The Inequality Puzzle
Thomas Piketty’s tour de force analysis doesn’t get everything right, but it’s certainly gotten us pondering the right questions.
Once in a great while, a heavy academic tome dominates for a time the policy debate and, despite bristling with footnotes, shows up on the best-seller list. Thomas Piketty’s Capital in the Twenty-First Century is such a volume. As with Paul Kennedy’s The Rise and Fall of the Great Powers, which came out at the end of the Reagan Administration and hit a nerve by arguing the case against imperial overreach through an extensive examination of European history, Piketty’s treatment of inequality is perfectly matched to its moment.
Like Kennedy a generation ago, Piketty has emerged as a rock star of the policy-intellectual world. His book was for a time Amazon’s bestseller. Every pundit has expressed a view on his argument, almost always wildly favorable if the pundit is progressive and harshly critical if the pundit is conservative. Piketty’s tome seems to be drawn on a dozen times for every time it is read.
This should not be surprising. At a moment when our politics seem to be defined by a surly middle class and the President has made inequality his central economic issue, how could a book documenting the pervasive and increasing concentration of wealth and income among the top 1, .1, and .01 percent of households not attract great attention? Especially when it exudes erudition from each of its nearly 700 pages, drips with literary references, and goes on to propose easily understood laws of capitalism that suggest that the trend toward greater concentration is inherent in the market system and will persist absent the adoption of radical new tax policies.
Piketty’s timing may be impeccable, and his easily understandable but slightly exotic accent perfectly suited to today’s media; but make no mistake, his work richly deserves all the attention it is receiving. This is not to say, however, that all of its conclusions will stand up to scholarly criticism from his fellow economists in the short run or to the test of history in the long run. Nor is it to suggest that his policy recommendations are either realistic or close to complete as a menu for addressing inequality.
Start with its strengths. In many respects, Capital in the Twenty-First Century embodies the virtues that we all would like to see but find too infrequently in the work of academic economists. It is deeply grounded in painstaking empirical research. Piketty, in collaboration with others, has spent more than a decade mining huge quantities of data spanning centuries and many countries to document, absolutely conclusively, that the share of income and wealth going to those at the very top—the top 1 percent, .1 percent, and .01 percent of the population—has risen sharply over the last generation, marking a return to a pattern that prevailed before World War I. There can now be no doubt that the phenomenon of inequality is not dominantly about the inadequacy of the skills of lagging workers. Even in terms of income ratios, the gaps that have opened up between, say, the top .1 percent and the remainder of the top 10 percent are far larger than those that have opened up between the top 10 percent and average income earners. Even if none of Piketty’s theories stands up, the establishment of this fact has transformed political discourse and is a Nobel Prize-worthy contribution.
Piketty provides an elegant framework for making sense of a complex reality. His theorizing is bold and simple and hugely important if correct. In every area of thought, progress comes from simple abstract paradigms that guide later thinking, such as Darwin’s idea of evolution, Ricardo’s notion of comparative advantage, or Keynes’s conception of aggregate demand. Whether or not his idea ultimately proves out, Piketty makes a major contribution by putting forth a theory of natural economic evolution under capitalism. His argument is that capital or wealth grows at the rate of return to capital, a rate that normally exceeds the economic growth rate. Thus, economies will tend to have ever-increasing ratios of wealth to income, barring huge disturbances like wars and depressions. Since wealth is highly concentrated, it follows that inequality will tend to increase without bound until a policy change is introduced or some kind of catastrophe interferes with wealth accumulation.
Piketty writes in the epic philosophical mode of Keynes, Marx, or Adam Smith rather than in the dry, technocratic prose of most contemporary academic economists. His pages are littered with asides referencing Jane Austen, the works of Balzac, and many other literary figures. For those who don’t like or trust economics and economists, Piketty’s humane and urbane learning makes his analysis that much more compelling. As well it should: The issues of fairness of market outcomes that he deals with are best thought of as part of a broad contemplation of our society rather than in narrow numerical terms.
All of this is more than enough to justify the rapturous reception accorded Piketty in many quarters. But recall that Kennedy seemed to hit the zeitgeist perfectly but turned out later to have missed his mark as the Berlin Wall fell and the United States enjoyed an economic renaissance in the decade after he wrote; similarly, I have serious reservations about Piketty’s theorizing as a guide to understanding the evolution of American inequality. And, as even Piketty himself recognizes, his policy recommendations are unworldly—which could stand in the way of more feasible steps that could make a material difference for the middle class.
Piketty’s argument is straightforward, relying, as he says in his conclusion, on a simple inequality: r>g, in which the rate of return on capital exceeds the growth rate. Its essence is most easily grasped by thinking about population growth. Think first of a world where couples have four children. In that case, an accumulated fortune will dissipate, as the third generation of descendants has 64 members and the fourth has 256 members. On the other hand, if couples have only two children, a fortune has to be split only 16 ways even after four generations. So slow growth is especially conducive to rising levels of wealth inequality, as is a high rate of return on capital that accelerates wealth accumulation. Piketty argues that as long as the return to wealth exceeds an economy’s growth rate, wealth-to-income ratios will tend to rise, leading to increased inequality. According to Piketty, this is the normal state of capitalism. The middle of the twentieth century, a period of unprecedented equality, was also marked by wrenching changes associated with the Great Depression, World War II, and the rise of government, making the period from 1914 to 1970 highly atypical.
This rather fatalistic and certainly dismal view of capitalism can be challenged on two levels. It presumes, first, that the return to capital diminishes slowly, if at all, as wealth is accumulated and, second, that the returns to wealth are all reinvested. Whatever may have been the case historically, neither of these premises is likely correct as a guide to thinking about the American economy today.
Economists universally believe in the law of diminishing returns. As capital accumulates, the incremental return on an additional unit of capital declines. The crucial question goes to what is technically referred to as the elasticity of substitution. With 1 percent more capital and the same amount of everything else, does the return to a unit of capital relative to a unit of labor decline by more or less than 1 percent? If, as Piketty assumes, it declines by less than 1 percent, the share of income going to capital rises. If, on the other hand, it declines by more than 1 percent, the share of capital falls.
Economists have tried forever to estimate elasticities of substitution with many types of data, but there are many statistical problems. Piketty argues that the economic literature supports his assumption that returns diminish slowly (in technical parlance, that the elasticity of substitution is greater than 1), and so capital’s share rises with capital accumulation. But I think he misreads the literature by conflating gross and net returns to capital. It is plausible that as the capital stock grows, the increment of output produced declines slowly, but there can be no question that depreciation increases proportionally. And it is the return net of depreciation that is relevant for capital accumulation. I know of no study suggesting that measuring output in net terms, the elasticity of substitution is greater than 1, and I know of quite a few suggesting the contrary.
There are other fragmentary bits of evidence supporting this conclusion that come from looking at particular types of capital. Consider the case of land. In countries where land is scarce, like Japan or the United Kingdom, land rents represent a larger share of income than in countries like the United States or Canada, where it is abundant. Or consider the case of housing. Economists are quite confident that the demand for housing is inelastic, so that as more housing is created, prices fall more than proportionally—a proposition painfully illustrated in 2007 and 2008.
Does not the rising share of profits in national income in most industrial countries over the last several decades prove out Piketty’s argument? Only if one assumes that the only factors at work are the ones he emphasizes. Rather than attributing the rising share of profits to the inexorable process of wealth accumulation, most economists would attribute both it and rising inequality to the working out of various forces associated with globalization and technological change. For example, mechanization of what was previously manual work quite obviously will raise the share of income that comes in the form of profits. So does the greater ability to draw on low-cost foreign labor.
There is also the question of whether the returns to wealth are largely reinvested. A central claim by Piketty is that a country’s wealth-income ratio tends toward s/g, the ratio of its savings rate to its growth rate. Hence, as he argues, a declining growth rate leads to a higher wealth ratio. But this presumes a constant or rising saving ratio. Since he imagines returns to capital as largely reinvested, he finds this a plausible assumption.
I am much less sure. At the simplest level, consider a family with current income of 100 and wealth of 100 as opposed to a family with current income of 100 and wealth of 500. One would expect the former family to have a considerably higher saving ratio. In other words, there is a self-correcting tendency Piketty abstracts from whereby rising wealth leads to declining saving.
The largest single component of capital in the United States is owner-occupied housing. Its return comes in the form of the services enjoyed by the owners—what economists call “imputed rent”—which are all consumed rather than reinvested since they do not take a financial form. The phenomenon is broader. The determinants of levels of consumer spending have been much studied by macroeconomists. The general conclusion of the research is that an increase of $1 in wealth leads to an additional $.05 in spending. This is just enough to offset the accumulation of returns that is central to Piketty’s analysis.
A brief look at the Forbes 400 list also provides only limited support for Piketty’s ideas that fortunes are patiently accumulated through reinvestment. When Forbes compared its list of the wealthiest Americans in 1982 and 2012, it found that less than one tenth of the 1982 list was still on the list in 2012, despite the fact that a significant majority of members of the 1982 list would have qualified for the 2012 list if they had accumulated wealth at a real rate of even 4 percent a year. They did not, given pressures to spend, donate, or misinvest their wealth. In a similar vein, the data also indicate, contra Piketty, that the share of the Forbes 400 who inherited their wealth is in sharp decline.
But if it is not at all clear that there is any kind of iron law of capitalism that leads to rising wealth and income inequality, the question of how to account for rising inequality remains. After Piketty and his colleagues’ work, there can never again be a question about the phenomenon or its pervasiveness. The share of the top 1 percent of American income recipients has risen from below 10 percent to above 20 percent in some recent years. More than half of the income gains enjoyed by Americans in the twenty-first century have gone to the top 1 percent. The only groups that have outpaced the top 1 percent have been the top .1 and .01 percent.
Piketty, being a meticulous scholar, recognizes that at this point the gains in income of the top 1 percent substantially represent labor rather than capital income, so they are really a separate issue from processes of wealth accumulation. The official data probably underestimate this aspect—for example, some large part of Bill Gates’s reported capital income is really best thought of as a return to his entrepreneurial labor.
So why has the labor income of the top 1 percent risen so sharply relative to the income of everyone else? No one really knows. Certainly there have been changes in prevailing mores regarding executive compensation, particularly in the English-speaking world. It is conceivable, as Piketty argues, that as tax rates have fallen, executives have gone to more trouble to bargain for super high salaries, effort that would not have been worthwhile when tax rates were high (though I think it is equally plausible that higher tax rates would pressure executives to extract more, so as to maintain their post-tax income levels).
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