Saturday, August 23, 2014

Mr. Piketty and the classics

For a seminar in Oslo on September 4, I was asked (although I did not expect it) to speak of the significance for economics, and especially economics of inequality, of  Piketty’s recent work.  So I decided in this brief note to put some thoughts together.

The major contribution of Piketty is, in my opinion,  a (I did not say “the”) general theory of laws of motion of capitalism which  combines theories  of growth, factoral income distribution and personal income distribution.  (For those who have read my review in JEL, this is not a new opinion. I thought so already in October 2013 when I read Piketty’s book and wrote the review. ) Theories of growth and factoral income distribution were always related, but the explicit connection from factoral to personal income distribution, substantiated with a  huge amount of empirical evidence, gives to Piketty’s work a new, and unique, value.  

 As in many ground-breaking pieces of work, it is not that each individual part is novel and something that nobody before ever thought up. Clearly, neoclassical growth theory goes  fifty or more years back. Even the discussion of personal income distribution  in the book comes from Piketty’s own previous work, as well as that of his colleagues Tony Atkinson,  Emmanuel Saez and Facundo Alvaredo. To somebody familiar with  15 years  of that literature, there is again, not much new in Capital in the 21st century. But it is the combination of the three elements  I mentioned before that gives the book its unique color  and importance. Thus the whole is greater than the sum of the parts. 

Let me now address the key parts of Capital which have received so much attention: Piketty view about the inexorable tendency towards income divergence in capitalist economies left to themselves, and his proposed remedy. There I think we need to distinguish five propositions.

1. Wealth. As  economies become richer, the capital-output (K/Y) ratio increases. The increase in K/Y  is nothing else but the definition of a rich economy: over the years (decades) people save, productivity increases, and economies become more capital-intensive.  In an economy where wealth is privately-owned,  individual wealth increases and people become richer.

 2. Distribution. In capitalist economies, historically and without a single exception, wealth and income from wealth are  distributed more unequally than labor income. The share of total wealth held by the top 1% of wealth-holders is greater than the share of total earnings  made by the top 1% of  wage-earners. Or differently, the Gini of capital income is greater  than the Gini of labor income. Or even more importantly, the concentration coefficient is greater for income from capital than income from labor. (The concentration coefficient is important because in its calculation, people are ranked by their total income and a high concentration coefficient does not mean only that wealth-holding is concentrated but also that it is concentrated in a particular fashion such that owners of wealth are generally rich in terms of total income too. To see the difference, notice that unemployment benefits are also heavily concentrated but their recipients are poor and the  concentration coefficient of unemployment benefits will be low or negative.)

3. Inter-personal inequality. Point 2 implies that any increase in the share of capital income will be associated with an increase in inter-personal inequality. 

4. r>g. If then income from capital increases faster than total income (or, by implication than income from labor) functional income distribution will shift toward capital, and personal  income distribution will become more unequal.  As rich economies have high K/Y ratios and if r is grater than g, income from capital will gradually tend to dominate income from labor. At the extreme, say K/Y=100 (vs. the current K/Y=6 or 7), even an r=0.5% will give ½  of national income to capital-owners. 

5. Taxation. To arrest this natural tendency of capitalism, a solution is progressive taxation of capital which will reduce r below g. It might affect the speed with which capital accumulates (although Piketty thinks that it will not), and slow down the increase in K/Y.

I think it is important to distinguish each of these five statements. No. 1 is empirically true (it is moreover the very definition of wealth). 

No. 2 is empirically true, although the rising concentration of labor incomes which we witness especially in the United States, may, in the future, reduce the universal validity of capital being more heavily concentrated than labor. But we are still far from it, with Ginis from capital income at 0.8, and Ginis of labor income at 0.4. However, a recent and important (yet unpublished) work by Christoph Lakner shows that in the US, the probability of a person having a high labor income also having a high capital income is greater than the reverse probability, of a person with high capital income having also a high labor income.  So we may be moving toward the emergence of a peculiar capitalism with high concentrations of both labor and  capital incomes.  

No 3 is also empirically true, with a caveat that I just mentioned and which might apply in the future. Notice however that a very high concentration of both labor and capital incomes and their high association will make overall inequality extremely high, perhaps even higher than it is today, but the source of that inequality will be different, that is will derive from high concentration of labor and capital incomes and not predominantly from the latter only.

So, the first three propositions are empirically incontrovertible: all the evidence that we have so far supports them. We cannot be sure that 2 and 3 will continue to behave in the future as they did in the past, but the likelihood of happening  so is very high.  

We now come to No. 4 which is a statement about the future and which has exercised Piketty’s critics a lot. But note that all his previous three statements are true, and while the future might hold a g>r rather than r>g, Piketty’s methodological contribution to our way of thinking about  wealthy capitalist economies is not diminished by whichever way r and g behave. The model holds whether r>g or g>r.
Thus, it is consistent to think both that Piketty’s contribution is enormous and that in  the future, the growth rate of the economy may be greater than the rate of return to capital. For example, with globalization r will tend to be kept  high for the reasons mentioned by Piketty and to be the same worldwide (so r=r* given to all), but the growth rates of the emerging economies like China and India may remain even higher. Thus, in China and India, we may have g>r* and the downward movement in inequality, while in the developed world, we may have r*>g, and increases in inequality as envisaged by Piketty. 

Finally, we come to proposition 5 which has also attracted huge interest. There one can too disagree with Piketty’s proposal, not the least because one may find it unrealistic. But there is no denying that the proposal derives  directly from the propositions  1-4, so we are dealing with a logically consistent set of analysis and prescription. 

There are, in conclusion, I think three different ways in which some of Piketty’s “predictions” may be falsified without, and I emphasize again, in any way affecting his key methodological contribution. The three different ways are: labor incomes may become more concentrated, the growth rate may exceed the rate of return to capital in many countries, global taxation of capital may not happen.

At the end, I would like to compare Piketty’s approach to Ricardo’s. Both authors have proposed a formidable model of development of capitalism which was based on the observable tendencies  of their times, and the projection of these tendencies in the future—unless they be checked by a change in economic policies.  In Ricardo’s case, that was free trade in grain; in Piketty’s case, taxation of capital. Ricardo’s model of ever increasing share of rent in national income was of course falsified, but, it could be argued, it was falsified exactly because his policy prescription was adopted in England. In the same way, Piketty’s model may also be falsified if his policy prescription is adopted. 

In the table below, I give in a very summary fashion some of the key things that, in my opinion, remain from the great economists of the past—even when many of their predictions did not materialize, whether because their policy prescriptions, as in the cases of Ricardo and Keynes, were adopted or, because, as in the cases of Marx, Pareto and Schumpeter, they were simply wrong. But even when the latter happened, the predictions that failed referred only to a part of their work, and the greatest body of their work is something without which today’s economics would be unimaginable and indeed much poorer. So, my point is, even if some of Piketty’s predictions  fail, be it because his idea of global taxation of capital indeed reverses inequality tendencies, or because inequality goes down for other reasons, his main contributions will be integrated in the corpus of economic knowledge in the same way as the insights of these great economists listed here were. And our understanding of economies will never be the same as it was before Capital in the 21st century was published.  

Things that remain
Wrong predictions
Dynamic model of a capitalist economy
Subsistence wages
Increasing share of income from land
Help capitalism through free trade
Two-sector model
Historical materialism

Subsistence wages
Tendency of the profit rate to fall
End of capitalism
Nationalization of the means of production as a way to transcend capitalism
General equilibrium

Nationalize land and use rent income in lieu of taxes
Pareto-type of concentration among top incomes
Income distribution is ruled by an “iron law”: inequality can never change (circulation of the elites)
[Do nothing]
Focus on macro
Real sector and financial sector equilibrium considered jointly

Euthanasia of the capitalist
Help capitalism by stabilizing it through a greater state role
Decentralized nature of economic information
Every state intervention is a step on the road to serfdom
Limited state action
Financially-driven movement from a stationary state to a developing state
Capitalism will be rejected by the intelligentsia

Inequality changes with economic development
Inequality in rich countries will go down

Personal income distribution unified with functional

Help capitalism by taxing capital

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