Capital in the 21st century: book review

Thomas Piketty: 

Le capital au XXI^e 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.

Shortcomings

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 resilience.org. 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.

Global warming, peak oil, collapse and the art of forecasting

Predicting the future usually means to provide an accurate analysis of the present and extrapolating some trends. Therefore the forecasts that try to look at least some decades into the future need to be well informed of the current situation. However, we have various options; we may make different decisions that will influence the outcome. For climate change, the amount of greenhouse gases emitted will be a major factor that determines the amount of warming, and this is obviously the topic for negotiations.

The Intergovernmental Panel on Climate Change (IPCC)

The IPCC thus operates with four "representative concentration pathways" (RCPs) of CO₂ equivalents in the atmosphere and what effects that will have on the climate. The pathways stand for different strategies of coping with the challenges, from turning off greenhouse gas emissions immediately (not likely to happen) to sticking ones head in the tar sands and increasing the emission rates as much as possible. A part of the debate now revolves around whether or not the most restrictive pathway can be combined with continued economic growth, but more about that below.

The IPCC's fifth report from November 1 2014 comes with its usual summary for policymakers. However, having a policy is not restricted to the assumed readers of the report; we are all policymakers. IPCC's report sketches the facts (the melting ice, acidifying of oceans etc) and suggest mitigation strategies and adaptation to the inevitable worsening climate in many parts of the world. Perhaps the physics behind global warming is assumed to be known, but possible positive feedback mechanisms are worth mentioning. This is how the summary alludes to that:

It is virtually certain that near-surface permafrost extent at high northern latitudes will be reduced as global mean surface temperature increases, with the area of permafrost near the surface (upper 3.5 m) projected to decrease by 37% (RCP2.6) to 81% (RCP8.5) for the multi-model average (medium confidence).

Melting ice means that the albedo will decrease so that a darker sea surface will absorb more energy. Methane may also be released, either gradually or in a sudden burp, as permafrost thaws. For the record, methane has a global warming potential many times that of CO₂ (the factor depends on the time horizon which is why different figures may be used).

As usual, the so called policy makers are reluctant of taking consorted action. From the debate it may appear as though the goal of limiting global warming to 2°C would be sufficient to keep up business as usual. Oil companies and their allied business partners either invest in campaigns casting doubt on climate science, or argue that their production is so much cleaner than in the rest of the world, and if they didn't drill for oil, then someone else would. Yet, we know that most of the known hydrocarbon sources will have to remain in the ground to minimize the impact of climate change. Even with one of the most optimistic scenarios, we would have to prepare for extreme weather; draughts, hurricanes, forest fires, flooding, and mass extinction of species. Perhaps there is an awareness of the unwillingness to take prompt measures to reduce greenhouse gas emissions that has tipped the IPCC's focus somewhat over on adaptation to shifting climate conditions rather than focusing narrowly on mitigation strategies.

Global Strategic Trends: a broader perspective

With this gloomy outlook in mind, one should not forget that there is a fast-paced development in science and technology in areas from solar panels to medicine and artificial intelligence. The British Ministry of Defence's think tank Development, Concepts and Doctrine Centre has compiled a report that tries to summarize trends in several areas in a thirty year perspective up to 2045. Their Global Strategic Trends (GST) report does not make predictions with assertions of the likelihood of various outcomes, but rather illustrates where some of the current trends may lead, as well as providing alternative scenarios. The strength of this Global Strategic Trends report is its multifaceted view. Politics, climate, population dynamics, scientific and technological development, security issues, religion and economics are all at some level interrelated so that significant events in one domain has implications in other domains. Such cross-disciplinary interactions may be difficult to speculate about, but the GST report at least brings all these perspectives into a single pdf, with some emphasis on military strategies and defence. A weakness of the GST report is that it is perhaps too fragmented, and the most important challenges are almost lost in all the detail.

Peak oil, the debt economy and climate change

A better and more succinct summary of these great challenges might be one of Richard Heinberg's lectures. As Heinberg neatly explains, the exceptional economic growth witnessed the last 150 years is the result of the oil industry. In the first years, oil was relatively easy to find and to produce. Gradually, the best oil fields have been depleted and only resources of lesser quality remain such as the recently discovered shale oil across the UK. The production of unconventional oil is much less efficient than that of standard crude oil. The question is, how much energy goes into producing energy, or what is the Energy Return On Energy Invested (EROEI)? As this ratio goes down to 1, the energy produced is equal to that invested in producing it. Although exact figures are hard to estimate, it is clear that the EROEI of unconventional oil is significantly lower than that of conventional oil; its EROEI is so low in fact that even in strictly economic terms it is scarcely worth producing, leaving aside its potentially devastating effects on the environment.

Heinberg discusses three issues which combined seem to have very dramatic consequences for the civilised world as we know it: First, there is the energy issue and peak oil. It appears unlikely that renewable energy sources and nuclear power will be able to replace fossil fuel at the pace that would be needed for continuing economic growth. Second, there is debt as the driver of economic growth. As an illustration, Heinberg mentions the early automobile industry with its efficient, oil-powered assembly line production, so efficient in fact that it led to over-production. The next problem became how to sell cars to customers, because these were more expensive than people could generally afford. Hence came the invention of advertising, of "talking people into wanting things they didn't need" and subsidiary strategies such as planned obsolescence; making products that broke down and had to be replaced, or the constant redesign and changing fashion so that consumers would want to have the latest model. The solution to the cars being too expensive was to offer consumers credit. Money is created every time someone gets a loan from the bank with the trust that it will be paid back in the future, which again necessitates economic growth. This system has sometimes been likened to a pyramid game, and it is not a very radical idea to believe that it could collapse at some point. The third issue that Heinberg brings up is the climate change, which will lead to global disruption as large parts of the world become uninhabitable.

Two of Heinberg's recent essays deal with the energy situation and the coming transition to a society with a very different pattern of energy consumption. His criticizes the excessive optimism on behalf of renewable energy on one hand and "collapsitarians" on the other, some of which even think we are bound for extinction. The conclusion is that energy use and consumption in general must be reduced, either voluntarily or as a matter of necessity when there are no longer any alternatives.

An even more vivid account of more or less the same story is given by Michael C. Ruppert in the documentary Collapse. And after the realisation that this is probably where we are heading, it may be best to take the advice of Dmitry Orlov who has some experience of living in a collapsed Soviet Union: just stay calm, be prepared to fix anything that breaks down yourself and don't expect any more holiday trips to the other side of the planet!