I just finished Piketty’s book, Capital in the Twenty First Century. The one thing that everyone, including his critics, can agree on is that he has elevated the data entering the discourse on inequality. That his critics then ignore his data does not deter them from assuring us that it is very good.
First let me summarize the historical part of the book so that you can pretend to have read it just as well as everyone else at your dinner party. Then I will talk about the implications and his policy prescriptions in a later post.
Growth and the Capital/Income Ratio
Now all of the trends revealed by Piketty can be divided into three eras: before WW1, the intrawar period and post-WW2. The world was economically extremely stable before the industrial revolution, demographic growth was minuscule, less than .1% with productivity growth (due primarily to technological invention) at a similarly low level. Obviously data from this period is quite scarce, but such estimates follow from a basic analysis of subsistence level economics and the cumulative effects of population growth. That is, if population growth were any higher then there would be a lot more people around by modern times considering what we know about population in antiquity (ancient Rome for instance).
The point is that this is hugely different from what we have seen from the industrial revolution onward. With industry came productivity growth an order of magnitude higher than that seen at any previous point in human civilization. Until the World Wars, this productivity growth came with a concomitant increase in demographic growth. It was only after WW2 that productivity growth really outpaced demographic growth in the Western nations, a consequence of historically unprecedented productivity growth and a declining birth rate, especially among European countries.
However, all estimates of the future suggest that demographic growth will continue to trend downward across the world. Countries on the world technological frontier, i.e. the developed nations, will probably only experience about 1-2% productivity growth a year, which is a bit lower than experience in the recent past, but still amazing over the scope of human history. As more countries reach the technological frontier global productivity growth will fall to this level as well. This means that overall growth, the sum of population and productivity growth, will likely be lower than we are accustomed to, though again still quite high compared to before the Industrial Revolution.
So the basic trajectory is that the world was quite economically stagnant until the last two hundred years. This burst of growth though will likely turn out to be anomalous as going forward we can expect growth to fall.
Piketty first informs us of the history of the capital/income ratio which he claims is better for historical analysis than the more prominent labor/capital income split. As he notes, the World Wars caused the latter ratio to vary quite a lot, but it has now settled back at similar levels to the Belle Epoque. Because the Industrial Revolution changed the nature of capital fundamentally from land to industrial and financial assets, there must be something else at play stabilizing the labor/capital income ratio.
Now, the capital/income ratio is essentially the ratio of the amount of stuff a nation has versus how much it produces in a given year. At an individual level if the only thing you owned was a house worth 300k and you made 100k a year then your capital/income ratio would be 3.
Piketty fastidious data taking allows him to track the capital income ratio in a handful of countries, though throughout the book he focuses heavily on France since they have the best and longest record of economic data. Anyways, the capital/income ratio is 6-7 in Europe in the Belle Epoque and about 4-5 in the U.S. It then tumbles, reaching a low point after WW2 before again reaching similar levels in contemporary society.
Now you can get the labor/capital income split from the capital/income (C/I from now on) ratio by multiplying the latter by the rate of return on capital. If you have a rate of return of 5% and a C/I ratio of 6 then 30% of income is from capital with the rest accruing to labor. Thus, we can see that if the C/I ratio is similar to its level in the past then if the rate of return on capital is also stable that this would explain the stability of the labor/income ratio.
And indeed, the return on capital seems to always be 4-5% on average. And by always I mean throughout human history it is always about the same. There is no economic reason it should be this rate. This is born out because even with the vast shifts in technology and society in the last two hundred years the rate of return on capital is still approximately the same as it was in Julius Caesar’s time. Instead it must be some kind of universal human psychological effect, a combination of our discount rate (i.e. how much we value present versus future money) and what we deem fair. An interesting discussion for another time, perhaps.
Since the rate of return on capital is relatively constant, we see that the determinant of the labor/capital income ratio is drive by the C/I ratio. So what determines this ratio? Asymptotically it approaches the ratio of savings to growth. This can be visualized easily by realizing that savings is the rate of increase of capital and growth is the rate of increase of income so their ratio is the level at which C/I remains constant.
Thus, we see why the future trajectory of growth is so important as it will at some level determine the C/I ratio. It does not take a large change in growth to alter the C/I ratio. For instance if we take a representative savings rate of 12% and growth rate of 2% we recover a C/I of 6, very near what we now observe. However, if growth decreases to 1.5%, as is expected, then the ratio becomes 8. We might also expect the numerator, savings, to continue to increase as people prepare for longer retirements.
A good case study of this relationship is Japan. They have an elderly population with little in the way of demographic growth. Thus they have a very high savings rate and a very low growth rate so we should expect a high C/I. Indeed, Japan’s C/I is 7-8 among the highest in the world. This simple formula has a high degree of predictive power. It also explains why in the low growth past the C/I ratios were much higher than we saw in much of the 20th until very recently.
The Distribution of Capital and Income Within the Population
Let me now transition to a topic that is far more interesting to most of us, how wealth and income are distributed. The C/I ratio tells us absolutely nothing about this topic so Piketty compiles more data to get at this highly pertinent question.
What he uncovers is that in the Belle Epoque inequality was extremely high in all of Europe. Something like the top decile of wealth controlled 90% of the wealth. Furthermore, the wealth distribution was much like a step function, you were either impoverished or you were among the lucky few with land that put you in the upper echelons of society. There was no middle class as we conceive of it today. The U.S. due to its high levels of demographic growth from mostly poor immigrants and lack of existing capital had a much more egalitarian distribution of wealth. The one exception was the South where the establishment of large plantations and the ownership of slaves mimicked the conglomeration of capital in the hands of the few seen in Europe.
The other important characteristic to note was that all the very wealthiest people derived their income almost exclusively from capital. Income from labor was paltry in comparison. Apart from a very lucky few merchants, you inherited or married your way into real wealth. In an interesting aside, Piketty uses a story from Balzac’s Le Pere Goriot where the character Vautrin lectures us on how marrying a rich heiress is the easiest and only way to secure a good income; that putting in a lifetime of service as a relatively lucrative lawyer would still pale in comparison for much more toil. As a result, income from labor is naturally far more egalitarian than that of income from capital in this period.
In the immediate post-WW2 period inequality of wealth reached a nadir. Capital was decimated by the wars and Europe went through a period of rapid catch-up growth. The new socialized state emerging from the ashes of war greatly ensured that the spoils of this growth were distributed throughout the populace. A patrimonial middle class, as Piketty calls it, emerged for the first time ever. That is, a substantial fraction, that Piketty identifies with the 4 deciles below the top decile of wealth, of the population actually managed to accrue some amount of wealth. For once in human history it seemed that your economic status really was mostly due to the fruits of your labor. Of course, this ignores the fact that the bottom 50% of the population still had less than 5% of national wealth to their name.
Sadly, this period ended around the 80s due to a complex mix of political and economic factors. The share of national capital in the hands of the top decile is again above 50% if not close to 70% in the developed nations and the rate of increase seems to be, if anything, accelerating. This has mostly come at the expense of the patrimonial middle class as the poorest half of the population essentially had nothing to lose.
Now while capital income (derived from wealth) is still far more unequally distributed than labor income, the latter has seen a dramatic decrease in its egalitarianism. While all the very richest people derive the bulk of their income from capital, you can now go very high up the income scale and still find people that derive most of their income from labor. This is, according to Piketty, due to the rise of the supermanager, as I discussed in a previous post.
Now in standard economic theory, productivity growth should translate into wage growth. What Paul Krugman pointed out two decades ago was that 70% of the gains of productivity growth have gone to the top 1% in the income distribution through the 80s with the trend continuing today. And you can show that the top .1% garnered an even more outsized proportion of the gains. Therefore the really really rich are pulling away from the really rich who are pulling away from the just plain old rich and so on.
The War Years and Their Consequences
Before I continue let me convey the economic shock the world went through during both World Wars. As I said earlier, inequality hit a trough after the wars and this coincided with a complete eradication of most capital in mainland Europe with lesser shocks in the U.K. and U.S. Recall that the top incomes are all based on capital and particularly so in this period and therefore the trajectory of capital is the trajectory of the economic elite. Some of this was just the plain destructive nature of war. However, there was also a Great Depression and the government responses to it. Things like rent control, nationalization and progressive income taxes with very high marginal rates came into being during this period. All of these reduced the power of the rentier class.
One other fact that might be unfamiliar to most people is that nature of inflation in the past. We live in a world of low stable inflation, but this is actually a modern fact of life. Before the wars inflation was essentially zero. Five thousand British Pounds were worth about the same amount for centuries. Compared to this even the inflation rate of 2% we have now is enormous.
Now after the World Wars pretty much every country had a fiat currency and used that power to engage in high levels of inflation to get rid of their debt. Combined with historically unprecedented tax rates they managed to overcome their war debt relatively quickly.
Contrast with lets say Great Britain after the Napoleonic Wars that racked up debt equal to 200% of GDP. They did not have inflation as a tool and taxes were extremely low compared to modern standards. As such they borrowed money and the only people to borrow from were the small subset of people that actually had capital. And unlike today, government debt had very good yields, comparable to other asset classes and remember there is no inflation in this period. So the owners of capital were also beneficiaries of government spending at this time. In the end it took a century for Great Britain to bring its debt levels down.
I bring all this up to show how the inflation engaged in during and after the World Wars was a significant factor in reducing capital. This isn’t always true, any assets that appreciate with inflation are fine, but government debt is almost entirely denoted in nominal terms and so inflation is particularly ruinous to anyone holding that particular asset. While the owners of capital were becoming more sophisticated at this time, they still invested heavily in government debt and were thus wiped out. Inflation would not necessarily curb inequality today as a middle class now exists with non-negligible wealth and the truly rich are much more sophisticated investors in a wide variety of financial assets. In fact I would suspect government debt is mostly held by said middle class since the very low yields are very unattractive for the knowledgeable investor.
Now at the same time labor income remained relatively stable. So again, the collapse of inequality was really the collapse of capital. Then Europe had its post-war boom which further mitigated the benefits of previous stocks of capital. After all if the pie is getting bigger every year then the little bit of pie you saved from last year starts to look smaller. So we had a novel period where the distribution of wealth was more egalitarian and mirrored the distribution of labor income quite closely. One could conceivably describe it as a meritocracy. That period, however, is over and the sooner we get over the euphoria of that age the better.
Now that is most of the background history that is necessary. From here we look at the future of capital and income accumulation and how to deal with its increasing agglomeration among a small part of the population.