Our economy has become increasingly global. We import and export more than ever before. Yet, three facts about international financial transactions, when taken together, pose a puzzle. First, financial capital moves freely across country borders, at least in the case of the developed countries. Returns on similar dollar-denominated assets in different countries are very close to each other — differences in returns have essentially been eliminated because some investors buy and sell assets internationally. Second, residents of most major industrialized countries hold most of their wealth in domestic assets, forgoing the benefits of diversifying their portfolios by including foreign assets. A fundamental tenet of finance holds that portfolios should be diversified, and presumably, such diversification includes holding foreign stocks and bonds. Third, domestic saving is closely tied to domestic investment. However, if financial capital moves freely across borders, countries that want to invest more than they are saving domestically should be able to borrow from other countries to finance investment, while countries that have excess savings should be able to lend those savings to foreigners. This would mean domestic saving and investment wouldn’t necessarily move together, but they are closely linked in the data.

This article appeared in the Third Quarter 2001 edition of Business Review.

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