Piketty: Capital/income Ratio in the Long Run

In his comparison of Europe and North America Thomas Picketty showed that there were differences between the Old World and the New World in the pricing of capital.  For one thing, the capital/income ratio has tended to be lower in the United States and Canada.  That's because North America has seen a huge increase in population over the modern era and people don't show up at Ellis Island with lots of capital.

But why has the capital/income ratio returned to its 19th century level in Europe after a collapse in the wars and turmoil of the early-to-mid 20th century, and why should the ratio in the United States always be lower?

To answer the question, Piketty introduces a "Second Fundamental Law of Capitalism."  It is this:

Capital/income ratio = (savings rate) / (growth rate)

What does that mean, exactly?  Here is Piketty's explanation:

[I]f a country saves 12 percent of its national income every year, and the rate of growth of its national income is 2 percent per year, then in the long run the capital/income ratio will be equal to 600 percent[.] 

Just to be clear, the "First Fundamental Law of Capitalism" introduced in the chapter on Income and Output was that:

Capital/income ratio = (share of income from capital) / (rate of return on capital)

I've shuffled the equation around a bit, but here is Piketty's explanation of his First Law:

[I]f national wealth represents the equivalent of six years of national income, and if the rate of return on capital is 5 percent per year, then capital's share in national income is 30 percent.

So my first question is: where does this "savings rate" come from?  How can you even measure such a thing.  The closest I can come to an explanation is on page 28 of the Technical Appendix (pdf), where Piketty writes that the Second Law "stems directly from the basic mathematical equation describing wealth accumulation."

In a model without price effect, and where wealth entirely comes from accumulation (no natural resources), wealth in year t+1 W_t+1 simply equals the sum of wealth in year t W_t and savings [in year t] S_t[.]

Oy!  Deirdre McCloskey says: capitalism is not about "accumulation"; it is about innovation.  George Gilder says that capitalism is "surprise."  For instance Apple Computer.  At the end of 2008 AAPL stock price was about $85 per share.  At the end of 2009 AAPL was about $211.  Assuming about 900 million shares, that's an increase in wealth from $76 billion to $190 billion.  You call that savings? Give me a break.  Instead, what we see is the capitalization of an unanticipated future income stream from an amazing innovation, a Steve Jobs surprise, called the iPhone.

Anyway, Piketty goes off into a long riff about what happens if a nation starts with zero and "saves 12 percent of its national income for a year.  It will take 50 years to "save the equivalent of six years of income" and then, of course, the national income will be bigger.  Accumulation takes time.

No!  Here's how the world works.  Carnegie creates cheap steel and bingo, the economy rockets into the stratosphere as steel rails allow much heavier railroad trains. Ditto Rockefeller and oil; Ford and autos.  That's not accumulation; that's a quantum leap.

Anyway, Piketty explains the increase in the capital/income ratio since World War II by his accumulation theory.  The return of a high capital/income ratio means "the emergence of a new patrimonial capitalism."  What we are seeing is low growth and high savings, he says. (Yes, but how exactly is he computing "savings"?)

But what about the future?  Using his Second Law, Piketty estimates that the world capital/income ratio will slowly rise to about 6 to 7 times national income by the end of the 21st century, "approximately the level observed in Europe from the eighteenth century to the Belle Époque.  And we know what that means.

Discussion

Piketty gives us the accumulationist narrative.  Here's the Austrian/innovation/surprise narrative.  After a big war, when lots of things and people have been destroyed, only the most urgent production and capital projects make sense.  The future is heavily discounted; what matters is to work and rebuild now; you get the French Trente Glorieuses.  Interest rates are high and therefore capital is priced low.  But as the emergency passes the national wealth increases; interest rates go down and people get more relaxed about the future.  Capital values go up and less urgent projects start to make sense.  Meanwhile, all the time, crazy kids keep turning up with crazy ideas that turn into Texas Instruments, Microsofts, Qualcomms, Apples, Facebooks: literally creating huge wealth out of nothing.

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

Piketty: New World Capital and Slavery

From a survey of capital in Britain and France Thomas Piketty in Capitalism in the Twenty-First Century moves on to Germany and the United States.

While capital in Germany in the late 19th century represented about six to seven times annual national income and crashed to two times national income in the wars of the 20th century, it hasn't climbed back quite as far as in Britain and France.  Housing isn't as big a factor because of the cheap houses from East Germany and "stricter rent control."  Domestic capital in businesses is lower because the stock market valuation of German firms is lower because of "the stakeholder model" that lets German workers sit on the boards of German corporations.

But the collapse in the value of capital in the mid 20th century was not just due to the destruction of war but to the "budgetary and political shocks".  In addition savings was low and the "postwar political context" of nationalization and regulation reduced private wealth.

The United States did not see a collapse in private wealth in the mid 20th century.  Nor did it experience the high capital to income ratios of 600% to 700% common in Europe in the 19th century.  The capital to income ratio was about three in 1800 and rose to five by 1910.  It sank to four by 1950 and since then has risen back to about 4.5.

Piketty reckons that the difference is that there was much less established wealth in the US.  People "did not cross the Atlantic with their capital of homes or tools or machinery".  They had to create it and that takes time.  We are to understand that this means there was less inequality in the US.  Also the US never had the colonial empires and foreign capital that the Europeans enjoyed.  Foreigners have tended to invest more in the US than vice versa.  In Canada this effect was magnified.  Foreign investment in Canada in 1900 was about 100% of national income; in the US it has never exceeded a few percent.

Now we come to slavery.  Earlier, Piketty rejected the idea of including intangible wealth in knowledge and workers in the capital total, but now he wants to include the value of slaves in his capital accounts.  If the value of the slaves was about 100% of national income then the capital to income ratio in the United States stood at about 4.5 to five. He writes:

[I]t is clear that [counting the capital value of workers] makes sense only in a slave society, where human capital can be sold on the market, permanently and irrevocably.

Then he goes on to criticize "some economists" for wanting to capitalize the "value of the income flow from [free] labor."  They find to their "amazement that human capital is the leading form of capital in the enchanted world of the twenty-first century."

But is it? It seems pretty obvious that it was their human capital that enabled the Europeans to rebuild their nations so rapidly after World War II.  So why not count it?  Probably because it would cause problems for Piketty's goal, which is to call for taxes on the rich to curb inequality.  On the other hand there might be a problem with double counting, because human capital is probably already included in the capitalization of private corporations (and probably also slave plantations).

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

Piketty: Changes in Capital

Thomas Piketty is going to want us to agree that the idle rich should be taxed.  So he reserves a chapter where he particularly wants us to look at the metamorphoses in rentier capitalism.

Strictly speaking, "rentier" means a holder of French government bonds, traditionally called rentes.  When Keynes talked about the "euthanasia of the rentier" he meant the obliteration of government bond-holders in the inflations after World War I.

But first he shows us the change in the composition of capital in charts of the value of national capital as a percent of national income.  In both France and Britain, capital in 1700 was mostly farmland.  One-third of the rest was housing, and the rest "other domestic capital" meaning everything else, including "building used for business and the associated land, infrastructure, machinery, computers, patents, etc."

But three centuries later, the value of farmland is almost zero.  Its share of capital has been replaced by housing.  Meanwhile, in the nineteenth century both France and Britain saw a substantial rise and fall in "net foreign capital."  The World Wars of the 20th century also dug a hole in overall capital value: "commensurate with the violent military, political, and economic conflicts" of the times.

But what about public debt?  This nets out to zero, because it is owed by the government and owned by the private sector.  But the size of the debt is significant because debt service can take up a huge share of government revenue.  After the Napoleonic Wars Britain had a national debt over 200 percent of GDP; that's a lot of interest going to the wealthy rentiers.  But in France the government repudiated its debt, with less government revenue going to rentiers.

Piketty almost, but not quite, suggests that a large public debt is a way of redistributing government revenue to the rich.  Conversely the 20th century inflations were a way of despoiling the rich by devaluing their fortunes in government debt.  He suggests, but doesn't quite say, that debt or no debt doesn't make a difference on the bottom line.  For instance Britain had a national debt over 200 percent GDP in 1945 and France essentially cancelled public debts.  Yet both countries grew out of the devastation of World War II, and both featured a lot of government ownership in the economy.  In France the growth was particularly robust, when the government owned a lot of the economy including auto manufacturer Renault, so much so that the period 1950-1980 was called the "Trente Glorieuses", or glorious thirty years.

The lesson seems to be that nations can transform their national capital, or at least their national debt, and yet nothing seems to change.  The world goes on.

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

Piketty: The End of Growth

After building a theoretical framework for income and output and the rate of return on capital, Thomas Piketty turns to growth: demographic growth and economic growth.

His idea is that the current era shows a bell-curve of growth.  It starts with the demographic bulge that started after 1700 and the economic bulge the started after 1800.  Obviously, he writes, it's all going to end.

Piketty points out that there were about 600 million humans on the earth in 1700 and 7 billion right now.

If this pace were to continue for the next three centuries the world's population would exceed 70 billion in 2300.

The fact is that the world population growth rate peaked at about 1.8% per year in about 1950-1990, according to a chart on page 80.  Now the growth rate is coming down, and it's expected to continue to go down.

Piketty thinks that economic growth is on a similar path.  Growth in Europe and North America peaked in 1950-1990 and in the last 20 years from 1990-2012 it has trended lower.  The rest of the world will go the same way once it has caught up to the West.

Thus (in a chart on page 100) Piketty forecasts that world per-capita economic growth will peak at 2.5% per capita per year in 2012-2030 and will be down to 1.2% per capita per year by the end of the century.

A world of slow growth, economic and/or demographic, is a world where opportunity to rise is reduced.  This means that the world will return to the world of Jane Austen and Balzac novels.  Back in those days, before 20th century inflation and modern growth, the average person subsisted on about £30 per year. But the average Austen or Balzac family knew that you needed about £600 to £1,000 a year to live "free from need."  Mostly, they inherited their wealth.

In those days, before the modern era, where the population and the economy were both pretty static, inequalities persisted from generation to generation.

In the last century we have see persistent inflation; this has obscured the monetary benchmarks of the pre-inflationary world.  But the future is likely to return to something similar, wealth through inheritance rather than wealth through growth, unless we do something about it.

Introduction

Part One: Income and Capital

Income and Output

End of 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

Piketty: Income and Output

Is foreign capital investment a good thing?  After telling us that he's going to propose a global wealth tax, Thomas Piketty in Capital in the Twenty-First Century shows us that income and output aren't the same thing.

For the developed countries, income and output are about the same, but for poor countries, output can very often be substantially more than income, because the return on capital investment gets transferred abroad.  And this causes political problems between political parties that want to expropriate the foreign capitalists and the parties that want to encourage them.

And that's why Piketty opens his chapter on Income and Output with a description of the 2012 Marikana miners' strike in South Africa.

In Piketty's telling, the "South African police intervened in a labor conflict between workers... and the mine's owners... Thirty-four miners were killed."  The miners wanted to double their wages from 500 euros to 1,000 euros a month.  But in Wikipedia's telling things were a bit more complicated than that.

The strike occurred against a backdrop of antagonism and violence between the African National Congress-allied National Union of Mineworkers (NUM) and its emerging rival, the Association of Mineworkers and Construction Union (AMCU). According to a Guardian columnist, the NUM was closely linked to the ruling ANC party but lost its organisational rights at the mine after its membership dropped from 66% to 49% and its leadership began to be seen as 'too close' to management.

If you read Howard Zinn's A People's History of the United States or Emile Zola's Germinal you find that usually there are radical suits behind the great strikes.  The radical suits -- we call them community organizers today -- lead the workers into bloody confrontations with the owners.  And then head off to their next gig.  The workers are usually worse off than before.  It's the eternal refrain of the modern era. Capitalism works on the individual's surrender to the market, but the workers, emerging from feudal collectivism, still think you have to fight with your fists to win a livelihood.

The other Big Thing that Piketty wants us to know is the "First Fundamental Law of Capitalism." It is this:

(Share of national income from capital) = (rate of return on capital) x (capital/income ratio)

You can see what is going on here.  Piketty is not interested in just describing what capitalism does.  He wants to rush immediately to the result.  Are the capitalists getting a fair share on the national income? Is the capitalist share going up?  So what are we going to do about it?

And what about the capital/income ratio?  That's the "total wealth owned at a given point in time" divided by the "quantity of foods produced and distributed in a given period."  In the Nineteenth century the ratio was high, about 600%.  Then after the World Wars it came down to 300%.  Now it's gone back up to 500%.

We shall see what Piketty wants to do with these notions in future posts.  But you can see what is coming.  If the income of the poor nations is less than their output, then maybe the rich nations should return the surplus they have ripped off back to the poor nations.  Because inequality.

Stay tuned.

Introduction

Part One: Income and Capital

Income and Output

End of 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

Piketty: Inequality is the Problem, Government is the Cure

You get the point pretty early on in Thomas Piketty's Capital in the Twenty-First Century. On the first page of the Introduction he writes:

When the rate of return on capital exceeds the rate of growth of output and income, as it did in the nineteenth century and seems quite likely to do again in the twenty-first, capitalism automatically generates arbitrary and unsustainable inequalities that radically undermine the meritocratic values on which democratic societies are based.(p.1)

It does?  But, writes Piketty, there "are nevertheless ways democracy can regain control over capitalism and ensure that the general interest takes precedence over private interests"(p.1).

Thank goodness for that!  Notice the assumption: capitalists work for private interests; government works for the general interest.  You mean like Sen. Harry Reid (D-NV)?

Piketty develops his larger argument in the introduction.  First, he cites David Ricardo, who argued in 1817 that the natural scarcity of land would result in the almost unlimited  rise in the value of land and therefore rents.  The landlords would inherit the earth, "upsetting the social equilibrium."  So Ricardo proposed a "steadily increasing tax on land rents."(p.6)

Then  came Marx.  He extended Ricardo's principle of accumulation of land rents to capitalism as a whole, the "inexorable tendency for capital to accumulate and become concentrated in ever fewer hands, with no natural limit to the process."(p.9)  He proposed an "apocalyptic end" to capitalism.

In other words, both Ricardo and Marx proposed that wealth would concentrate without limit and that something should be done about it.  Remember this was before Stein's Law that if something cannot go on forever, it will stop.

But then after World War II along came Simon Kuznets, who showed that, since World War I, inequality had been declining, so there was nothing to worry about.  Let capitalism do its thing.

Unfortunately, writes Piketty, the reduction in inequality stopped right after World War II.  On page 24 he shows a chart of the top 10% share of US income from 1910 to 2010.  It's 40 percent from 1910 to 1920, rises in the 1920s to 45 percent and stays there right through the Great Depression.

Then suddenly, the top 10% share drops off a cliff from 45 percent to 35 percent in two years between 1941 and 1943 at the start of World War II.  It stays there for the next 40 years until the 1980s.  Since 1980 the top 10% share has gone steadily up, hitting 40 percent of income around 1990, 45 percent in the late 1990s and briefly hitting 50% right before the Great Recession.

Then Piketty shows a chart of capital/income ratio in Europe for 1870 to 2010 on page 26.  It shows that the "market value of private capital" in the late 19th century was 6 to 7 times national income.  Then after the two world wars it crashed to two to three times national income.  Ever since 1950 the ratio has been climbing.  In France and Britain the ratio is back to 5 times national income.  In Germany it's back to 4 times national income.

In other words, "the process by which wealth is accumulated and distributed contains powerful forces pushing towards... an extremely high level of inequality."(p.27) and these "forces of divergence" may be getting the upper hand unless we do something about it.

Discussion Points

1. What does it mean when the "rate of return on capital" exceeds the growth in "output and income"?  Does it mean that the capitalists are grabbing the goodies, or is capital income the price we pay for growth?
2. It's pretty obvious why the top 10% share of income in the US dropped in 1941-43. Income taxes, with the top rate going to 90 percent, where it stayed until the tax rate cuts started in the late 1970s.  Over the next 20 years taxes on income and capital were reduced again and again. But what does the spurt in top 10% income share mean?  Does it mean that the most able grabbed more income?  Did they hide their income in the high tax years?  Or does it mean that capitalism automatically rewards achievers?
3. Piketty takes it for granted that inequality is a scandal.  But is it?  Put it this way.  In the agricultural era the landed warriors collected rent because they had seized the land and forced the peasants to pay them for the privilege of farming the land.  OK, bad, bad, bad, as in barons of the crags.  But capitalism is different.  Today people with savings put money into commercial and industrial ventures.  If the venture succeeds (i.e., provides products and services that people want) the investors reap huge benefits.  If it fails they lose their money unless government comes in and bails them out.
4. What about the notion in economics that interest on a loan is an example of "time preference?"  Money in the here and now is worth more than money in a year, so you have to compensate someone to forego spending money now.  We pay workers to forego their leisure; we pay capitalists to forego immediate spending.  What's the scandal? (In a later chapter Piketty writes that time preference is "simplistic."

But I still have my question.  What does it really mean when capitalists are making tons of money?

Introduction

Part One: Income and Capital

Income and Output

End of 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

Waiting for Piketty

If I were home right now I could be at home reading Thomas Piketty's Capital in the Twenty First Century.  But I'm not at home.  So I have to wonder about the alleged argument of his book.  That capitalists make 4-5 percent on their money, but the GDP only increases 1.5 percent per year.  Therefore inequality.



Heather Wilhelm argues today that the fuss over Piketty reflects the frustration of the up-and-coming professional in a lefty city. She quotes David Brooks.

“If you are a young professional in a major city, you experience inequality firsthand,” Brooks wrote. “But the inequality you experience most acutely is not inequality down, toward the poor; it’s inequality up, toward the rich.”



Frustrated up-and-comers, he notes, mix and mingle with the wealthy, brushing elbows at cocktail parties, facing the constant indignity of having other people’s privilege shoved in their faces: “You wait in line at the post office,” he writes, “but they have staff to do it for them.”

Yes.  It must be insupportable to have to kow-tow to rich guys like Donald Sterling.



But I wonder what the Piketty thesis means.  What does it mean that capitalists are making 4-5 percent on their money?  What is the 4-5 percent compensating them for?  Is it too much or too little?  Or put it this way?  How much return on capital is economically necessary to yield 1.5 percent real GDP growth?  Return on capital is a tricky thing.  At one end it is the return on widow-and-orphan bonds, supposedly secured by bond covenants and collateral.  Those chaps don't deserve anything.  Right?  At the other end it is a reward for risk, taking a flier on an uncertain future.  How much is enough for that?



And that is to say nothing about whether we should do anything about inequality, let alone use it as a reason to give governments more money.



So I sit here and wait.  For the moment when I get to read what the New York Times calls "the big-think book of the moment."