a standard growth model with full capital mobility, foreign savings might not respond to changes in differential returns if after-tax returns on capital are equalized via tax policy. Obstfeld and Rogoff (2000) highlight the role of international trading costs in explaining the observed correlation in the data.