Thinking

Pikettynomics

Piketty’s almost universally hailed Capital in the Twenty-First Century is a work of great importance; one that will be widely known decades from now. The reason why this book is so path-breaking — and this tells us a lot about the discipline — is that Piketty brings two hundred years of economic history to bear on the question of inequality. Economists have for too long ignored both economic history and the distribution of wealth and income. Almost every economist worth his salt has written a raving review. The Economist: “The book aims to revolutionize the way people think about the economic history of the past two centuries. It may well manage the feat.” What’s everyone raving about?

The gist of the Piketty’s argument is that there is a natural tendency in capitalism towards ever-greater stratification. Left to itself, the system inexorably concentrates wealth and capital; and that this means that sooner or later inherited wealth comes to dominate lifetime savings of the highest earners. The causal mechanism that drives this process is the difference between the return on capital and the growth rate of the economy. Piketty finds that the return on capital has been remarkably stable over the very long run, at around 4-5%. Similarly, GDP growth has displayed remarkable stability over the very long run, staying close to 1-2% for countries at the technological frontier and a stable population.

This gap of 3% between the growth of wealth and national income means that the ratio of accumulated wealth to average incomes keeps increasing. On the other hand, growth, whether demographic or in per capita incomes, works against increasing concentration. However, the demographic explosion of the nineteenth and twentieth centuries is unlikely to be repeated and per capita incomes only grow quickly in countries playing technological catch-up — no country at the technological frontier not undergoing sustained demographic expansion has ever achieved growth rates higher than 2%. Given that we are almost back at Victorian era levels of capital/income of 600-700%, the wealthy countries are facing a highly inegalitarian future ripe for political instability.

Let me digress here to provide a quick rule of thumb to familiarize the reader with the magnitudes involved. As of writing, there is a rough 10-1/2 rule in the income distribution: 10% of the highest earners take home roughly 1/2 of all income, the top 1% take 1/4, the top 0.1% take 1/8, and the top 0.01% take 1/16. The distribution of (non-home) wealth is twice as concentrated: the top 10% of wealth holders own 3/4 of all assets, the top 1% own 1/2, the 0.1% own 1/4, and the 0.01% own 1/8. Furthermore, due to the fact that larger asset portfolios earn higher returns on average — roughly 12% for portfolios in billions, 10% for hundreds of millions, 8% for tens of millions, and roughly 6% for smaller ones — capital gains (net increase in wealth) are still more concentrated: with the top 0.1% of wealth holders (with assets in excess of $20m) taking nearly 1/2 of all gains.

Top wealth shares

One last point before we return to Piketty. Earned income dominates the upper levels of the income distribution all the up to the 0.1%, at and above this level, income from capital becomes larger than earned income. Since the dynamic is driven by the differential returns to capital and labor, this is the line of demarcation that one needs to pay attention to. Loosely speaking, a rentier society is one where ‘the weight of the past’ is so strong that even the highest income earners cannot match the unearned incomes of the upper classes, whose inherited wealth allows them a lifestyle that is simply unachievable to those who did not win the birth lottery. That is, Jane Austen’s world.

Piketty’s historical narrative is straightforward. Eighteenth and nineteenth century Europe was a rentier society that grew steadily more stratified. Demographically exploding America, with its virtually free land, was very slow to catch up (modulo the plantation south). It was only at the turn of the century that the United States became half as stratified as Europe; although, by then, it too had become a rentier society. On the eve of the Great War, Europe attained a yet to be outdone peak of both capital/income ratio (700%) as well the highest concentration of wealth. In 1910, the top 1% of British wealth holders owned 70% of national wealth, while the top 0.1% held 40%. The continent was only slightly more egalitarian, with the top 1% controlling just 60%, whereas America’s wealthy lagged behind at 40%.

The period 1914-1945 saw a virtual ‘euthanasia of the rentiers’ as the world wars, depression, hyperinflation, and exaction by the state decimated accumulated fortunes. This process was much more pronounced on the continent which bore the brunt of the physical destruction, debt defaults, and hyperinflation. The Anglo-Saxon countries survived relatively unscathed, but their response to the Great Depression has similar, if attenuated, effects on accumulated wealth. In Piketty’s telling, the rapid growth rates of the post-war period along with anti-capital policies meant both that the return on capital was lower than the rate of growth and asset prices remained depressed. After 1980, return of low growth and a sustained asset price recovery due to capital friendly policies led to a rebound in wealth inequality.

Due to the inherent slowness of the process, it took nearly three decades for the wealthy countries to return to the distribution last seen in the nineteenth century. If there is no major shock or dramatic shift in policies, by 2030, Europe will surpass the levels of concentration attained around 1910. This process will be slower in the United States due to expected population growth of 1%. US wealth stratification is expected to reach pre-World War I European levels only by 2050. Parenthetically, Piketty explains the rise in earned income inequality as being a response to the lowering of tax rates. Skyrocketing executive compensation is responsible for two-thirds of the increase. He reckons that lower taxes on high incomes mean that executives face strong incentives to bargain for fat paychecks.

Piketty’s proposal to thwart this relentless march towards rentierdom is a progressive global tax on capital. That is, an annual tax of a few percent on great wealth facilitated by international data sharing which is already technologically feasible. “One might imagine a rate of 0 percent for net assets below 1 million euros, 1 percent between 1 and 5 million, and 2 percent above 5 million. Or one might prefer a much more steeply progressive tax on the largest fortunes (for instance, a rate of 5 or 10 percent on assets above 1 billion euros).” The benefits include not just a levelling of the playing field, but also a “more just and transparent international tax system.” Although it would be optimal, Piketty thinks it is “utopian,” owing to the political power of plutocrats.

Musings

The motor behind the natural law towards ever greater concentration of wealth is the difference between the rate of return on capital and the rate of growth of income. How can the rate of return on capital exceed GDP growth in perpetuity? Piketty has demonstrated that this is what obtained. But why?

Controlling for demographic factors, the growth of national income in the very long run is determined almost solely by growth in productivity. Why has this been more or less constant at 1% over the past two centuries? Why the same rate in the early nineteenth century and the late twentieth? GDP estimates only began during the Great Depression. Perhaps earlier figures are more extrapolations than estimates? It’s hard to believe that American growth rates were constant from the Early Republic through the railroad revolution and the rapid industrialization of the late nineteenth century that forged the greatest industrial power in history. Same goes for Britain. Shouldn’t we expect growth rates in Britain to be substantially higher between 1820-1850??

The near constant 4-5% rate of return on capital is similarly inexplicable. The stability of the rate of return on capital in the nineteenth century is stunning. Piketty talks about how Balzac and Austen move freely between describing a gentleman as being worth £250,000, or equivalently as one with £10,000 in annual income. Why should this be the case? During the long nineteenth century (1815-1914), there was zero inflation in the center countries. Moreover, the bulk of the financial assets were held in government bonds, which paid 4-5%. But landed estates derived their income from agriculture. Even if the former were stabilized by the prudent fiscal management of the Crown, why the latter? In particular, there must’ve been considerable long term movements up and down in the terms of trade between industry and agriculture. Why then were the incomes from landed estates so stable?

Piketty has ignored the long-term effects of monetary regimes. Dumenil and Levy demonstrated the key role played by real interest rates in the distribution of surplus between labor and capital since the end of World War II. The long-term empirical stability of the rate of return on capital is an epiphenomena. Perhaps one that is an artifact of monetary regimes rather than a constant of nature. If this is the case, then — due to the absolute stability of the monetary regime between Waterloo and World War I — the entire century would count as a single observation. Economic historians who are familiar with the rates since the sixteenth century need to weigh in here. Unfortunately for us all, Braudel is long dead.

My personal feeling is that we can’t get to the bottom of this without a solid explanation of these remarkable regularities. There is no such thing as an empirical law — Piketty himself attacks Kuznets for extrapolating from limited data. Although he has compiled an impressive dataset, the forecast for the twenty-first century may have greater variance than he concedes. For now however, we must treat Piketty’s projections as the baseline scenario. Given that variance works both ways, this is already pretty scary.

This is by no means the last you have heard of Piketty on these pages. We’re sure to be talking about this for a long time.

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