Wednesday, May 14, 2014

Piketty: Inequality of Capital Ownership

Labor income inequality is on the rise again, according to Thomas Piketty in Capital in the Twenty-First Century. Now he looks at capital inequality since the turn of the 19th century.  This is important because the compression of inequality in the 20th century came from a "collapse of high incomes from capital."

Wealth is always more concentrated that income. Down the ages the "least wealthy half... own virtually nothing".  Generally the top 10% own 60% or more of the wealth and the folks in the middle from 5% to 35%.  The significance of the modern era is the emergence of a "patrimonial middle class" owning between 25% and 33% of national wealth.  How did this middle class emerge?

Of course, it is difficult to estimate historical wealth trends because France only started to record property transfers after the Revolution and Britain and the US a century later after the shock of World War I.  Piketty shows the wealth of the top 10% and 1% in France from 1810 to the present in a chart. It shows wealth inequality going up in France throughout the 19th century.  The top 10% owned 80% of wealth in 1810 and 89% of wealth by 1910.  The top 1% owned 46% of wealth in 1810 and 60% by 1910.

Now, of course, the content of wealth was totally transformed over this period, with land being replaced by "industrial and financial capital and real estate" -- not to mention vast political changes -- but the capital/income ratio stayed pretty constant throughout.

Then came the world wars and the top 10% wealth share in France declined from 89% in 1910 to 62% in 1970 and then started a slow recovery.  For the top 1% wealth declined from 60% to 22% over the same period, recovering to about 24% by 2010.

Wealth inequality in Britain and Sweden followed a similar path, but the US started with less inequality and ended up with more as you can see in the following tables from Piketty's charts.

Wealth Share of the Top 10%
Country1810191019702010
France80%  89%  62%  63%
Britain83%92%64%70%
Sweden83%88%54%59%
United States58%81%65%71%

So you can see that the US started out more equal and ended up more unequal.  Now let's look at the top 1%.

Wealth Share of the Top 1%
Country1810191019702010
France46%  60%  22%  24%
Britain55%69%22%28%
Sweden57%61%18%21%
United States26%45%29%33%

Piketty wants to ask why wealth inequality was so extreme before World War I, and why is it today significantly below its high.  Is this "irreversible?"  In any case, we clearly see the emergence of a "patrimonial middle class" with about 33% share of the wealth.

Now we come to the center of Thomas Piketty's argument.
The primary reason for the hyperconcentration of wealth... prior to World War I... is that these were low-growth societies in which the rate of return on capital was markedly and durably higher than the rate of growth.
Or, as Piketty likes to show in the following inequality: r > g.

In a world of low growth, say 0.5% to 1% per year, the rate of return on capital is much higher, say 4% to 5% per year. If the capitalist saves a good part of his income, his capital can grow faster than the economy.
For example, if g=1% and r=5%, saving one-fifth of the income from capital... is enough to ensure that the capital inherited from the previous generation grows at the same rate as the economy.  If one saves more... then one's fortune will increase more rapidly than the economy, and inequality of wealth will tend to increase[.]
Piketty shows a couple of charts here and here to show the history of r and in France in the 19th century. They shows that the rate of return on capital is typically "10 to 20 times greater than the rate of growth of output (and income)."  He shows a chart of r and g since antiquity that forecasts r and g through 2100.  In another chart, Piketty forecasts that the return on capital, which collapsed in the 20th century, will return by 2200 to near historical levels while economic growth declines.  This is not a "plausible hypothesis, precisely because its inegalitarian consequences would be considerable and would probably not be tolerated indefinitely."

But what about "time preference"?  Isn't the rate of return on capital mostly time preference, "that measures how impatient they are and how they take the future into account"?  Well, yes, but this "theory" is "somewhat tautological".
[A]ssuming a zero-growth economy, it is not surprising to discover that the rate of return on capital must equal the time preference[.]
The problem is that the time preference theory "is too simplistic and systematic" because we can't reduce all savings behavior to one parameter.  And it requires that during rapid growth the gap between r and should be greater than during zero growth. There are a lot of other things to consider, including "precautionary savings, life-cycle effects" and the prestige of wealth itself.

On the validity of Piketty's ideas, that the inequality r > g allows the capitalists to increase their share of wealth without limit, and that time preference is just one of many factors in the rate of return on capital, hangs the entire argument of Capital.  See the Discussion below.

Of course, Piketty admits, if the capitalists save without limit, the only thing that can avoid "an indefinite inegalitarian spiral" is that eventually, the rate of return on capital would go down.  But this could "take decades to operate."  Alternatively "shocks of various kinds" whether demographic or economic, can deplete capital.  No doubt that's why many aristocratic societies were based on primogeniture "to conserve the family's wealth."  Since 1800, of course, western societies have progressively abandoned primogeniture.

Primogeniture was abolished in the French Revolution, but inequality in France continued for another century.  That's where the inequality r > g comes in.  When the rate of return of capital is as high as it was in France in the 19th century you can expect an increase in inequality.  And beyond a certain threshold "inequality of wealth will increase without limit".

In the event, though, inequality today is still less that the peak at the end of the 19th century.  Why is that?  Piketty admits that he doesn't have a good answer to this.  Obviously the shocks of 1914 to 1945 destroyed a lot of wealth, and probate records show that many rentiers failed to reduce their expenditure to match their reduced income.  And many of the largest fortunes were plundered by expropriation, as with the nationalization of the Renault fortune after World War II and the French "national solidarity tax" of 1945.

One answer is that "governments in the twentieth century began taxing capital and its income at significant rates" and also taxed estates.  The highest estate tax in Germany is "15-20 percent, compared with 30-40 percent in France" and 50 percent in the United States.

Piketty does not expect inequality to return to the level of the Belle Époque, principally because he expects the return on capital to come down and the rate of growth to stay high compared to pre-modern rates.

But if there are no shocks from war and if the taxation of capital and high incomes continue to come down then there is a "high risk" of inequalities of wealth returning to the extremes of the Belle Époque at the turn of the 20th century.

Discussion

Piketty argues that his inequality r > g means that when the rate of return on capital is a lot bigger than the rate of growth then inequality can increase without limit, because if the capitalists save a decent part of their capital income their share of wealth keeps going up.  But this is belied by his own numbers.

  1. He shows that the return on capital was about 4.5% for centuries before the modern growth spurt.  This implies, according to his way of looking at things, that it takes more than 4.5% return to spark any growth at all.
  2. If you look at the history, the aristocracy didn't see wealth as something to be increased by savings.  They saw their wealth as a necessary support of their political power and they typically used their wealth for that purpose.  Savings was something you did in the generational tournament of acres where the fortunate increased their land ownership by an arranged marriage.  The idea was to combine the acres of the eldest son with a rich heiress.  She could be a young woman with a large dowry or she could be the beneficiary, like Trollope's Lady Glencora, of a family without a male heir.
Piketty rather carelessly brushes off time preference as a tautology and a "theory," and simplistic to boot.  In fact researchers have studied time preference not just theoreetically, but empirically in actual human experiments.  Here is Nicholas Wade in A Troublesome Inheritance introducing the idea.
When inflation and risk are subtracted, an interest rate reflects the compensation that a person will demand to postpone immediate gratification by postponing consumption of a good from now to a future date.
This business of time preference is extreme in young children, a demonstrated in Walter Mischel's marshmallow test, where young children were offered a choice between "one marshmallow now or two in fifteen minutes."
[T]hose able to hold out for a larger reward had higher SAT scores and social competence in later life... American six-year-olds, for instance, have a time preference of about 3% per day, or 150% per month; this is the extra reward they must be offered to delay instant gratification.
According to Wade, society's time preference has been about 10% per year down to 1400 AD. "Interest rates then entered a period of steady decline, reaching about 3% by 1850." Note that Piketty's chart asserts that the rate of return on capital was 4.5% from antiquity until 1800.

Obviously Thomas Piketty must brush aside the notion of time preference.  Otherwise his entire thesis collapses.

Introduction

Part One: Income and Capital

Income and Output

Growth

Part Two: The Dynamics of the Capital/Income Ratio

Changes in Capital

New World Capital and Slavery

Capital/income Ratio in the Long Run

Capital's Share of Income

Part Three: The Structure of Inequality

Inequality and Its Concentration

Two Worlds: France and the US

Inequality of Labor Income

Inequality of Capital Ownership

Merit and Inheritance in the Long Run

Global Inequality of Wealth in the 21st Century

Part Four: Regulating Capital in the Twenty-First Century

A Social State for the 21st Century

Rethinking the Progressive Income Tax

A Global Tax on Capital

The Question of the Public Debt

Conclusion

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