Golden rule of capital accumulation (1961)

A term used by English economist ERNEST PHELPS (1906-1994), golden rule of capital accumulation analyzes the best plan of economic growth which will give the optimal sustained level of consumption per capita in an economy.

It is assumed that each generation will save for future generations a proportion of the income which was in turn saved for it by its previous generation.

Source:
E S Phelps, ‘The Golden Rule of Accumulation: A Fable for Growthmen’, American Economic Review, vol. LII (September, 1961), 638-43

The Golden Rule is a guideline for the operation of fiscal policy. The Golden Rule states that over the economic cycle, the Government will borrow only to invest and not to fund current spending. In layman’s terms this means that on average over the ups and downs of an economic cycle the government should only borrow to pay for investment that benefits future generations. Day-to-day spending that benefits today’s taxpayers should be paid for with today’s taxes, not with leveraged investment. Therefore, over the cycle the current budget (i.e., net of investment) must balance or be brought into surplus.

The core of the ‘golden rule’ framework is that, as a general rule, policy should be designed to maintain a stable allocation of public sector resources over the course of the business cycle. Stability is defined in terms of the following ratios:

1. The ratio of public sector net worth to national income
2. The ratio of public current expenditure to national income
3. The ratio of public sector income to national income.

If national income is growing, and net worth is positive this rule implies that, on average, there should be net surplus of income over expenditure.

The justification for the Golden Rule derives from macroeconomic theory. Other things being equal, an increase in government borrowing raises the real interest rate consequently crowding out (reducing) investment because a higher rate of return is required for investment to be profitable. Unless the government uses the borrowed funds to invest in projects with a similar rate of return to private investment, capital accumulation falls, with negative consequences upon economic growth.