R Minus G

Abstract

Long-term data show that the dynamic efficiency condition r>g holds when g is represented by the average growth rate of real GDP if r is the average real rate of return on equity, E(r e ) , but not if r is the risk-free rate, r f . This pattern accords with a simple disaster-risk model calibrated to fit observed equity premia. If Ponzi (chain-letter) finance by private agents and the government are precluded, the equilibrium can feature r f ≤E(g) , a result that does not signal dynamic inefficiency. In contrast, E(r e )>E(g) is required for dynamic efficiency, implied by the model, and consistent with the data. The model satisfies Ricardian Equivalence because, without Ponzi finance by the government, a rise in safe assets from increased public debt is matched by an increase in the safe (that is, certain) present value of liabilities associated with net taxes.