Wednesday, July 23, 2014

The short guide to Capital in the 21st Century

Thomas Piketty's Capital in the 21st Century is the most important economics book of the year, if not the decade. It's also 696 pages long, translated from French, filled with methodological asides and in-depth looks at unique data, packed with allusions to 19th century novels, and generally a bit of a slog.

The good news is that there's no advanced math, and anyone who puts in the time can read the book. But if you just want the bottom line, we have you covered.

Can you give me Piketty's argument in four bullet points?

  • The ratio of wealth to income is rising in all developed countries.
  • Absent extraordinary interventions, we should expect that trend to continue.
  • If it continues, the future will look like the 19th century, where economic elites have predominantly inherited their wealth rather than working for it.
  • The best solution would be a globally coordinated effort to tax wealth.

Who is Thomas Piketty?

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Thomas Piketty is a French economist who rose to prominence over the past decade thanks to his collaborations with Emmanuel Saez on income inequality. The duo was the first to carefully exploit American income tax data to show how highly concentrated income was in the hands not just of the top 10 or 20 percent of households but the top 1, 0.1, or even 0.01 percent. The vast majority of the contemporary debate on inequality is focused on the agenda set by that work. In his new book, Piketty largely leaves that research agenda behind in favor of an inquiry focused on wealth inequality.

What does Capital in the 21st Century argue?

The provocative argument of Capital in the 21st Century is that market capitalism, including the kind of welfare state capitalism practiced in continental Europe, will eventually lead to an economy dominated by those lucky enough to be born into a position of inherited wealth. Piketty argues that this is how the economy of early 20th century Europe worked, that the tyranny of inherited wealth was destroyed only by the devastation of two world wars, and that in the 21st Century the United States and Canada will suffer from the same affliction.

What is capital?

There are different concepts of capital floating around in the economics literature. But Piketty uses an expansive definition of capital so that it is the same as wealth. All the shares of stock and houses and cash assets that people own constitute capital, or wealth. And wealth is much more unequally distributed than income, so while a division of society into those who own things and those who work for a living is overly simplistic it's not totally off-base. In the United States, for example, 5 percent of households own a majority of the wealth while the bottom 40 percent have negative wealth due to debts.

Does this have anything to do with Karl Marx's Das Kapital?

Quite a bit, actually. Piketty's analysis of the economy is different from Karl Marx's, but his bottom line is that Marx was right to worry about capitalism.

During the Cold War years it appeared that Marx was simply wrong to assert that market societies would be dominated by owners of capital. Wages for ordinary workers were high and rising. Economic elites were largely business executives or skilled tradespeople (lawyers and surgeons, say) rather than owners of enterprises. And iconic "capitalist" figures were entrepreneurs who built businesses rather than heirs to old fortunes. Political debate focused largely on the question of a welfare state or social safety net for the poor, not the fundamental architecture of capitalism.

Piketty says that this was essentially a happy coincidence reflecting the unique circumstances of the post-war era. The fortunes of the wealthy were destroyed by two world wars, the Great Depression, and extreme wartime finance measures. Then a few decades of rapid economic growth created a situation in which newly earned income was a much bigger deal than old wealth. In the contemporary environment of slow economic growth, Piketty says this process is over. Unless drastic measures are taken, the future belongs to people who simply own stuff they inherited from their parents.

What are Piketty's key concepts?

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The main concepts Piketty introduces are the wealth-to-income ratio and the comparison of the rate of return on capital (r in his book) to the rate of nominal economic growth (g). A country's wealth:income ratio is simply the value of all the financial assets owned by its citizens against the country's gross domestic product. Piketty's big empirical achievement is constructing time series data about wealth:income ratios for different countries over the long term.

The rate of return on capital, r, is a more abstract idea. If you invest $100 in some enterprise and it returns you $7 a year in income then your rate of return is 7%. Piketty's r is the rate of return on all outstanding investments. A key contention of the book is that r is about 5 percent on average at all times. The growth rate (g) that matters is the overall rate of economic growth. That means that if g is less than 5 percent, the wealth of the already-wealthy will grow faster than the economy as a whole. In practice, g has been below 5 percent in recent decades and Piketty expects that trend to continue. Because r > g, the rich will get richer

What is Piketty's main finding?

The bulk of the book is dedicated to an exhaustive look at wealth in the United States, the United Kingdom, France, and Germany with some additional looks at other major economies including Italy, Canada, and Japan. What Piketty finds is that in all developed countries the wealth:income ratio is high and rising. He also finds that in the Old World countries, it exhibits a very marked U-shaped pattern-extremely high in the late-19th and early 20th centuries, very low at midcentury, then rising strongly since 1980. New World wealth:income ratios were not as high as in the old world (slaves were so valuable that how you treat this form of "capital" makes a difference here), so it's a bit of an uneven U with the wealth:income ratio reaching an unprecedented level in the contemporary United States.

But Piketty also finds that the increase in wealth:income ratio is not unique to the inequality-friendly Anglo-Saxon economies of the United States and Canada. In fact, the accumulation of wealth is most clearly seen in places like France and especially Italy where economic growth has been very slow. Piketty also finds that the rate of return on capital is about 5 percent on average across different countries. That's part of why he argues that the dynamic towards wealth inequality is built into capitalism rather than any one country's economic policies.

How does Piketty explain this?

Piketty's theoretical contribution is to argue that we should take these empirical findings at face value. The way capitalism works, says Piketty, is that existing wealth earns a 5 percent rate of return, r. The total pool of labor income, meanwhile, grows at the rate of overall GDP, g. When r is larger than g the pool of wealth owned by wealth-owners grows faster than the pool of labor income earned by workers.

Since r is usually larger than g, the wealthy get wealthier. The poor don't necessarily get poorer, but the gap between the earnings power of people who own lots of buildings and shares and the earnings power of people working for a living will grow and grow.

If it's that simple, how come nobody noticed before?

Piketty makes two claims about this. One is that in Victorian and Edwardian times, people certainly did notice. His many references to 19th century novels (in Jane Austen books a man's "income" is the rent received by the estate he inherited, not his salary) are designed to establish that something like his account of the central importance of inherited wealth was conventional wisdom in pre-war Europe, and not just among radicals. And of course there was a lot of political radicalism in pre-war Europe.

His second point is is to concede that the life experience of the non-Millenials alive today contradicted this narrative. World War I directly destroyed some wealth, and also led to very high levels of taxation and inflation as wartime finance measures. Then came the Great Depression in which many fortunes were wiped out. Then came World War II which directly destroyed even more wealth (as in cities were literally burned to the ground) and was associated with even more extreme wartime finance measures. Then came a fast period of postwar growth associated with European reconstruction and the unleashing of long-suppressed consumption impulses. It's only over the past 20 or 30 years that the underlying dynamic has reasserted itself.

Why does this matter?

Capital in the 21st Century essentially takes the existing debate on income inequality and supercharges it. It does so by asserting that in the long run the economic inequality that matters won't be the gap between people who earn high salaries and those who earn low ones, it will be the gap between people who inherit large sums of money and those who don't.

Piketty's vision of a class-ridden, neo-Victorian society dominated by the unearned wealth of a hereditary elite cuts sharply against both liberal notions of a just society andconservative ideas about what a dynamic market economy is supposed to look like. Market-oriented thinkers valorize the idea of entrepreneurial capitalism, but Piketty says we are headed for a world of patrimonial capitalism where the Forbes 400 list will be dominated not by the founders of new companies but by the grandchildren of today's super-elite.

What is to be done?

Piketty wants the major world economies to band together to assess a modest global wealth tax. Global cooperation is desirable to prevent the wealthy from simply shifting assets into other jurisdictions. But short of intense global cooperation, he thinks larger economic units-the United States, say, or the European Union-should move ahead with wealth taxes, estate taxes, and other efforts to curb the power of wealth.

The kind of international cooperation Piketty calls for is difficult to imagine happening in practice. And his enthusiasm for wealth taxes runs against decades of conventional wisdom in the economics profession holding that people should be encouraged to save and invest. Many people who find Piketty's positive analysis to be important and at least partially persuasive are going to disagree with his prescription here.

What are the main weaknesses of Piketty's book?

It's a big book containing a lot of ideas and there are many nits one could pick. The biggest weak points, however, relate to Piketty's theoretical analysis of r (the rate of return on capital) and g (the rate of economic growth).

Piketty says that r = 5 percent regardless of the rate of growth and provides fairly convincing empirical evidence that this has been the case in the past. But the theoretical basis for this pattern is unclear so it might not hold up. In principle, a permanent slowdown in growth could lead to a concurrent slowdown in the rate of return on capital leading to a stabilization in the wealth-income ratio. In that case, either everything would be fine or else if things weren't fine it would be because the growth rate is too low not because the wealth-income ratio is rising.

A related issue is Piketty's treatment of the growth rate. Boosting economic growth is something politicians are always promising to do. And according to Piketty, growth-boosting policies would forestall the growth of patrimonial capitalism. Piketty believes that economic growth is driven by deep structural factors related to demographics and technology rather than policy changes. This isn't a unique view of his by any means (Northwestern University Professor Robert Gordon has been arguing something quite similar recently in a different context) but it manages to be central to the book's conclusion without being extensively defended in the text.

What are some other possible solutions to the problem Piketty diagnoses?

The politically easiest way to avert Piketty's prophesy of doom would be to increase the economic growth rate. Everyone has their favorite ideas about how to do this, but the simplest ones involve mechanically increasing the population growth rate. The pre-war United States was less wealth-dominated than pre-war Europe largely because the population was growing much faster. Pro-fertility measures or more liberal immigration rules might do the trick.

We also might consider wealth-destruction methods that are a little more narrowly tailored than a broad wealth tax (or a world war). For example, much of modern-day wealth appears to take the form of urban land (Silicon Valley houses are much more expensive than houses in the Houston suburbs, not because the houses are bigger but because the land is more expensive), control over oil and other fossil fuel resources, and the value associated with various patents, copyrights, trademarks, and other forms of intellectual property. Land and resources differ from traditional capital in that even a very high rate of taxation on them won't cause the land to go away or the oil to vanish. Intellectual property is deliberately created by the government. Stiff land taxes, and major intellectual property reform could achieve many of Piketty's goals without disincentivizing saving and wealth creation.

What else should I read about this?

See our own collection of charts based on Piketty's data for the key empirical findings. Beyond that, everyone who's anyone is reviewing this book. If you want a discussion more thorough than a normal article but still shorter than Piketty's opus, then Branko Milanovic's 20-page review in the Journal of Economic Literature is for you. Ryan Avent in The Economist offered an excellent treatment of Piketty's economic ideasand Jacob Hacker in the The American Prospect tries to locate Piketty's insights in a political economy framework.

From the right, Ryan Decker argues that Piketty's work is more about accounting than economics and James Pethokoukis argues that his assumptions about the future are unfounded.

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