Should Germany pay?

I read this piece "The pathology of Europe's debt" by Benjamin Friedman in NYRB yesterday. It is about the predicament of the South European countries. Friedman makes two key non-technical points.

1) Debt issue is not a morality play as Germans seem to believe. And to help his case, he quotes 19th century Protestant obsession about never being in debt, never borrowing etc.

2) He then describes at length how Germany benefited from not repaying in full its obligations under the Versailles treaty, and had finally practically all of it nullified by UK, US and France in the early 1950s. And then of course Germany benefited from the Marshall plan.

The clear, albeit unstated, conclusion is that Germany should now be more flexible and generous with Greece, Spain etc. because she herself was a major beneficiary of Western largesse.

But Friedman makes, in my opinion, three mistakes.

1) He neglects to engage with the view that the Versailles Peace Treaty that exacted significant reparations from Germany was inequitable. The German delegation signed it under duress, practically with the gun pointed to its head. (They disagreed with the war guilt clause in the Treaty and the enormous reparations that flowed from that clause.) 

Now, I am not blindly defending Germany here because I am aware that Germany just a year earlier imposed on Russia under Brest-Litovsk peace agreement far worse terms than those about which  she complained in Versailles.  And it is also true that Germany made France pay an unreasonable amount after the 1870 Franco-Prussian war. It was nevertheless short-sighted and unjust from the Allies to have applied the same unscrupulous approach to Germany in 1918-19 that Germany applied to them and to the Russians before.  This should have stopped. And we know, it also backfired.

2) When the Western allies forgave all of German previous debts at the conference in London in the 1950s,  it was not only because they did it out of the goodness of their hearts but because they needed a  strong West Germany as a bulwark against Communism in Europe and more specifically against Soviet influence in all of Germany. Thus, they did it as much for themselves as for Germany.

And finally the biggest mistake of all:

3)  While Friedman first makes the case that borrowing  should not be a subject of moralizing he then turns around and starts moralizing Germany about the need to repay for the largesse that she has received from the Western allies by being “nice” to the Southern European countries in trouble now. Well, either one or the other. If economics (or debt) is not a morality play then it is not a morality play period; for anyone. If it is, on the contrary, all about interests, short-term or long-term, the argument needs to be made why it may in German long-term interest to restructure Greek debt, forgive a part of it, or agree to the issuance of Eurobonds, jointly guaranteed by all Euro countries (but of course principally, by Germany). Be consistent if you want to convince.

Why individualism does not necessarily imply preference for a minimalist state?

It is often thought that individualism as a philosophical position must go together with dislike of state involvement in economic life. Radical individualists must like a small state, or no state at all. I think it is an utterly wrong point of view: being a radical individualist does not predispose one to be in favor of a small or big state, to favor state-provided social transfers or to be against them.

Where does this erroneous view come from? We have at least three possible sources.

The first is associated with Ayn Rand and her identification of “rugged individualism” (of “creators”) with people who are basically wronged by the state that transfers whatever they have produced to the “moochers” and  thus, of course, the creators must be against the state. Ayn Rand’s view is so extreme (never have people divided so neatly into two categories, and never has the state spoliated all the “creators”) and a caricature of any real society that her views need not detain us any longer.

More serious is Mises’ view (and that of many Austrian economists) who similarly associate individualism and preference for a small state.  (Mises does it explicitly in “Human Action”) Individualists not only want to be left alone by the state, but (and this is a crucial addition) they also do not care about the state transferring money to others, or the state taking on an insurance role (through a pension system, unemployment benefits, or social assistance to the poor). Thus, individualism would seem to be compatible only with the “night-watchman” state: a state whose function is limited to the protection of property and life. Even the judiciary system run by the state and state’s monopoly over fiat money are disliked by many Austrians: private courts and private monies can do the job, they believe, even better.

Hayek’s position, particularly in “Law, legislation and liberty” is much more nuanced, realistic and worth of a consideration. (It is also different from his simplistic “Road to Serfdom”.) He allows for a number of state functions, including a guaranteed minimum income. So, Hayek, to a large extent, modifies the earlier view that by being individualistic one must necessarily (a) not only be against state interference into one’s affairs but also (b) indifferent to the fate of the others.

It is this crucial point (b) which is false. If one does not want anyone (and especially not the state) to meddle into her  affairs does not imply that she does not care at all about the fate of people who live near, who may be compatriots, or, even more broadly, who are just people like her wherever they are. But if  one does care, there are only two ways to help them. One is to rely on private charity, another to transfer that function to the state.

I will not discuss here which one is more efficient (I believe that, because of the economies of the scale, the latter is). But relying on private charity means, in reality, that a person wants to establish relations of hierarchy between herself and those whom she is helping. At the minimum, there is a paternalistic relation where help may be forthcoming or not, depending on whether the “givers” like the recipients, or approve of their actions. Such a relationship, whether of hierarchy or of paternalism, is profoundly demeaning for the recipients of aid. Thus, while on the one hand, a person is helping them, she is, on the other hand, reducing their human dignity. There is an unhealthy trade-off there: the more a person gives, the more he wants to exercise influence over their lives, and the more their dignity is impugned. Perhaps, on balance, giving may become counter-productive: one loses mores through trampling of one’s dignity than one gets through money.

The other option is to delegate this function to the state. Now, people who receive aid receive it not from another individual (who just happens to be luckier than them, or to have been born into a rich family) and to whom, personally, they ought to be grateful, but they receive it as full-fledged citizens of a country that guarantees that they do have the _right_ to such assistance. The situation of the poor totally changes: they are not at the mercy of an individual’s whim. They are receiving something which is their right, no less than a person who receives wages is getting something which is his/her right. Poor person’s human dignity is preserved.

But to see decisively which situation is preferable,  change your perspective, and assume that you are a recipient of aid: would you prefer to get it from an individual whom you must constantly please in order that she continues with the aid, or from the state, as a free citizen? I think the answer is obvious.

So, in conclusion,  if a radical individualist is (1) not indifferent to the fate of people with whom she lives, and (2) does care about their human dignity, there is absolutely no reason why she might not prefer to have the state play a strong income redistribution role. The equation individualism=small state is a wrong one, in a general case. There is no necessary association between the two.

On Mark Thoma: marginalism, Marx etc

Mark Thoma has written a very nice blog on how Piketty’s work is transforming economics by bringing it closer to its political economy roots. I found the post excellent, and wanted just to point out one thing which, I think, is very well argued by Thoma and another where he somewhat simplifies the matters.

What I liked?

Thoma’s point that distribution (both regarding the flows of income and distribution of asset endowments) was excluded from the economic analysis, and thus income distributions studies relegated to the netherworld of economics is absolutely correct. Until some 10 years ago one had hard time even finding in JEL classification the right slot for the papers on personal income distribution.  Thoma, very rightly, singles out two methodological developments which explain this disregard of income and wealth distributions: (1) theory of marginal productivity which took its “final” form with Marshall and Walras more than 100 years ago, and (2) the distinction between normative and positive economics, which he says (I did not know that) goes back to Nassau Senior.

The former provides fully market-based explanation for all incomes of the factors of production (thus dispensing with the need to introduce political elements) and allows us to conclude that any distribution  of income that emerges must be optimal. If we however want to question the initial endowment of assets (“yes, it is fine that capital gets x, but let’s see who owns that capital”), the positive economics kicks in, and says that we do not need to worry about the initial distribution of wealth either, because it is given and outside our analysis. These were two powerful developments which totally excluded any concern with distribution issues. This is why practically nobody cared about income and wealth inequalities.

Where I disagree?

I think that Thoma too easily glosses over Marx (one sentence) by saying  that Marx believed  that since labor is the only source of value,  the entire net product (after depreciation) should belong to labor. This is not entirely exact, and if it were would imply that both Smith and Ricardo should have (since they held labor theory of value) believed the same. Marx made an important new step by distinguishing between value of labor and value of labor power. The latter is equal to the value  of goods necessary to return  worker to where, in terms of physical and social needs,  he was  before the beginning of the process of production. Basically, it is equal to the subsistence  wage (amount of food, housing, satisfaction of other needs where the relative needs also crept in) that is necessary, after a full working day and worker’s exertion, to restore him/her to the original position. But in addition, Marx argued, labor possesses a unique characteristic that the value created during the process of production (say, during 10h of work) exceeds the value of the labor power, that is value of the  commodities that are included in the subsistence wage (e.g., you need to work 4 hours to get enough to purchase these commodities). The difference (6 hours) is the surplus value received by the capitalist.

Thus, in Marx we have two steps:  (a) labor theory of value, and (b) value of labor power which together show (Marx was very proud of this) that exploitation is not mere stealing but takes place on the back of the action of the law of value. Capitalism allows everything to be bought and sold according to its value, including labor. Surplus value and exploitation are thus “imbedded” in the “value-driven” or “value-based” nature of the capitalist process. They are not a robbery; they are just an intrinsic feature of the system.

Joan Robinson thought that Marx’s distinction between value  of labor and value of labor power was just “metaphysics.”  It is quite likely so. But nevertheless, it was an important methodological innovation which distinguishes Marx from Smith and Ricardo.

One year later: a few reflections on Thomas Piketty’s “Capital in the 21st century”

A friend who recently started a new English-language magazine "Horizons" in Belgrade asked me if I would agree to publish in the magazine either a revised version of my Piketty's review from the June issue of  the "Journal of Economic Literature" (an almost identical version can be found here) or to write an entirely new review. I choose the latter option. Here is the text.

It has been more than a year since Thomas  Piketty’s “Capital in the 21^st  century” was published in French. The world  of economics and economic commentators has, thanks to this book, been transformed.  It was perhaps the greatest success of an economics books since Keynes’ “General Theory” some 80 years ago. Of course, a question can legitimately be asked: will it remain so in ten or twenty years? I will try to answer that question below. My re-review of the book, which is also a review of what we have learned  in a year since the book was published, will be organized around three topics: why was “Capital…” so popular, what are the potential issues or critiques one could make, and how should we think about “Capital’s” recommendations.

Why was the book so popular? As always, in such judgments,  one has to distinguish  “objective” from “subjective” factors. Only the first, in principle, ensure the long-run sustainability and influence  of a book. But to have a huge short-run success that “Capital” certainly had, one needs the confluence of the two. On the objective side, the book was written by a well-known economist who has already distinguished himself by 15 years of first-rate papers and books. Then, the book provides a relatively simple, yet powerful, model that “unifies” economics of growth, of functional income distribution (labor vs. capital), and personal income distribution (inequality among individuals). This was bound to appeal to those among the economists that love the great syntheses. And indeed, very few people before Piketty, in the recent history of economics,  were able or brave enough to put things together on such a grand scale. Economists have lost the habit of “system-related’ thought (that is, of looking at capitalism as a “system”). Driven by the general “parcelization” of the field, they have preferred to focus on rather small issues (does the minimum wage reduce the number of jobs, do tariffs harm output, how do subsidies distort incentives…).

Moreover, this broad systemic thinking offered by Piketty was based on a huge and detailed historical database. Thus, the model plus the underlying data made it very difficult  for Piketty’s detractors to have a go at him. They could possibly disagree with his model and its implications but they could not overturn his data. Or, they could nitpick about this or that data point, but they could not propose an alternative worldview. Finally, among the “objective” reasons, I would  like to mention that the book is very well written. It can be read basically as a history book. It does not shy away from taking strong positions or from criticizing famous economists. It was written with conviction and no fear. Readers can sense that.

On the “subjective” side, I think that one can list the timing. With the recession that had  by then lasted six years, unhappiness about the real wage stagnation in both the United States and Europe, run-away income inequality driven by huge income gains on the top, any book that would seriously claim to explain these phenomena was guaranteed a good reception. So much more, an excellent book, steeped in history and written by one of the top economists.  Yes, had “Capital…” been published in 2006, I have little doubt that it would be successful among the economists, but there would be no chance of it becoming a “New York Times” bestseller.  

Among the subjective factors, one can, strangely, list that the book was originally published in French. Normally, this would be a minus since the global market of idea is essentially monopolized by the English language publications. (This is why your read this review in English.) But here, Piketty was lucky. The fame of his book spread to the United States (despite its rather lukewarm first reception in France) very quickly. The fact that the book was not available in English for six months, made the waiting and anticipation excruciating and all the more keen: the final, ultimate answer to all our problems  has been discovered, and it is only the language barrier that prevents us from finding it right now!  I half expected (and I think in some cases this indeed happened) that student  study circles would form to simultaneously learn French and read Piketty. It reminded me of the story of Russian students in Europe who got together in 1867 to learn German in order to read Marx’s “Capital”.  This anticipation made the publication of the book in English, marvelously  translated by Arthur Goldhammer (a premier American translator of French non-fiction) a real explosion in the worlds of science, punditry and popular culture.

 Leaving it for the end, I cannot just ignore the fact that several people thought that Piketty’s good looks, straight-talking, French accent and general American “engouement” with French thinkers were helpful too in wooing the American public.  And once you had the American public on your side, the world was yours.

So, this is why the book became a hit.

Will it have a lasting influence and what are its possible shortcomings? But being a yearly hit is not sufficient for a book to have a long-lasting influence. Piketty “Capital…”, I will argue, will be with us for a very long time. (On some optimistic days, I even think this Piketty might have made a mistake by putting “21^st century” so clearly in his title. The book’s importance might outlast this century, and people in the 22^nd century might be reluctant to read something whose validity appears  time-bound.  Perhaps “Capital now and in the future”, or  “The rise of patrimonial capitalism” might have been more durable titles.)

The influence of the book will remain for all the “objective” reasons that have made it a hit and because the basic  conflict between income that is earned from ownership (and which does not require working) and income that is earned through labor, will remain for the foreseeable future. In effect, capitalist societies are structured in such a way that this is a central conflict, however hard apologists try to mask it. Moreover, this conflict, in an ironic twist, will be, as Piketty shows, the sharper the richer the society. For being a rich society essentially means having more capital. Thus, richer societies’ capital/income ratios (by now the famous Piketty’s beta) are  greater which means that relatively more income is generated from ownership (compared to labor) than in poorer societies. Since ownership of capital has always been, and is likely to remain, very concentrated, the issue of having a significant percentage of the population both rich and not working either for the entirety of their income (rentiers) or for a large chunk of it (“working capitalists”)  will remain a problem of first importance, politically and ethically. This is why the messages from this book will not go away.

But does the book have problems, which, one year after the publication, literally hundreds of reviews have uncovered? Indeed, it does, and I would like to point to a couple.  A technical one is Piketty’s use of capital and wealth as if it were the same thing. In French, it is “patrimoine”, “richesse” and “capital” and, as Piketty writes, they are all used interchangeably. Now, it is perfectly logical to focus on wealth and to consider as wealth everything that is bringing an explicit or implicit income over a period of time, from stocks and shares to own housing and patent rights. This is what Piketty does when he defines the share of wealth-related income in current total income (his alpha). The problem arises  when that wealth is, as it were, introduced in the neo-classical production function  (and Piketty needs this in order to combine his theory of income distribution with the theory of growth) where it really takes the place of the productive capital (the K from economics). In other words, W has been conflated with (or treated as the same as) K. The results obtained regarding the rate of growth of output or the role of technological progress are derived from the world where K stands for the productive capital, but applied to the world where “non-earned” income is obtained from wealth (W), a concept much broader than K.  Thus, for example,  the crucial condition that ensures that the rate of return on capital r does not decline a lot as the K/Y ratio rises (so that r  can be treated as more or less fixed), namely, that the elasticity of substitution between capital and labor is greater than 1, is derived from the K world. But it  is applied to the W world.  This problem could become similar to the Marxian “transformation problem”: not in substance, but in questioning the logical foundations of the analysis.  It is already debated and it will be, I am sure, debated even more.

The second main issue is the  exclusive focus on the rich world. In the era of globalization we need books that deal with the world as a whole.  Indeed, it could be argued that we focus on the rich world because its developments are the developments through which the poor (or emerging) economics will have to go though as they develop. This is a linear conception of economic history which however may not be true.  In addition,  the income gaps between countries like China and the rich world are rapidly closing. Does Piketty’s book have much to say about China? It seems not, and it is a major omission. Consider simply the following fact, couched entirely within the Pikettian framework.  If globalization means free movement of capital, then we can expect a worldwide equalization of r.  In the rich world where economic growth (g) will be low, r>g relationship will, as per Piketty, imply growing income inequality. But, in China, a much higher growth rate will overturn this relation, and r<g should lead to decreasing inequality.  Thus, the world of the future may be characterized by one part (rich countries) where inequality increases and another part (emerging economies) where it decreases, with its growth, like in the post-War Western Europe, driven by the convergence economics. Moreover, in the emerging or poor world, Piketty’s famous policy recommendation of capital taxation may not make much sense. We move to that next.

              What to make of the global tax on capital?  This proposal has manifestly attracted most attention, even from those who have never read a single page of the book. Piketty calls for a global tax on capital of 1% on wealth in excess of 1 million euro, and 2% on private wealth in excess of 5 million euro.  The proposal is fully consistent with his main message. If run-away growth of capital and its high concentration in a relatively few hands are the main causes of inequality, then taxing capital and reducing  r is a way to deal with inequality. But that recommendation hardly applies to China, India and other emerging economies.  First, the growth rate of the economy there may be, as we just saw, higher than r,  and second, the capital/output ratios are low, and if indeed r<g, they will be decreasing further.  The K/Y ratios, calculated from the Global Wealth Report 2013, are about 5 for the rich countries like the United States and Switzerland, but only 2.7 for China, 2 for India, and even less, 1.5 for South Africa and Brazil.  Thus, the “inequality threat” from capital is much less in these countries: inequality may increase there but if it does, it would be driven by other factors than private ownership of capital. Piketty’s recommendations hardly seem relevant for the emerging world. But it gets worse.  For Piketty’s tax to make sense, one needs international coordination, and if that international coordination is not be forthcoming from China, India, South Africa and Brazil, a global tax on capital is doomed.  Even if OECD agrees to impose it, capital might flee to the emerging world.  And that very fact will be sufficient for the rich world not to impose the tax.

But will such a tax be as onerous as some people argue? In reality not: it will not affect that many people but it will indeed cover a lot of capital. According to the Global Wealth Report for 2013, there are 32 million adults in the world with net assets of over $1 million and they collectively own almost $100 trillion of wealth.  We can assume (back-of- the-envelope) that the average tax rate will be about 1.6-1.7%  (to simplify the matters, I take it that $1=€1) since  the distribution of wealth among the very rich is extremely skewed: there are many fewer people than 32 million with net assets above $5 million, but many of them are extraordinarily rich and would be assessed at the higher rate of 2%.  Total receipts from the tax may be thus estimated at $1.5 trillion which is about 2% of global GDP.  Or otherwise, even if the number of people who are subject to the tax is small (less than 1% of world adult population),  its yield would be huge. This is not surprising  because it simply reflects today’s immense differences in wealth between the top of the pyramid and practically everybody else. Just as a reminder,  even in the richest countries of the world, like the United States (Wolff, 2010, p. 43) or Germany (Grabka and Westermeier,  2014, Table 2, p. 9) respectively 20 and 30 percent of the households have zero or negative net wealth. But the fact that relatively few people would be subject to the tax seems to suggest, at first sight, that the tax may be politically feasible.  This however is not the full story. The reason why the tax is unlikely to be imposed is because it would not be appealing at all to the emerging market economies and because those who would be subject to taxation are politically sufficiently powerful to block  it. So, the tax would fail on other political grounds.

What to conclude? One year is a sufficiently long period to have some idea about the reception, and perhaps even about  the longer term impact of a book. For Piketty’s book like many others, we have to distinguish between its analytics, its recommendations, and its forecasts. One can agree with analytics without agreeing with the recommendations, or the reverse.  In my opinion, the analytics proposed in the book, by themselves, because they fit quite well the likely evolution of the rich world in the decades to come, will be influential for many years. Teaching economics without a mention of “Capital…” will be difficult to imagine. It will affect not only how we think of income distribution and capitalism of the future but also how we think about economic history, from Ancient Rome to the pre-revolutionary France. (We can already see some of these developments).  It will drive our economic thinking in the directions that were not even envisaged in the book. For example, if concentration of capital is the main culprit for increasing inequality, then much more widely-spread ownership of capital (in the form of worker ownership) may be a solution.  

But when it comes to the recommendations and policies, I do not think that the book will have an impact equal to that of Keynes’s “General Theory.”  The two books were written with different objectives  in mind.  Keynes’ was in reality the last great “cameralist”  treatise destined to convince policy-makers what to do (as well as the first book in macroeconomics); Piketty’s “Capital…”  is much more in the tradition of classical political economy:  description and analysis of the capitalist system. And as long as that system is with us, I do not think that Piketty book would  be forgotten.

REFERENCES

Credit Suisse (2013), Global Wealth Report 2012, authored by Jim Davies, Anthony Shorrocks and Rodrigo Lluberasis, October. 

Markus M. Grabka and Christian Westermeier (2014), “Persistently High Wealth Inequality in Germany”,  DIW Economic Bulletin 6/2014. Available at http://www.diw.de/sixcms/detail.php?id=diw_01.c.466987.en (accessed 16 November 2014).

Thomas Piketty (2014), Capital in the Twenty-First Century (translated by Arthur Goldhammer), Harvard University Press.

Ed Wolff (2010), “Recent trends in household wealth in the United States: rising debt and middle-class squeeze: an update to 2007”, Levy Economics Institute Working paper No. 589.