Assessing Dynamic Efficiency: Theory and Evidence

This paper asks whether actual capitalist economies have overaccumulated capital relative to the Golden Rule — the condition Diamond (1965) showed can leave an economy “dynamically inefficient,” so that a Pareto improvement exists by consuming down the capital stock. The authors generalize Phelps’ (1961) Golden Rule criterion to a stochastic economy with a very general production technology, and show that dynamic efficiency can be assessed simply by comparing the cash flow investors receive from the corporate/capital sector (profit net of investment, the “dividend”) with zero: if that net cash flow is always positive, the economy is dynamically efficient; if it is always negative, the economy is inefficient. Applied to United States national accounts data (1929-1985 in this draft) and to several other OECD economies (1960-1984), the criterion is satisfied “by a wide margin in all years” — capital income has exceeded gross investment by more than 15 percent of GNP every year since 1929 — so the authors conclude these economies are dynamically efficient. The paper then explains, using a simple infinite-horizon “fruit tree” asset-pricing example, why this finding is fully consistent with the empirical puzzle that safe real interest rates are often far below measured growth rates or even negative: capital-price risk can permanently depress the safe rate below the growth rate in an economy that is nonetheless dynamically efficient, so comparisons of the safe interest rate to the growth rate — unlike the cash-flow test — are not a valid way to diagnose overaccumulation.

Richard J. Zeckhauser | Macro Paper Warehouse

Assessing Dynamic Efficiency: Theory and Evidence