Politics and Efficiency of Separating Capital and Ordinary Government Budgets∗

We analyze the democratic politics and competitive economics of a ‘golden rule’ that separates capital and ordinary account budgets and allows a government to issue debt to finance only capital items. Many national governments followed this rule in the 18th and 19th centuries and most U.S. states do today. We study an economy with a growing population of overlapping generations of long-lived but mortal agents. Each period, majorities choose durable and nondurable public goods. In a special limiting case with demographics that make Ricardian equivalence prevail, the golden rule does nothing to promote efficiency. But when the demographics imply even moderate departures from Ricardian equivalence, imposing the golden rule substantially improves the efficiency of democratically chosen allocations of public goods. We use some examples calibrated to U.S. demographic data and find greater benefits from adopting the golden rule at the state level or with 19th century demographics than under current national demographics. ∗We benefited from comments from Manuel Amador, V.V. Chari, Mariacristina De Nardi, Robert Lucas, Leslie McGranahan, Ellen McGrattan, Edward C. Prescott, Robert Shimer, Nancy Stokey, Judy Temple, François Velde, Ivan Werning, and especially three referees and an editor. Florin Bidian and Vadym Lepetyuk provided excellent research assistance. Financial support from NSF and the Sloan Foundation is gratefully acknowledged. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Chicago, the Federal Reserve System, or NSF. †Federal Reserve Bank of Chicago, Research Department, 230 S. LaSalle St., Chicago, IL 60604, University of Minnesota, and NBER. Email: [email protected] ‡New York University and Hoover Institution. Email: [email protected]