But the rate of profit does not, like rent and wages, rise with the prosperity, and fall with the declension of the society. On the contrary, it is naturally low in rich, and high in poor countries, and it is always highest in the countries which are going fastest to ruin. The interest of this third order, therefore, has not the same connection with the general interest of the society as that of the other two.
Adam Smith, The Wealth of Nations (I, 11, 68)
At one time, we all believed the story. And why not? It was a hopeful story coming at a difficult time, a time of a struggle of bloody and epic dimensions. And moreover, the story seemed plausible, seemed to match what people were actually seeing in their own lives. The story told us that things were getting better and would continue to do so. Such a story can be powerful indeed.
The chief exponent of this story was Simon Kuznets, whose famous “Kuznets Curve” has become the standard model for development economics. The premise of this curve is simple enough: when capitalistic development begins, things actually get worse as only a few can take advantage of new technologies and capital. Hence inequality and other negative measures rise initially, but after some time, as capital and technology become more widespread, inequality falls and society becomes more fair, more stable, and more peaceful.
It was an easy story to believe because it seemed to be what was actually happening. Kuznets advanced his theory in 1955, not long after the catastrophes of the Great Depression and two world wars. The share of income that went to the top 10% reached 50% in 1928, but by 1955 this had shrunk to 33%, not an outlandish division. Further, there was a large and prosperous middle class, where the wages of one worker could support a whole family. Moreover, the Kuznets curve formed the perfect riposte to the Communists who pointed to Capitalism’s bleak history of dark, satanic mills and worker oppression. “Yes,” we could reply, “these things were part of our past, but they were merely the necessary, if regrettable, stage of development, but now everything is working out just fine.” We had constructed a narrative which absolved the past and looked forward to an even more glorious future. As a side note, it is interesting how much the Communist and Capitalist narratives resemble each other in this, with both positing and early stage of hardships and struggle but one that that inevitably leads to triumph for the worker.
And the worker seemed have triumphed. For thirty-five years, from 1947 to 1982, America seems to have built the most egalitarian society on the face of the earth, and perhaps in the history of the world. It seems that we had successfully moved from the Gilded Age of the Robber Barons in the 1890’s to “The Great Compression,” when differences between the very rich and the middle class seemed to have been ameliorated.
Alas, the story did not hold. Beginning in the 1980’s the old inequities began to reassert themselves, so that by 2007 the divisions of the Gilded Age reappeared, with the top 10% once again talking home 50% of the national income, while the bottom 50% of the population takes home less than 13%. Kuznets had posited an inverted U, with inequality rising and then falling, but the opposite seems to have happened: The immense divisions of the Gilded Age were followed by a brief era of income compression and then a new Gilded Age; the “U” was right-side up, which is the wrong side entirely.
But if the Kuznets Curve does not hold, what is needed is an explanation encompasses that both the gilded ages and the compression, and does it with a consistent set of data, comprehensible mathematics, and persuasive political and social theory on which to build solutions. That is the task that Thomas Piketty sets himself in Capital in the 21st Century. The book itself is something of a publishing phenomenon: a 700-page economics tome filled with charts, data, and mathematics that has nevertheless become a bestseller. I suspect that the reason for this success, at least partially, is that the events of the past decade have pushed the question of inequality to the forefront.
The first problem then is assembling the data. What is amazing about modern economics is that so many of the great theories of a supposedly “empirical” science are assembled with almost no actual data and hence very little testing; for a science that had modeled itself on the physical sciences, it has become a peculiarly platonic and idealistic discipline, ever seeking more abstract—and more incomprehensible–formulas . At best, theorists could rely on consistent data sets of only a few decades. Simon Kuznets himself noted that his famous curve was “5% data, 95% speculation, and all tainted by wishful thinking.” We now live in a world of statistics but we forget that these are of recent origin. GDP and unemployment numbers only date from 1947, and everything prior to that involves inferences from partial, incomplete, and inconsistent data sets. Piketty’s first great accomplishment is to assemble these diverse and partial data sets on wealth and income into a single set for each country, sets going back 100, 200, or even 300 years in some cases. And as a bonus to all researchers, he has made these data sets available on line at http://piketty.pse.ens.fr/en/capital21c2.
When we look at the data, the “U” formation clearly emerges, beyond any reasonable question. And since it does emerge, we need a reasonable explanation, one that has a secure mathematical foundation. Piketty’s mathematics are transparent even to the non-mathematically inclined, such as myself. They resolve into two fundamental ratios and two fundamental equations which depend only on accounting identities, and one fundamental inequality that forms the heart of his argument. The fundamental ratios, labeled α and β, are the ratio of capital incomes to total national income, and the ratio of total private capital to total national income. So for example, if a nation has private capital equal to six years of national income, it has a β of 600% or 6. And the proportion of income going to capital is equal to the average rate of return times the β. So for example, a nation with a β of 6 and an average return to capital of 5%, the portion of income that goes to capital is 5% time 600%, or 30%.
If Piketty’s equations seem straightforward, his basic inequality, r > g, is a show-stopper; it means that the rate of return to capital tends to be higher than the growth of the economy. Obviously even a small gap in the rates of r and g will mean that the proportion of national income that flows to capital will increase, and the wider that gap, the faster the increase will be. Piketty points out that this does not represent an imperfection in capital markets; it is not a failure, it is a feature of those markets.
Piketty has changed the nature of the debate over demographics by including the rate of population growth in the over-all growth rate of an economy. Previously, population growth was viewed negatively, and an ample supply of condoms was viewed basic to any aid package. But strong population growth tends to diminish the importance of inherited wealth, while low growth does the opposite. Higher growth means that new skills, functions, and opportunities are created in each generation, along with new and expanding markets. But we are in a period of negative population growth throughout the world. This is not so evident in the United States because immigration makes up the deficit in fertility. But of course this only means that our gains are precisely measured by somebody else’s losses.
Piketty’s mathematics adequately explains the upper arms of the historical “U”, and those arms could reach pretty high. The β for Europe reached 6.5 in 1910, and 4.5 for the United States. Since the United States had an abundance of land, it was cheaper and the value of capital overall was therefore lower. By 2010, the figures had again risen to 5.5 and 4.3 and are continuing their rise. But in between these arms, there is the “rocker” at the bottom, when the β dropped to 3.0 for Europe and 4.0 for the United States. The causes of this drop are not hard to find. First there were the catastrophes of 1914-1945, two world wars and The Great Depression, which wiped a large portion of European capital. Since American cities were untouched by the wars, we suffered fewer losses and therefore had a lower reduction. Secondly, the reduction in capital cleared the way for political reforms which specifically aimed at reducing the gap between rich and poor. This was the period of “The Great Compression” in which Kuznets and his colleagues wrote with such hope. However, the reforms were not lasting, and beginning in the 1980’s political leaders in the United States and Europe slowly unraveled the post-war order, so that we are well on our way to recreating a new Gilded Age, complete with a new set of Robber Barons.
The third part of Piketty’s thesis has to do with solutions, and this is where the book is at its weakest. Since the problem is the gap between “r” and “g,” Piketty proposes a tax on wealth to lower its rate of return and bring it closer to “g,” the growth rate of the economy. However, he immediately runs into a problem that leads him to a problematic proposal. Since modern capital is so mobile, any state that imposed such a tax would immediately see capital flight. Hence Piketty proposes a global wealth tax under some global authority. His fear is that such a proposal cannot be implemented; my fear, however, is that it can be. I think the idea is naïve. Surely, one of the great problems of accumulated wealth is that it allows for the wealthy to capture national governments; I see no reason why the same wealth could not just as easily capture a global government.
Indeed, this ability to capture governments is one reason that wealth accumulates (as Piketty himself realizes). The wealthy can use their control of government to externalize costs or to obtain subsidies, suppress competition, to buy up public assets at a steep discount (“privatization”), etc. And when we look at such global structures as the World Bank or the IMF, the suspicion grows that the rich have already captured them and have already bent the world to their will.
The problem lies in Piketty’s basic inequality, r > g, which contains a basic error, one that has been with us through most of the 20th century, and which was the subject of the so-called “Cambridge Capital controversy”. I take it as intuitively obvious that the rate of return to capital cannot exceed the growth rate of an economy for any appreciable amount of time; if it did, a few would end up owning everything and everybody else nothing. In short order, we would become a stagnant slave society, in fact if not in law. But it is just as certain that a certain kind of investment can and does exceed the overall growth rate. What is needed is a better analysis of r > g.
The basic problem is that that term “capital” includes three very diverse types of assets, each governed by different rules of return: Man-made assets, like tools, machines, buildings, etc.; land including natural resources; and financial instruments, like loans or equities. For the first class, their return is the value of the things they produce. It is unlikely that returns to these assets, as a class, could ever exceed g, because they are g; every other asset class is merely claims to whatever is produced by this asset class.
The second class of capital is land and natural resources. Since all production requires these, they are subject to the Ricardian Law of Rents, which states that the owner of the land will appropriate more and more of what the user of the land produces, eventually leaving him with only subsistence. In this case, returns to land do not exceed what is produced on the land, but they are reallocated from the entrepreneurs and workers who actually produce it and to the rentier who produces nothing; r = g holds, even if all the g goes to r.
It is the third class of capital, financial assets, which are problematic. The first two classes are closely related to, and limited by, production, but the third class has no such limitation or relation. Clearly, the returns to this class can indeed exceed the growth rate g; if you doubt that, just look at the interest rate on your credit card and ask If the economy is growing that fast. Moreover, this is the asset class of money and credit, and the banks create these out of thin air. Contrary to popular understanding, the banks do not lend out deposits, they create them. The money you deposit is not lent but held as a reserve, while a multiple of that deposit is lent by creating an account against which the borrower can write checks. This is the Fractional Reserve System, which is how we create money in the modern world.
The only limitation on returns to this asset class is the periodic financial crises they produce, which wipes out a portion of the capital to bring the return closer to the real growth rate, or it does if they don’t get a bailout. In the process, these collapses create hardships for everybody, save those who caused the problem, because they can usually protect themselves, as we saw in the last crash.
We can use an example here to illustrate the differences. A farmer can increase his wealth only by increasing his production of grain. Hence r = g. If he is leasing the land, the landlord can raise the rent over time to absorb more of the increased output. Hence the return is still equal to the growth, but it is reallocated in whole or part to the rentier; you still have r = g. But if the farmer can only increase his wealth by increasing is production, the banker can increase his assets (loans) by pressing a few buttons on a computer. He can lend this ex nihilo money to the farmer, and if the farm fails, perhaps because the bankers have collapsed the economy, the bank ends up in possession of the farm, the grain, and the equipment. This is exactly what happened in the last recession, where the “failed” banks ended up larger than before, and in possession of a good share of the real estate of the nation. The “To Big To Fail” banks are now bigger than before, and r has very definitely exceeded g. And this is only one of the schemes that multiplied loans without adding to production.
There is an ancient term for this, and that term is usury. Piketty uses the term only five times, and even then in the conventional sense that relegates the discussion to the ancient past. But usury is precisely the problem; only in this case can the rate of return exceed the growth rate. This was always the ancient objection to the practice. Surely an investor or lender is entitled to a just share of the profit; but in no case can the investor claim more than is produced, nor can the banker claim anything more than a fee for making the loan. The investor risks his own money; the banker risks just a little time. If the loan fails, the banker is out nothing because he created the loan from nothing. He might be disappointed but he is not disadvantaged.
We know well what to do about the first two classes. Actual production should be taxed lightly, if at all; it’s reallocation to rentiers should be taxed more heavily. These two classes are not mobile and are not subject to the problem that Piketty cites as reason for a world authority. But while the third class is mobile, it is actually less important. None of the countries that have developed successfully, such as China, Japan, Taiwan, and South Korea, relied much on foreign capital; they generated the capital internally and China imposes strict capital controls.
Let me suggest that Piketty’s work needs to be further refined by separating his capital/income ratio, the β, into three subcategories: βM (man-made capital), βL(land), and βF (financial capital),to distinguish between the three types of capital and their different rates of growth. I suspect this will yield an entirely different picture leading to an entirely different analysis and more targeted—and local—solutions.
It is beyond the scope of this review the means by which capital can be made once again to be the servant of production rather than its master. Suffice it to say that as long as r > g holds, we have a past that devours our future: it squeezes out the small entrepreneur and leaves spaces only for corporate collectives and government control. It turns us all into dependents of these public and private collectives. Thomas Piketty has done us a great service by documenting the history and extent of this basic inequality, but more work needs to be done to ensure that the growth of the wealthy does not exceed the growth of wealth itself, and further that the growth is fairly allocated to those who actually produce the growth, and not to those whose financial power allows them merely to appropriate it.
Conservatives, or more specifically neo-conservatives, have attacked this work, usually on very specious grounds. But what the work demands is not attack but engagement. If it is true that his solutions do not hold, it is equally true that Kuznets’ fairy tale no longer holds: Things are not better, they are getting worse. And it is good to remind ourselves just how economically unstable the Gilded Age was. In the period 1870 to 1933, the economy was in recession an astounding 40% of the time. By comparison, the post-war economy has been in recession only 15% of the time, and moreover the recessions were half as deep, half as long, and half as frequent as the pre-war variety. Further, we do well to remember the corrosive effects that the extreme division of wealth and poverty had on family life, social life, and moral life. We cannot go back to that future without destroying everything that we love.
Finally, we can note that Piketty’s Challenge is not new; it is precisely the same challenge issued by Adam Smith. That is to say, it is a question woven into the very heart of capitalism and which arises at the very moment of its foundation. Smith’s concern was that social and economic progress would not be equitably shared, but appropriated by one class to the detriment of all others. It was Smith’s great fear, and it should be ours as well.