The Market Failure That Matters Most

Why ignoring the Golden Rule rate of economic growth leaves future generations worse off.

If you’ve taken a macroeconomics course, you may remember a concept called the Golden Rule rate of economic growth. The Golden Rule rate is the rate of economic growth that maximizes consumption across time. In many textbooks, it’s introduced briefly—almost in passing—before the course moves on to other material. Yet the Golden Rule is arguably the standard by which macroeconomists should measure intergenerational welfare.

In this post, I’ll explain why the Golden Rule rate of growth matters, why it’s not automatically achieved under laissez-faire conditions, and why it highlights a deep economic inefficiency that we often gloss over.

The Golden Rule Rate of Growth

The Golden Rule rate of growth typically shows up in economic growth models like the Solow model or the Ramsey model of optimal saving. The idea is straightforward. If a society saves (and correspondingly invests) too little, it forgoes capital accumulation that could boost future output and welfare. If it saves too much, the current generation sacrifices so much current consumption for the sake of the future that the future is burdened by having to maintain an excessively large capital stock, one that produces negative real returns (this is called dynamic inefficiency).

At the Golden Rule rate of growth, you get the highest possible steady-state level of consumption per capita, spanning across generations. The economy forgoes enough current consumption today to accumulate capital at a rate that maximizes consumption for future use. A related concept is the Golden Rule rate of saving.

Why Markets Don’t Save “Enough” on Their Own

Under laissez-faire, there’s no inherent mechanism that pushes an economy to this Golden Rule rate. Individuals make saving decisions based on personal preferences and other constraints, but they typically do not coordinate these decisions to achieve intergenerational efficiency.

In standard growth models, the reason the laissez-faire equilibrium doesn’t yield the Golden Rule is that each person maximizes his or her own welfare—taking future returns and future consumption into account for itself, but not for a broader “societal” objective. In the Solow framework (a simple model), the saving rate is often assumed to be fixed by some outside factor such as a “rule of thumb” or cultural norm; there’s no direct reason why this savings rate would be the Golden Rule rate.

In the Ramsey model (which is more sophisticated), a representative individual chooses consumption over time to maximize its own utility. The outcome is governed by the individual’s rate of time preference. There’s no built-in reason that this private solution aligns with the intergenerational optimum—the so-called Golden Rule level of capital accumulation. In fact, we can expect individuals won’t achieve this outcome, because they discount the future. A considerable amount of future welfare is lost in this discounting process.

In other words, the market doesn’t fully account for the external benefit that current saving bestows upon future generations. Any individual generation, on its own, could be made better off relative to the Golden Rule level by reducing its rate of saving. Each generation would prefer consume more out of current income for itself than the Golden Rule level. Relative to following its own preferences, then, the Golden Rule rate of saving requires some sacrifice for the sake of the future.

When Externalities Span Generations

This lack of alignment between private decision-making and social (intergenerational) welfare is a classic market failure—only it’s far more sweeping than the market failures we typically learn about in textbooks.

Externalities typically bring to mind short-term scenarios. A noisy neighbor, an overly chatty train passenger, or a polluter who fouls the local water supply. These are all valid inefficiencies: one person is imposing a cost on another that isn’t fully reflected in market transactions. The standard policy remedy is to implement a Pigouvian tax or a regulation that aligns private incentives with social costs.

But the Golden Rule problem highlights a massive externality across time. When one generation does not save enough, future generations pay the price. Even if markets are efficient in the narrow sense of clearing and allocating resources at a given moment, they fail to optimize over long time horizons because they do not internalize the value of future consumption that is lost when we partake in consumption today.

Why This Market Failure is More Acute

Let’s compare this intertemporal externality to a more trivial externality—like loud talking on a train. A chatty passenger causes annoyance, which is a real cost to the person next to them. The overhearer would be willing to pay a modestly higher fare for a quieter train. A textbook fix might be a “noise tax,” prompting the passenger to speak more quietly (or pay a fee, assessed by a noise enforcer on the train). This might be good for near-term efficiency, because we reduce a negative externality.

But notice something crucial: in the typical case, the externality has little to do with saving. Unless people on the train respond to loud talking by forgoing the subway entirely (thus drawing down savings to pay for taxis, or otherwise changing their saving-consumption patterns), the effect on future generations is negligible.

Suppose we do impose a tax to curb loud talking, and this policy incidentally reduces overall saving, for example because people engage in costly tax avoidance behavior or because the costs of enforcement are high. That means there’s less capital accumulated for future generations. Even if, at the moment, people value the quieter train ride quite highly, the compounding returns to forgone saving will eventually grow huge. After many years (or decades), future generations might say, “We’d have been willing to live with the loud talkers all this while if it meant we got a far larger capital stock and thus higher consumption possibilities.”

This scenario illustrates how the intergenerational externality can dwarf other, more mundane externalities. A short-term annoyance pales in comparison to a long-term shortfall in capital accumulation, because investment returns compound over time.

Why Economists “Discount” the Future

Given the dizzying implications of allowing future generations full say in today’s policies, economists often introduce a discount rate to reflect the current generation’s time preference. This moves the math and policy prescriptions back toward more palatable territory that doesn’t require today’s society to sacrifice most of its consumption for the sake of tomorrow.

But never forget: this is a normative choice. The discount rate is not handed down from a higher authority; it’s how economists (and policymakers) decide to weigh the present against the future, often to avoid conclusions that would seem extreme or politically off-putting. For example, failing to discount the future might imply we should subsidize polluting industries when the health risks of pollution fall on seniors who, because they are retired, live off their savings. Discounting the future helps avoid this conclusion. However, a discount rate does not eliminate these tradeoffs; they exist regardless of whether we choose to acknowledge them.

Dynamic Efficiency Versus Static Efficiency

This tension highlights two different types of efficiency. Dynamic Efficiency means achieving the ideal rate of economic growth over time, i.e., saving and investing in such a way that we maximize wellbeing across all generations. Static Efficiency means making the best possible use of resources at a particular moment in time, given current tastes, technologies, and incomes.

Pursuing one often means having to sacrifice the other. Piling up capital for the future generally means reducing today’s consumption (a sacrifice in static efficiency). But ignoring tomorrow’s wellbeing to enjoy maximum consumption today means falling short of dynamic efficiency.

Ideally, policymakers would aim for win-win interventions that improve both present-day welfare and future welfare. For example, public investments in infrastructure that boost short-term productivity while also increasing future capital stocks and living standards illustrate this approach. All too often, however, policy debates revolve around taxes or regulations and their effects today, without explicitly considering their effects on long-term saving.

Ask the Right Questions

Next time an economist proposes a new tax or regulation for the sake of “economic efficiency,” ask yourself: How does it affect future generations? Are we reducing or increasing saving and investment possibilities? Does the policy inadvertently make the economy less dynamically efficient?

A policy that improves static efficiency but reduces the incentive (or capacity) to save may be a net loss for society if the compounding gains foregone by future generations outweigh the current benefits.

Recognizing this tension is a first step to addressing the market failure that stems from the under-accumulation of capital for future generations. In a world where small changes in saving can lead to large differences in future wellbeing (thanks to compounding), there’s a real danger that the loudest voice at the policy table will be that of the present—while the (economically) biggest voice might belong to the future.

If we focus only on short-run market efficiencies and overlook the Golden Rule for growth and saving, we risk creating a massive intergenerational externality that leaves future generations poorer than they need to be. Whether and how we correct that market failure remains a deeply normative choice, which is precisely why it’s one of the most important policy questions we face.

In short, don’t let the Golden Rule rate of growth fade into obscurity after your intermediate macro class. It’s a reminder that “efficient” market outcomes at a snapshot in time may fail spectacularly when measured against what’s possible across longer timespans. And that’s a market failure that truly matters.