A new discussion paper by Miguel León-Ledesma and Alessio Moro, KDPE 1604, May 2016.
Non-technical summary
The possible tendency for the returns to investment in real capital to fall as economies develop has been a long-standing problem in Economics that already preoccupied classical economists. In standard models of economic growth, the concept of balanced growth path (BGP) implies that the real return on capital, the rate of growth of GDP, the capital-to-output, and investment-to-output ratios are all constant. In the data, this is consistent with the so-called “Kaldor stylized facts”. Models of growth that achieve BGP, thus, imply that the rate of return on capital is constant in the long run.
However, several observations are at odds with this. First, when measured in real terms, i.e. deflated by their respective prices, the capital-to-output and the investment-to-output ratios in the US economy both have a positive trend. Intuitively, this implies a lower average product of capital and, under certain conditions, a lower marginal product. Second, recent evidence for the US shows that the so-called “natural” or equilibrium real interest rate has declined quite substantially during the past 50 years. This has occurred at a time when there has been a massive transformation in the structure of the economy from manufacturing to services. Consumption of services was a mere 40% of total consumption expenditure in 1950, and is now close to 70%. This was accompanied by a very marked decline in the prices of goods relative to services.
In this paper, we propose an explanation for all these facts. We use a model of structural change from goods producing to services producing industries driven by productivity growth differences between the two sectors. Productivity grows slower in services. This differential explains the drop in the relative price of goods. The model generates BGP, with a constant real return to capital. However, this is only the case if this return is measured in terms of a chosen price, the price of goods (including investment goods). If we take the model-generated real return and GDP growth, and we measure them as it is done in national accounts, we actually would observe a secular decline. This is because services are now a larger share of consumption and GDP and their prices grow faster, hence reducing the actual number of units of consumption or output that one can buy after an investment project in real capital (i.e., the real return).
We estimate that, for the 1950-2015 period, the fall in the real rate of return due to this mechanism is of the order of 40%. The rate of growth of GDP falls by a less substantial 16% for the 65 years of the sample. These are both very significant shifts with important consequences for macroeconomic policy design, pension plans projections, and financial management.