Overview

Signed in 1992, the Maastricht Treaty stipulates that the total public debt of each member country should be less than 60% of its GDP and the yearly public deficit smaller than 3% of GDP. Today these criteria apply to 28 countries of the European Union as well as to any potential member. One may infer that those numbers have been determined by some reference to the optimal savings of a nation. In fact, any such link was totally absent, and those rules that have a bearing not only on the present but also on the future welfare of half a billion individuals are not supported in any way by optimal growth theory. Why? This chapter will argue that the theory, as it has been developed, has never been able to come up with a reasonable answer to the problem of determining how much a nation should save.

We will show that the traditional approach, based on the systematic use of strictly concave utility functions, never delivered; and when the bold step of modifying the utility function to obtain a reasonable answer was taken, it unfailingly led to nonsensical values for other variables of central importance such as the growth rate of real income per person, the marginal product of capital, or the capital–output ratio.

Our profession should have taken note of those inadequacies long ago. They had been met already by the very originator of the theory, Frank Ramsey (1928), who tried to get numbers from the theory, and whose disappointment when obtaining an “optimal” savings rate of 60% is almost palpable. Thirty years later, Richard Goodwin (1961) obtained even worse results in all models he considered – but contrary to Ramsey, he set out to defend them in a dumbfounding way. Finally, Robert King and Sergio Rebelo (1993) convincingly showed that it was an impossible task to replicate the observed development of an economy by assuming some form of the traditional model.