Three Longs & Three Shorts

Thomas Piketty is right: Everything you need to know about “Capital In The Twenty-First Century”

Now let’s move from Paul Graham’s theory to see an application of this theory i.e. let’s dig into one of the most original books published this century. Thomas Piketty’s “Capital in the Twenty-First Century” was published in 2013. At that time, the discourse on the widening inequality in income was already five years old. Piketty added another dimension to that debate – by showing that inequality in wealth (as opposed to income) was even greater – and then adding a time dimension to it – by showing that over the next century inequality in wealth is bound to increase significantly. [This has all sorts implications for businesses including Marcellus.]
A year after the publication of Piketty’s book, the Nobel Laureate Robert Solow wrote an outstanding review of the book in The New Republic. In this review, Solow, the father of modern economic growth theory, not only summarised Piketty’s key findings but also applied his formidable intellect to teasing out the pathbreaking nature of Piketty’s work.
Solow begins by summarising the breadth and diligence of Piketty’s scholarship in Capital: “Piketty’s strategy is to start with a panoramic reading of the data across space and time, and then work out from there….It all begins with the time path of total—private and public—wealth (or capital) in France, the United Kingdom, and the United States, going back to whenever data first become available and running up to the present. Germany, Japan, and Sweden, and less frequently other countries, are included in the database when satisfactory statistics exist.”
The result of all of this detailed historical number crunching is that Piketty is able to show that UK, France and USA – the 3 countries studied extensively in the book – capital: income i.e, wealth as a multiple of national income “has been increasing since 1950, and is almost back to nineteenth-century levels. He projects this increase to continue into the current century…In fact he predicts….that the world capital-income ratio will rise from just under 4.5 in 2010 to just over 6.5 by the end of this century. That would bring the whole world back to where a few rich countries of Europe were in the nineteenth century.” {Solow summarises in his review how Piketty reaches this powerful conclusion but we won’t reproduce the maths here.}
Having demonstrated that the stock of capital:national income ratio will rise, Piketty then shows that capital’s share of national income also has to rise. In Solow’s words: “The key thing about wealth in a capitalist economy is that it reproduces itself and usually earns a positive net return. That is the next thing to be investigated. Piketty develops estimates of the “pure” rate of return (after minor adjustments) in Britain going back to 1770 and in France going back to 1820…He concludes: “[T]he pure return on capital has oscillated around a central value of 4–5 percent a year, or more generally in an interval from 3–6 percent a year. There has been no pronounced long-term trend either upward or downward…. It is possible, however, that the pure return on capital has decreased slightly over the very long run.”…
Now if you multiply the rate of return on capital by the capital-income ratio, you get the share of capital in the national income. For example, if the rate of return is 5 percent a year and the stock of capital is six years worth of national income, income from capital will be 30 percent of national income, and so income from work will be the remaining 70 percent.
At last, after all this preparation, we are beginning to talk about inequality, and in two distinct senses. First, we have arrived at the functional distribution of income—the split between income from work and income from wealth. Second, it is always the case that wealth is more highly concentrated among the rich than income from labor…and this being so, the larger the share of income from wealth, the more unequal the distribution of income among persons is likely to be. It is this inequality across persons that matters most for good or ill in a society.”
Solow then takes us into the heart of Piketty’s famous finding of “r>g” i.e. the real rate of return on capital being higher than real GDP growth, a finding which ensures that the rich will get richer both in terms of their share of income and in terms of their share of wealth: “Over the long span of history surveyed by Piketty, the rate of return on capital is usually larger than the underlying rate of growth. The only substantial exceptional sub-period is between 1910 and 1950. Piketty ascribes this rarity to the disruption and high taxation caused by the two great wars and the depression that came between them.
There is no logical necessity for the rate of return to exceed the growth rate: a society or the individuals in it can decide to save and to invest so much that they (and the law of diminishing returns) drive the rate of return below the long-term growth rate, whatever that happens to be. It is known that this possible state of affairs is socially perverse in the sense that letting the stock of capital diminish until the rate of return falls back to equality with the growth rate would allow for a permanently higher level of consumption per person, and thus for a better social state. But there is no invisible hand to steer a market economy away from this perversity. Yet it has been avoided, probably because historical growth rates have been low and capital has been scarce. We can take it as normal that the rate of return on capital exceeds the underlying growth rate….
Now imagine someone whose income comes entirely from accumulated wealth. He or she earns r percent a year. (I am ignoring taxes, but not for long.) If she is very wealthy, she is likely to consume only a small fraction of her income. The rest is saved and accumulated, and her wealth will increase by almost r percent each year, and so will her income. If you leave $100 in a bank account paying 3 percent interest, your balance will increase by 3 percent each year.
This is Piketty’s main point, and his new and powerful contribution to an old topic: as long as the rate of return exceeds the rate of growth, the income and wealth of the rich will grow faster than the typical income from work…
This interpretation of the observed trend toward increasing inequality…is not rooted in any failure of economic institutions; it rests primarily on the ability of the economy to absorb increasing amounts of capital without a substantial fall in the rate of return. This may be good news for the economy as a whole, but it is not good news for equity within the economy.” Solow calls this the “rich-get-richer dynamic”.
To give us a taste for what Piketty’s remarkable prediction implies, Solow creates for us a vignette using the US and Europe: “Capital is indeed very unequally distributed. Currently in the United States, the top 10 percent own about 70 percent of all the capital, half of that belonging to the top 1 percent; the next 40 percent—who compose the “middle class”—own about a quarter of the total…and the remaining half of the population owns next to nothing, about 5 percent of total wealth….The typical European country is a little more egalitarian: the top 1 percent own 25 percent of the total capital, and the middle class 35 percent….If the ownership of wealth in fact becomes even more concentrated during the rest of the twenty-first century, the outlook is pretty bleak unless you have a taste for oligarchy.
Income from wealth is probably even more concentrated than wealth itself because, as Piketty notes, large blocks of wealth tend to earn a higher return than small ones. Some of this advantage comes from economies of scale, but more may come from the fact that very big investors have access to a wider range of investment opportunities than smaller investors.
Income from work is naturally less concentrated than income from wealth. In Piketty’s stylized picture of the United States today, the top 1 percent earns about 12 percent of all labor income, the next 9 percent earn 23 percent, the middle class gets about 40 percent, and the bottom half about a quarter of income from work. Europe is not very different…
You get the picture: modern capitalism is an unequal society, and the rich-get-richer dynamic strongly suggest that it will get more so.”
We won’t get into the policy implications of Piketty’s work. What we like about his work is the ability of one man to immerse himself in data for a decade and emerge with a compelling picture of how the world will unfold for many decades hence.