Beneath the Surface

Previous | Next

The structure of inequality

So far I have focused on Piketty’s discussion of the share of national income going to investors, which is highest when the rate of return on capital (r) is much higher than the rate of growth in output and income (g). That in itself would not have to result in very much overall inequality, since in theory every household could derive income from a combination of earnings and investment. Far more households do that today than in the early days of capitalism. But to the extent that the ownership of capital is highly concentrated, the class of capitalists can receive a share of national income out of all proportion to their numbers, and they do.

A quite different source of income inequality is inequality of earnings from labor, which is greater today than in previous centuries. That reinforces the capital inequality, because the highest earners can afford to invest not only a higher absolute amount, but a greater proportion of their earnings.

Piketty thus describes two different–but not mutually exclusive–ways for a capitalist society to generate extreme inequality. In the “hyperpatrimonial society,” more common before the 20th century, the inequality is primarily between the owners of inherited wealth and those who work for a living. In the “hypermeritocratic society,” more characteristic of the 20th century, the inequality is more a matter of differences in pay. Piketty uses the latter term somewhat ironically, since he thinks that the highest paid managers receive compensation far beyond any demonstrable merit.

If Piketty were only describing a transition from patrimony to meritocracy, he wouldn’t be covering any new ground. What he is actually doing is warning that capital accumulation and inherited wealth are on the rise again, so that both sources of inequality may be important once more:

What primarily characterizes the United States at the moment is a record level of inequality of income from labor (probably higher than in any other society at any time in the past, anywhere in the world, including societies in which skill disparities were extremely large) together with a level of inequality of wealth less extreme than the levels observed in traditional societies or in Europe in the period 1900– 1910. It is therefore essential to understand the conditions under which each of these two logics could develop, while keeping in mind that they may complement each other in the century ahead and combine their effects. If this happens, the future could hold in store a new world of inequality more extreme than any that preceded it.

The distribution of capital

Wealth is always more unequally distributed than earnings, since the most fully invested fortunes normally grow at a faster rate than the economy as a whole (r > g). While the top 10% of earners usually get 25-30% of the income from labor, the top 10% of owners has always controlled at least 50% of the wealth. The rest is almost entirely owned by the group between the 50th and 90th percentiles, since the lower half of the population owns practically nothing.

In the societies where wealth is most equally distributed (…the Scandinavian countries in the 1970s and 1980s), the richest 10 percent own around 50 percent of national wealth or even a bit more, somewhere between 50 and 60 percent, if one properly accounts for the largest fortunes. Currently, in the early 2010s, the richest 10 percent own around 60 percent of national wealth in most European countries, and in particular in France, Germany, Britain, and Italy.

In the United States, the share of the richest 10% rose from under 60% in 1810 to 80% in 1910. Then it fell to about 66% by 1940 and 63% by 1970, but then started rising again and was over 70% by 2010. US wealth inequality, traditionally less than that of Europe, has surpassed Europe’s since 1970.

The U-shaped trend in wealth inequality is consistent with Piketty’s earlier discussion of the 20th century. At first, the top decile’s share of the wealth declined, as the growth in earned income created a “patrimonial middle class” that now made enough money to accumulate some capital. Meanwhile, income and estate taxes took their toll on large fortunes. More recently, however, middle-class wage growth and capital accumulation have slowed down, while growth at the top continues, assisted by reductions in income and estate taxes.

The largest fortunes tend to grow the fastest, partly because their owners can afford to reinvest most of the earnings. In addition, they have access to the best financial management and the investments earning the highest returns. Smaller investors put more of their money in safe but low-return instruments, such as bank accounts.

The portion of wealth that is inherited has also followed a U-shaped curve. In France, the country with the best inheritance data, inherited wealth amounted to 80-90% of all private capital in the 19th and early 20th centuries, fell to just over 40% by 1970, but rose to about two-thirds in 2010. Piketty expects it to be approaching 80% again by the 2030s, a situation increasingly difficult to defend: “No matter how justified inequalities of wealth my be initially, fortunes can grow and perpetuate themselves beyond all reasonable limits and beyond any possible rational justification in terms of social utility.”

Although many people worry about new forms of global inequality, such as the ownership of too many global assets by China or Saudi Arabia, Piketty sees much greater potential for “the rich countries…to be owned by their own billionaires or, more generally…all countries…to be owned more and more by the planet’s billionaires and multimillionaires.”

The distribution of earnings

Earnings from labor are not as unequally distributed as are capital and the return on capital. But they are becoming more unequally distributed, and that trend is a major driver of increasing inequality in general. Bear in mind that we are talking only about income from labor, excluding any income from capital:

In countries where income from labor is most equally distributed, such as the Scandinavian countries between 1970 and 1990, the top 10 percent of earners receive about 20 percent of total wages and the bottom 50 percent about 35 percent. In countries where wage inequality is average, including most European countries (such as France and Germany) today, the first group claims 25– 30 percent of total wages, and the second around 30 percent. And in the most inegalitarian countries , such as the United States in the early 2010s (where…income from labor is about as unequally distributed as has ever been observed anywhere), the top decile gets 35 percent of the total, whereas the bottom half gets only 25 percent.

Mainstream economic theory rests on two main hypotheses about earnings: “First, a worker’s wage is equal to his marginal productivity, that is, his individual contribution to the output of the firm or office for which he works. Second, the worker’s productivity depends above all on his skill and on supply and demand for that skill in a given society.” This sets up a race between education and technology. New technologies increase the demand for new skills and reduce the demand for unskilled labor, and educational credentials have to keep up to justify decent wages. One implication is that egalitarian access to higher education, as in the Scandinavian countries, should be reflected in more egalitarian wage structures.

Piketty finds this theory too limiting, however, in that it leaves out “other factors, such as the institutions and rules that govern the operation of the labor market in each society.” In the US, most workers have little bargaining power, while “at the very highest levels salaries are set by the executives themselves or by corporate compensation committees whose members usually earn comparable salaries (such as senior executives of other large corporations). He also observes that the countries where executive salaries have skyrocketed are the same countries that have put an end to very high marginal tax rates on the highest incomes, so that managers now have a greater incentive to fight for higher pay. Corporate managers make up 60-70%of the very highest paid workers (the top 0.1% of the income hierarchy).

The distribution of total income

The distribution of total income in the United States is a combination of the distributions of both labor income and investment income, with the first contributing more than the second. The portion of total income received by the richest 10% was a little over 40% in 1900-1920, rose to over 50% in the 1920s before the stock market crash, and then declined until fluctuating in the range of 30-35% between 1950 and 1980. “Since 1980, however, income inequality has exploded in the United States. The upper decile’s share increased…to 45-50 percent in the 2000s–an increase of 15 points of national income.” So 15% of the national income was transferred to the top 10% from everybody else. Furthermore, “the bulk of the growth of inequality came from ‘the 1 percent,’ whose share of national income rose from 9 percent in the 1970s to about 20 percent in 2000-2010.”

Piketty believes that this growing inequality was a contributing factor to the financial crisis:

In my view, there is absolutely no doubt that the increase of inequality in the United States contributed to the nation’s financial instability. The reason is simple: one consequence of increasing inequality was virtual stagnation of the purchasing power of the lower and middle classes in the United States , which inevitably made it more likely that modest households would take on debt, especially since unscrupulous banks and financial intermediaries, freed from regulation and eager to earn good yields on the enormous savings injected into the system by the well-to-do, offered credit on increasingly generous terms.

Continued

Previous | Next

Having described the relationships among the main variables in Piketty’s analysis, I want to turn now to an overview of his historical description, focusing especially on Britain, France and America. What has happened to capital since the Industrial Revolution, especially in the most developed countries? In general, capital has undergone a metamorphosis in form without losing its economic importance in the economy or its value to those who control it.

National capital includes farmland, housing, other domestic capital such as corporate and government assets, and net foreign capital (the difference between a country’s ownership of foreign assets and foreign ownership of its assets). In theory, capital’s value lies in its provision of housing and its use as a factor of production, especially for investment in new technologies. The biggest change in the form of capital due to industrialization was the decline of farmland relative to other assets. Britain and France experienced declines in net foreign capital in the twentieth century due to the loss of their colonial empires.

The value of capital measured in years of national income (the beta discussed in the previous post) has fluctuated over history without taking a consistent direction. It was consistently high in Britain and France in the eighteenth and nineteenth centuries, and lower but rising in nineteenth-century America. It then moved in a U pattern in the 20th century, first falling and then rising. The share of national income that goes to capital rather than labor (alpha) tends to move in tandem with the capital/income ratio, so it too has fallen and then risen in the 20th century. It doesn’t usually fluctuate as widely, however, because a higher capital/income ratio increases the supply of capital and lowers the return on capital somewhat. There is certainly no consistent trend toward a lower valuation of capital relative to national output. Only under the exceptional conditions of the early 20th century did the relative value of capital fall, but it is rising again today.

When capital gets a larger slice of the economic pie, labor gets a smaller one. Labor’s share of national income is higher than it was in the 19th century but has been falling recently. The hope that workers could get ahead collectively as well as individually by enhancing their “human capital” has not yet been realized. Workers are becoming better educated and skilled, but that doesn’t increase their share of the rewards if job requirements rise as fast as they can meet them, or if wages increase too slowly to keep pace with returns on capital.

Before the twentieth century

In the 18th and early 19th centuries, European countries had very low rates of economic growth and thus very high capital/income ratios, as Piketty’s theory predicts. The novels of Jane Austen in England and Balzac in France describe a world in which the inheritance of land was the key to living a comfortable life. Lending money to the government could also be very remunerative, especially in England, where the government was seriously in debt from war spending. There was little inflation to erode the value of your bonds. Income from labor–even professional labor–was simply too low and growing too slowly to provide anything like the living available to those with capital.

The situation in early America was quite different, at least in the North. Just owning and renting out land didn’t provide as good a living, since land was plentiful and cheap. Inherited wealth counted for less because so many people came to America with very little. Both productivity growth and population growth were higher than in Europe. The capital/income ratio, which was around 7 in Britain in 1810, was only about 3 in America. In 1840, Tocqueville attributed American democracy partly to the lack of large fortunes. The South was a different story, however,  because the ownership of slaves dramatically boosted the capital of landowners. Piketty observes, “All told, southern slave owners in the New World controlled more wealth than the landlords of old Europe.” He goes on to describe the implications:

In fact, the New World combined two diametrically opposed realities. In the North we find a relatively egalitarian society in which capital was indeed not worth very much, because land was so abundant that anyone could became a landowner relatively cheaply, and also because recent immigrants had not had time to accumulate much capital. In the South we find a world where inequalities of ownership took the most extreme and violent form possible, since one half of the population owned the other half: here, slave capital largely supplanted and surpassed landed capital.

Over the course of the 19th century, economic output grew at a faster rate, due both to higher productivity and rapid population growth. Here I wish that Piketty had provided clearer connections between the history and the theory. Other things being equal, one would expect a higher growth rate to bring down the capital/income ratio at least slowly (since beta approaches s/g). In Britain and France, it remained up around 7 throughout the century. In America, it increased from about 3 in 1810 to about 5 in 1910. Piketty tends to lump the 18th and 19th centuries together and describe them as a period of relatively low growth and domination by capital, except for early America. I didn’t think he explained very clearly what made it possible for capital to maintain or increase its domination even as industrialization raised productivity and population growth peaked. His formulas would seem to require an increase in the savings rate s to offset rising g, which I don’t believe he discusses in that context.

The twentieth century

In Europe, the twentieth century began with a dramatic collapse of European capital during World War I. Between 1910 and 1920, the capital/income ratio fell from around 7 to 3 in both Britain and France. After that, it remained low through the 1940s due to economic depression, declining income from foreign colonies, a lower saving rate, and public policies less favorable to capital. Then came the years of highest growth, the three decades known as the “Trente Glorieuses” in France, when Europe had a sustained rate of growth over 3%. This time the workers did receive the benefits, since capital’s share of income fell from around 35% to 20% in both France and Britain between 1910 and 1970.

The United States experienced a more moderate decline of capital, from a ratio of 5 to 4 times income. The New Deal strengthened the bargaining power of labor and increased the regulation and taxation of wealth. By 1975, capital’s share of income was a little above 20%.

So by midcentury, the potential of high economic growth to create a more egalitarian distribution of income had been realized, but only with the help of political conditions unfavorable to capital.

After 1980, however, things took a turn in the opposite direction. Growth of output and income slowed, due to slowdowns in both population growth and productivity growth. For the richer countries, the great demographic transition that had first exploded populations by extending longevity was now stabilizing them by reducing birth rates. Advanced economies were not getting the same productivity gains in service industries that they had been able to get in manufacturing industries. Piketty describes the results: 

At the beginning of the 1970s, the total value of private wealth (net of debt) stood between two and three and a half years of national income in all the rich countries, on all continents. Forty years later, in 2010, private wealth represented between four and seven years of national income in all the countries under study.  The general evolution is clear: bubbles aside, what we are witnessing is a strong comeback of private capital in the rich countries since 1970, or, to put it another way, the emergence of a new patrimonial capitalism.

Capital’s share of income has reversed course and is now rising again too, from a range of 15-25% in rich countries in 1970 to 25-30% recently.

In the poorer nations of the world, growth is often much higher. Many of them are still in the explosive growth phase of the demographic transition, with birth rates far above death rates. Productivity growth is often rapid too because of the speed at which economic innovations can be imported from more developed countries. As poorer countries come to resemble richer ones, however, their growth will almost inevitably slow as well, making it harder to alleviate traditional inequalities.

Economics in political context

One of Piketty’s central conclusions is that we cannot rely on economic growth alone to create a more egalitarian society. He makes this abundantly clear for the current historical situation, where economic forces are moving us in the opposite direction. His argument there is very clear: The higher the ratio of savings to economic growth, the higher the ratio of capital to income in the long run. And the higher the ratio of capital to income, the greater the share of income going to those with capital. Thus as the growth rate falls, the above ratios go up, and capitalists gain at the expense of workers, other things being equal. Since “there is no natural, spontaneous process to prevent destabilizing, inegalitarian forces from prevailing permanently,” democratic society has to intervene in some way to put things on a different course, if it has the will to do so.

At times, Piketty seems to overgeneralize his argument to any situation in which the return on capital r is higher than the growth rate g, which is almost always the case in a capitalist system. Recall from the last post that only because r > g can investors spend a portion of their returns and still see their capital and income grow at least as fast as the general growth rate. Piketty often talks as if inequality must inevitably grow:

The inequality r > g implies that wealth accumulated in the past grows more rapidly than output and wages. This inequality expresses a fundamental logical contradiction. The entrepreneur inevitably tends to become a rentier, more and more dominant over those who own nothing but their labor. Once constituted, capital reproduces itself faster than output increases. The past devours the future.

My understanding of Piketty’s own equations is this: The greater the difference between r and g, the higher the capital/income ratio and the higher the share of income generated by capital. But the capital/labor inequality only keeps increasing if g keeps falling, or if g has been falling and beta has not yet stabilized at a higher s/g, something that takes time. So r > g is a necessary condition of rising inequality, but it is not sufficient. The mathematical model certainly allows for situations when inequality is stable because the relevant rates are stable, or declining because the growth rate is rising, even though it remains below r, as it usually does.

The story Piketty most wants to tell is that the capitalist economy creates more and more inequality, but democratic government can take action to counteract that trend. That’s a powerful story for our time, when growth is slowing. For inequality in the 19th century, a more complex story may be needed. Rising industrial productivity and rapid population growth created a potential for greater economic equality, but that potential wasn’t realized until well into the 20th century. Somehow the capitalist class maintained its domination, and their influence over a conservative state may have helped them keep workers disorganized, hold wages down, and keep capital accumulating by means of a high savings rate. Only when the system collapsed in the crisis of the early 20th century did a more egalitarian society emerge, and that crisis was economic as well as political. While Piketty speculates that inequality would have kept growing in Europe if it hadn’t been for World War I and other political developments, one could use his own equations to argue that rising productivity was working against that. Labor’s share of income was too small to allow them to consume enough of the goods that a high-productivity economy could produce, and so extreme inequality just wasn’t going to work economically any more. In that situation, inequality may have been to a degree self-limiting, although that runs counter to Piketty’s main thesis, that only the democratic state can halt the spiral of inequality.

Continued

Previous | Next

Thomas Piketty. 2014. Capital in the Twenty-First Century. Translated by Arthur Goldhammer. Cambridge, MA: The Belknap Press of Harvard University Press.

As John Maynard Keynes was the economist of economic depression and government stimulus, Thomas Piketty may be the economist of sluggish growth and growing economic inequality. This is the strongest argument I’ve seen against the notion that the rising tide of economic growth lifts all the boats, the yachts and the little rowboats alike. That notion has the most truth to it when the economy is growing at an exceptionally high rate. Piketty explains why it can’t work when the growth rate is reverting to a lower level. Then the income going to investors increases faster than the income going to wage earners. If the growth rate remains persistently low, the share of national income received by investors may eventually stabilize, but it will stabilize at a very high level. If left to its own devices, a capitalist economy will then tend to create a capitalist class living off of large inherited fortunes, a situation not conducive to political equality and democracy.

Piketty reaches his conclusions by studying the fundamental relationships among several economic variables: the rate of economic growth (g), the rate of return on capital (r), the savings rate (s), the share of national income going to capital (alpha), and the ratio of capital to national income (beta). At the heart of the argument is the observation that r is usually greater than g. This difference explains why people who live off of investments get a disproportionate share of national income, and also how that share will grow whenever r increases or g falls.

Some commentators have oversimplified the economics by saying that inequality automatically gets worse just because r > g, and Piketty himself makes statements that contribute to that impression. That would be true if capital always grew at the rate of return r. But as any investor should know, an investment doesn’t actually compound at the rate of return unless all returns are reinvested. If you save only some returns and spend the rest, as many investors do, then your capital actually grows less than r.  For the economy as a whole, the rate of capital expansion is not r, but a lower value that takes the national savings rate into account, and that actually approaches g if the relevant rates remain stable for a long time. The following example should clarify these dynamics.

Imagine a two-class society consisting of capitalists and workers. The capitalists get their income primarily from investments, and the workers get their income primarily from wages. Imagine that national output and income are growing at a real sustained rate of 2%, but the average rate of return on investments is 5%. Capital has the potential to grow over twice as fast as average income, but that potential isn’t normally realized because some income from capital is spent rather than reinvested. Suppose that the national savings rate is 10% of income, a rate that is five times the growth rate of national income. The growth in capital will reach a limit when amount of capital is also five times as much as annual income. At that point the savings rate of 10% of income can only add 2% to capital, since capital is 5 times income. So the growth rate of capital stabilizes at g, not r. Multiply the 5% rate of return by 5, the ratio of capital to income, and you get the share of income derived from capital (25%). But the savings rate is only 10%, so the savings added to capital each year are only 40% of the income from capital. So it makes sense that capital will actually grow at g (2%), instead of r (5%). A household living entirely from investment income needs to invest only 40% of its income to increase both its capital and its income by 2% a year.

These relationships can be summarized by two equations given by Piketty:

Capital-to-income ratio Beta = s/g = 10%/2% = 5

Capital’s share of income Alpha = r x Beta  = 5% x 5 = 25%

Now we are in a better position to see why r is normally greater than g. This difference enables some people to derive their income from capital, save and invest a portion of that income while spending the rest, and still see their income grow as fast as the general growth rate of the economy. It’s hard to see how capitalism could work if r weren’t greater than g, because then it wouldn’t pay to be a capitalist.

This example also illustrates that as long as the rates are stable and the difference between r and g is not too large, capital’s share of income is not extreme, although it is usually disproportionate to the size of the group that gets most of it. And although a superficial reading of Piketty might lead one to conclude that general inequality will keep increasing as long as r > g, the math says that capital’s share of income does approach stability as long as r, g and s are constant. What may not approach stability is the size of large inherited fortunes, since their owners can live off a small portion of the income and maintain a savings rate much higher than the national average. Their capital can grow as fast as r, or even more than that if they receive superior investment advice.

But now let’s get to the heart of Piketty’s argument by looking at what happens when the growth rate falls. Suppose that the growth rate slows from 2% to a sustained 1%. One might expect the return on capital to be cut in half as well, but that has not been the the historical experience. The rate of return r has fluctuated in a narrow range of about 4 to 5% whether economic growth g is high or low. (Maybe that’s why it’s called capitalism: the capitalists get richer more consistently than the workers!) So let’s suppose that the return on capital remains 5%, allowing capital to grow faster than income and output. If growth remains 1% for some time, the ratio of capital to income will grow from 5 to 10, and capital’s share of income will grow from 25% to 50%:

Beta = s/g = 10%/1% = 10

Alpha = r x Beta = 5% x 10 = 50%

Just a 1% decline in the growth rate has produced a huge transfer of income from labor to capital.

What Piketty establishes is that the difference between the return on capital and the growth rate is the crucial determinant of the division of income between capital and labor. The fact that r is greater than g is what makes it pay to be a capitalist. And the greater the gap between r and g, the more it pays to be a capitalist. Since r has usually varied within a narrower range than g, variations in g are more crucial. With a return on capital of 5% and a savings rate of 10%, it takes a sustained growth rate of at least 1% to keep capital from receiving over 50% of the national income. With a high growth rate, getting ahead through labor compares favorably with getting ahead through investment, but with a low growth rate, it becomes much more important to have capital to invest. With sustained growth at 0.7%, capital gets 71% of the income, and with growth of only 0.5%, capital theoretically takes all the income! (With growth below that, no equilibrium point can be calculated.)

Piketty drives the point home:

In a society where output per capita grows tenfold every generation, it is better to count on what one can earn and save from one’s own labor: the income of previous generations is so small compared with current income that the wealth accumulated by one’s parents and grandparents doesn’t amount to much….

When the rate of return on capital significantly exceeds the growth rate of the economy (as it did through much of history until the nineteenth century and as is likely to be the case again in the twenty-first century), then it logically follows that inherited wealth grows faster than output and income. People with inherited wealth need save only a portion of their income from capital to see that capital grow more quickly than the economy as a whole. Under such conditions, it is almost inevitable that inherited wealth will dominate wealth amassed from a lifetime’s labor by a wide margin, and the concentration of capital will attain extremely high levels— levels potentially incompatible with the meritocratic values and principles of social justice fundamental to modern democratic societies.

Are there any natural economic limits on the gap between r and g, or can it increase until the lion’s share of the national income goes to capital? One limit could be that as capital accumulation becomes too extreme, the rate of return on capital has to come down a bit. It becomes too hard to invest all that capital productively in a slow-growth economy, and imprudent investments just produce asset bubbles that eventually burst (sound familiar?). Decline in g may be offset partly by decline in r, so that capital’s share of income doesn’t increase as much as if r were constant. In the previous example, if the return on capital falls to 4% (with g = 1%), capital’s share of income becomes 40% instead of 50%. But in practice, fluctuations in r are not usually enough to keep fluctuations in g from producing substantial redistributions of income.

Piketty believes that limits on economic inequality have to come primarily from noneconomic factors, either through unwanted “shocks” to capital like war, or deliberate public policies like progressive taxation. For most of capitalism’s history, the growth rate has not been high enough to prevent capitalists from hogging a large share of the income and accumulating vast fortunes. The biggest exception was during the postwar economic boom, fueled both by recovery from a period of depression and war and by a baby boom. Piketty expects economic growth in the twenty-first century to be much lower. His projection is for 1.2% per-capita growth in the richest countries (with population growth providing a small but declining boost to output in some countries). Capital’s share of income, which was in the range of 15-25% for rich countries in 1970, has already increased to 25-30%, and would be expected to rise to at least 40% if growth remains this low. To make matters worse, disparities in pay between top managers and ordinary workers have risen to unprecedented levels, and taxes have declined on high incomes and estates, with the US leading both these trends. Welcome to the twenty-first century!

Piketty’s book has already started a global conversation, and may well frame the debate over economics and public policy for years to come.

Continued