Dynamic Efficiency, Private Capital, and Taxpayer Investments in Government Wealth: A Response to Martin Sandbu

Martin Sandbu has a truly interesting and excellent comment on my first, inital draft of thoughts for next week’s Blanchard-Rajan-Rogoff-Summers “Rethinking Macroeconomics” conference.

But I do think he oversimplifies one crucial issue: dynamic efficiency.

Elementary neoclassical growth theory tells us that to the extent that patience and tolerance for intergenerational inequality between the past and the future allows, societies should try to push their accumulation of capital toward the point of the Golden Rule: the point at which the marginal product of capital r has fallen to the economy’s labor-force growth rate n plus its labor productivity growth rate g. And it tells us that an economy that has pushed accumulation beyond that point–that has g+n > r–has overdone it. Such an economy is dynamically inefficient, and it should disinvest in its accumulation of capital.

The United States economy today is surely not dynamically inefficient as far as its private capital stock goes. Its accumulated and properly-depreciated capital stock is equal to no more than four times annual net income. The 30% of net output paid as income to capital thus sets an average net product of capital of 7.5% per year. And the marginal product of capital is unlikely to be much lower. As this is a real return, it is to be compared with the sum of the 0.75% per year labor-force growth rate and a current trend labor-productivity growth rate of 1.5% per year. We see a very substantial wedge by which r is greater than n+g, for private capital.

But we as a society and as taxpayers invest not just in private capital wealth but in the wealth of our government as well. Our investments in the wealth of our government produce cash flows through the government’s infrastructure and organization. We invest in the wealth of our government by paying taxes used to build up infrastructure and organization and by buying back the debt that the government has previously issued. And it is here, I think, that the neoclassical growth-model dynamic-efficiency framework becomes relevant. The current ten-year TIPS rate for U.S. government debt is zero. Yes, that is: 0. There is no real resource cost to the U.S. government from selling a TIP today, using the money for a decade, and paying it back in 2025. n+g > r.

And n+g > r for a long, long time. Since the start of the twentieth century, only during the Great Depression has the interest on the debt been more than the smoothed decade-average growth rate of the American economy.

What does this tell us about the value of using our tax money to pay down or even slow the growth rate of the national debt? Nothing good. It tells us that we taxpayers should disinvest our wealth from the government, and keep on doing so until, for claims on the government as well as for claims on the private sector, r > n + g.

But, you may ask, why is there this very wide gap between the marginal return to investments in private capital and the marginal return to investments in government wealth via paying down the government debt? Why a 7.5%/year real return on physical and organizational capital, a 5%/year return on investments in diversified equities, a 2.5%/year real return–4.5%/year nominal–on seasoned Baa corporate bonds, 0%/year real for investments in long-term government securities, and -1%/year at the moment for Treasury bonds purged of duration risk?

That is a great puzzle. It is strongly suggestive of major, major financial market dysfunction. Systematic risk can, we know, account for at most 100 basis points of that 850 basis point spread. But the origins, and the potential cures, of these enormous spreads have no bearing on the Golden Rule lessons–that it strongly looks like we need to invest a lot more in private physical and organizational capital, for the gap between 7.5% and 2.5% is far more than taxes, fees, enterprise, and other middle intermediaries can justify. And it strongly looks like we taxpayers need to invest a lot less in government wealth via being in a hurry to pay down our current debt, for the gap between 2.5% and 0% on that side is wide as well.