Friday, February 20, 2015

Capital in the 21st century: book review

Thomas Piketty: 

Le capital au XXIe siècle. Seuil 2013

Economic inequality concerns everyone, we all have an opinion about what is fair. On the other hand, equity has not been a primary concern for most economists in recent times, at least not until the publication of Piketty's work. This review is based on the original French edition, although the book has already been translated to several languages.

Piketty's approach is historical, beginning with an overview of capital and revenues in the rich countries from the 18th century to the present. While it turns out to be true that inequalities have increased since the mid 20th century, it is perhaps surprising to learn that there were once even greater inequalities, peaking in the decades before the first world war. Social mobility was low and the best way to ensure a comfortable living standard for someone who was not born into a wealthy family was to marry rich rather than try to get a well paid job. When the gaps between the rich and the poor shrank in the 20th century, at least until the 1970s, Piketty argues that this happened mainly as a consequence of the two world wars. Governments appropriated private capital and introduced heavy marginal taxes that gradually led to a redistribution of wealth and the emergence of a middle class.

Le capital is written for a broad audience with no prior knowledge of economic theory. Central concepts are clearly explained in an accessible way. Mathematical formulas beyond plain arithmetic are avoided, even when their use could have simplified the exposition. However, Piketty stresses that economics is not the exact science it is often believed to be, and he is rightly sceptical about the exaggerated use of fancy mathematical theories with little grounding in empirical facts.

Although Piketty tries to avoid the pitfalls of speculative theories, he still makes some unrealistic thought experiments, not least concerning population growth and its bearings on economic growth. Population growth has two important effects: to increase economic growth and to contribute to a gradual diffusion of wealth. When each person on average has more than one child who inherits equal parts of their parents' patrimony, the wealth gradually becomes more equally distributed. Now, it does not require much imagination to realise that population growth cannot go on for much longer on this finite planet, and large scale space migration is not a likely option any time soon.

Piketty is at his best in polemics against other economists or explaining methodological issues such as how to compare purchasing power across the decades. Some products become cheaper to produce, so being able to buy more of them does not necessarily imply that the purchasing power has risen. Entirely new kinds of products such as computers or mobile phones enter the market, which also makes direct comparisons complicated.

Human capital is often supposed to be one of the most valuable resources there are, but Piketty seems uneasy about the whole concept. Indeed, when discussing the American economy in the 19th century, a conspicuous form of human capital enters the balance sheets in the form of slaves with their market value. The wealth in the Southern states of America before abolition looks very different depending on whether you think it is possible to own other human beings or not.

Top incomes in the United States have seen a spectacular rise in the last decades. An argument often advanced in favour of exceptionally high salaries is that productive people should be rewarded in proportion to their merits. The concept of marginal productivity describes the increase in productivity as a job is done by a person with better qualifications. However, there is no reliable way to measure the marginal productivity, at least not among top leaders. In practice, as Piketty argues, there is a tendency to "pay for luck" and not for merit as such; if the company happens to experience success, then its CEO can be compensated. The modern society's meritocracy, Piketty writes, is more unfair to its losers than the Victorian society where nobody pretended that the economic differences were deserved. At that time, a wealthy minority earned 30-50 times as much as the average income from revenues of their capital alone.
Cette vision de l'inégalité a au moins le mérite de ne pas se décrire comme méritocratique. On choisit d'une certaine façon une minorité pour vivre au nom de tous les autres, mais personne ne cherche à prétendre que cette minorité est plus méritante ou plus vertueuse que le reste de la population. [...] La société méritocratique moderne [...] est beaucoup plus dure pour les perdants (pp. 661-2).
The level of marginal taxes and progressive taxation appear to be decisive for top incomes. Lowering taxes actually makes it easier for top leaders to argue in favour of increased salaries, whereas high marginal taxes mean that most of the increase will be lost in taxation anyway. On the other hand, there is the problem of tax havens or fiscal competition between countries that is not easily solved. In addition to that, lobbyists spend quite some money on trying to convince politicians to keep taxes low, as a new study from Oxfam has shown.

The relative proportions of capital and revenue in the rich countries as it varies over time is studied in detail. The amount of capital is usually equivalent of a few years of revenue. However, the curve of capital over time as measured in years of revenue is found to be U-shaped, with a dip during the two world wars. This relative balance of capital and revenue actually sheds light on the structure of wealth distribution. Most capital is private and consists of real estate and stocks. There are mechanisms that make capital grow, effortlessly as it seems: "L'argent tend parfois à se reproduire tout seul."

Here the interesting principle of capital-dependent growth comes to play. As it happens, the more capital you have to begin with, the faster you can make it grow. This is the case even in bank accounts where the interest rate on savings is usually higher above a certain threshold. However, those interest rates are usually not higher than barely to compensate for the effects of inflation, and for small amounts of savings they are usually lower. On the other hand, capital in the form of real estate or stocks may grow faster than wages. One reason for the level-dependent growth of wealth is that it is easier to take financial risks and to be patient and await the right moment with a larger initial amount of capital, but the most important explanation, according to Piketty, is that the richest investors have more options to engage expert advisors when making their placements so they can seek out less obvious investments with high capital revenues.

Inheritance, rather than well paid work, was the way to wealth in the 19th century. To what extent are we about to return to that economic structure today? Indeed, there are worrisome indications that today's society risks a return of the rentiers, or persons of private means. Piketty's solution to the wealth distribution problem is, roughly, to increase the transparency of banks and to impose a progressive tax on capital in addition to revenue taxation.


Capital has become a bestseller and has already had a significant impact on the public debate (e.g. a recent report from citi GPS on the future of innovation and employment). Piketty leaves the old quarrels between communism and free market capitalism behind and proposes solutions based on evidence rather than wishful thinking or elegant theories with little grounding in reality. However, the last word in this debate has not been said. Free market proponents will have their familiar criticism, but it seems more appropriate to point out the shortcomings and the limited perspective of Piketty's account from an entirely different point of view. This is still some flavour of classical economic theory that does not seriously consider the role of energy consumption for the economy, nor is it sufficiently concerned with the finite resources of minerals including fossil fuels that are being depleted or the problems of pollution, global warming and ecological collapse that will soon have tremendous impacts on the economy. Piketty is probably fully aware of these problems and yet, with the exception of a brief mention of the Stern Review he neglects to make them a part of the narrative which therefore becomes one-sided. Perhaps this is an unfair criticism since the aim of the book is to demonstrate the mechanisms driving the increasing inequality in a historical perspective, but nonetheless important facets are missing.

Although no background knowledge of economics is assumed and many concepts are lucidly explained to the general audience, the book is not trying to be an introductory text book on economic theory.  Fortunately there are many resources to read up on the basic mechanisms of economy that include the environment and energy resources as part of the equation. Gail Tverberg's introduction is a good place to start. Many interesting articles appear at Ugo Bardi's blog resource crisis is worth a visit for further reading. The interwoven problems of debt, peak oil and climate change have been discussed at length by Richard Heinberg, and also in a previous post here. The new keyword that will shape our understanding of the economic system is degrowth.

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