Piketty’s Importance and Basic Theory
Thomas Piketty’s book ‘Capital in the 21st Century’ has spurred vigorous public discussion in developed countries about the growth in inequality and what to do about it.
Others have previously raised the issue of inequality. But Piketty has been hard to ignore because his book relies upon painstaking analysis of taxation and other data to make out his case regarding the growth of inequality.
As the US Marxist economist Richard Wolff has put it, in terms of documenting the growth of inequality, Piketty’s work “is the best we have”. It is the most careful and systematic work available on the issue.
But according to Wolff, the popularity of the book says more about the societies which Piketty analyses than it does about the book itself. The book has “struck a nerve”- the controversy relating to growing inequality.
Piketty’s basic theory is well known by now- capitalism has an innate underlying tendency to produce greater and greater inequality. The period between 1945 and 1973 when incomes converged, was taken by some economists as indicating capitalism’s underlying tendency to increase equality and social mobility. But this is not its underlying tendency.
Piketty asserts that this period was an exception to the general tendency to produce ever increasing inequality. Piketty’s explanation for capitalism’s tendency to increase inequality is disarmingly simple: the rate of return on capital is generally higher than the rate of economic growth. Returns on assets, like real estate and shares, disproportionately held by the wealthy, rise faster than overall economic growth, thereby increasing the overall proportion of the total wealth that is held by the rich.
As Piketty puts it:
“An apparently small gap between the return on capital and the rate of growth can in the long run have powerful and destabilizing effects on the structure and dynamics of social inequality.”
Piketty says that returns on capital have been steady over a very long period of time. Returns average out at 4-5%. The more that the rate of return on capital exceeds the rate of economic growth, the greater is the tendency for inequality to increase.
Since the 1980’s many social democrats have joined traditional supporters of capitalism by suggesting that it sufficient to foster economic growth which is “a rising tide that lifts all boats”. At times it is even suggested that the role of government should be limited to intervention to correct market failure. For example, the ALP national platform states:
“We believe a properly functioning market economy creates wealth and provides opportunity and we look for market-based solutions, with robust and balanced regulation. Market design should promote sustainable growth that delivers for working people, combining free and open exchange with strong and durable institutions. Through a dynamic market-based economy we are committed to giving all Australians opportunities and making sure no-one is left behind. Unrestrained greed is damaging to the public interest.”
Other parts of the platform say that the ALP is a “party of equality” and imply a greater role for government in ensuring equal outcomes, not just equality of opportunity. But the suggestion in the passage above seems clear enough- provided that markets function “properly”, they will naturally create wealth and opportunity. People will not be “left behind”. Seemingly it is only market failure or “unrestrained greed” that threatens these outcomes, requiring intervention or “market design” by government.
But for Piketty the tendency for capitalism to increase inequality and to concentrate wealth is not a market failure. On the contrary Piketty asserts that the more perfect the capital market, the more the rate of return on capital will exceed the overall growth rate, thereby exacerbating inequality.
Neither is growing inequality a result of “unrestrained greed” by rogue individuals or corporations that can be checked through “balanced regulation”. Rather, inequality and concentration of wealth, is an underlying tendency of the capitalist economic system. It will come to the fore in the absence of interventionist counteractive policies from government, such as those that characterised the ‘New Deal’.
If GDP represents the total economic activity by which the total “pie” of wealth increases each year and the rate of return to capital exceeds the growth rate, then simple maths means that over time the total share of wealth owned by capital must increase. For various reasons, including decline in the rate of population growth, Piketty estimates that economic growth will be only 1-1.5% for most of the 21st Century. But he expects that the rate of return on capital will still be 4-5% in the long run. Therefore his prediction is that the growth in inequality, already evident since the 1980’s, will most likely continue to deepen.
Conservative Agreement with Piketty’s Basic Theory
Not all conservatives disagree with Piketty’s basic analysis that inequality results from the rate of return on capital exceeding the growth rate.
Writing about Piketty in the conservative US monthly magazine, ‘The American Spectator’, James Piereson agrees that it makes intuitive sense that returns to capital grow more rapidly than the economy as whole. He gives the example of returns from the stock market typically exceeding the rate of economic growth. Piereson agrees that over decades, or generations, wealth tends to accrue to those who already have it. He says that there is little mystery to the “U” curves Piketty uses to demonstrate that wealth shares of the very richest were higher prior to 1917, then dipped and have been returning to higher levels since the 1980’s. Two wars and the Great Depression wiped out capital assets, and progressive taxes made capital accumulation more difficult. But then beginning in the 1980’s tax rates were reduced on incomes and capital gains, leading the old patterns to reappear, especially in the USA and the UK.
But Piereson disputes what he describes as Piketty’s view that higher returns to capital than to labour is the “driving force” of the capitalist system. He says the driving force is the “relentless innovation that improves productivity and raises living standards”. This has resulted in workers having “less burdensome forms of work” and consumers gaining “access to ever more inexpensive products that make life easier.”
Distinctions between Piketty and Marx
Although the title of Piketty’s book is an obvious reference to the famous work of the same name written by Karl Marx, Piketty’s politics are far closer to Keynes than Marx. And, like Keynes, Piketty’s objective appears to be to save capitalism from itself. Although he shares Marx’s concern with inequality, Piketty’s view about the most important tendencies within capitalism are different to those of Marx.
Marx was an exponent of the law of the tendency for the rate of profit to fall over time. Marx described the tendency of the rate of profit to fall as the most important law of political economy. Marx was not alone in his view that the rate of profit tends to fall. It was a view held by other economists in the 19th century. But Marx was the first to say that the tendency for the rate of the profit to fall would inevitably lead to the overthrow of capitalists by the working class.
Marx believed that once the rate of profit fell too much, capitalists would either stop investing, or would try to restore their rate of profit by reducing their workers wages. If the capitalists stopped investing, then economic stagnation and unemployment would result. If the capitalists tried to reduce their workers wages, this would result in conflict with those workers. Either way, economic and political tension would grow. As the rate of profit continued to fall, it was inevitable that tensions would escalate and would ultimately result in revolutions through which the working class would remove the capitalists.
Nowadays the theory of the tendency for rate of profit to decline is not accepted by most economists. Others argue that the rate of profit does continue to decline but that the effects are far slower and uneven than Marx had predicted. For example, the tendency is delayed by the mobility of capital in a globalized economy, including the capacity of large corporations to shift production to countries with lower labour costs, also a major reason for consumers gaining access to cheaper products, as referred to by Piereson. There are few objective studies; though Manolakos did conduct an econometric study of the US economy between 1948-2007 and found there was evidence of a long run downward trend in the general profit rate in the US economy over the period.
Piketty criticizes Marx’s theory on the law of the tendency of the rate of profit to fall. Piketty’s main argument here is the capacity of technological progress and increases in productivity to act as a counterweight to the tendency. So it seems that Piereson errs if he is suggesting that Piketty ignores capitalism’s capacity to innovate and increase productivity. He draws on this very capacity to criticise the theory of the decline in the rate of profit. Piketty is asserting that the data shows that technological progress and productivity improvements have not been enough in themselves to prevent increases in inequality and that, absent other policy interventions, do not prevent capital increasing its share of overall wealth.
Thus according to Branko Milanovic:
“Marx’s revolutionary end point—where everything devolves into crisis and revolution—is when the rate of profit approaches zero. Piketty’s is when capital grows so large as a percentage of annual income that it absorbs all of national income.”
Will the return on capital remain at 4-5%?
Piketty documents the average return to capital of 4-5% and the way this average return has outstripped economic growth. But he does not really detail the precise mechanism by which capital is able to extract this average rate of return despite the rate of economic growth. He does however suggest that ultimately the determinants of wealth distribution are political:
“The history of the distribution of wealth has always been deeply political, and it cannot be reduced to purely economic mechanisms…The reduction of inequality that took place in most developed countries between 1910 and 1950 was above all a consequence of war and of policies adopted to cope with the shocks of war. Similarly, the resurgence of inequality after 1980 is due largely to the political shifts of the past several decades, especially in regard to taxation and finance.”
Piketty’s assumption that capitial will continue to be able to extract this rate of return in the future, despite languishing economic growth rates would therefore seem to contain some implicit assumptions about how our political future will evolve. His assumption that the return to capital in the future will remain more or less constant (based on the past trends he documents) is not shared by all economists, even some of those who admire his work.
For example, veteran economist Robert Solow, winner of the 1987 Nobel Prize for economics and economics adviser in the Kennedy Administration, agrees with Piketty’s analysis that the rate of return on capital appears to be trendless over the period of his study, averaging 4-5%. Nevertheless he thinks that sluggish economic growth, together with continued levels of economic inequality, will likely operate to increase the saving rate by the wealthy and diminish their investment in the real economy, leading to a risk of stagnation and rising unemployment over the next 50 years.
Piketty’s solution to inequality
James Galbraith says that in 1999 he and colleague Thomas Ferguson produced a report based upon payroll tax records to track the growth of inequality in the USA since the 1920’s. The result was to document trends similar to those now documented by Piketty. Galbraith asserts that there is nothing “natural” about increases in inequality:
“The evolution of inequality is not a natural process. The massive equalization in the United States between 1941 and 1945 was due to mobilization conducted under strict price controls alongside confiscatory top tax rates. The purpose was to double output without creating wartime millionaires. Conversely, the purpose of supply-side economics after 1980 was (mainly) to enrich the rich. In both cases, policy largely achieved the effect intended.”
Galbraith goes on to criticise Piketty’s proposed “solutions” to the inequality problem:
“As for remedy, Piketty’s dramatic call is for a “progressive global tax on capital”—by which he means a wealth tax…As Piketty admits, this proposal is “utopian.” To begin with, in a world where only a few countries accurately measure high incomes, it would require an entirely new tax base, a worldwide Domesday Book recording an annual measure of everyone’s personal net worth…
For the United States, (Piketty) urges a return to top national rates of 80 percent on annual incomes over $500,000 or $1,000,000…But would it work to go back to that system now? Alas, it would not. By the 1960s and ’70s, those top marginal tax rates were loophole-ridden…It would be too easy to evade the rates, with tricks unavailable to the unglobalized plutocrats of two generations back. Anyone familiar with international tax avoidance schemes like the “Double Irish Dutch Sandwich” will know the drill.
If the heart of the problem is a rate of return on private assets that is too high, the better solution is to lower that rate of return. How? Raise minimum wages! That lowers the return on capital that relies on low-wage labor. Support unions! Tax corporate profits and personal capital gains, including dividends! Lower the interest rate actually required of businesses! Do this by creating new public and cooperative lenders to replace today’s zombie mega-banks. And if one is concerned about the monopoly rights granted by law and trade agreements to Big Pharma, Big Media, lawyers, doctors, and so forth, there is always the possibility (as Dean Baker reminds us) of introducing more competition.
Finally, there is the estate and gift tax—a jewel of the Progressive era. This Piketty rightly favors, but for the wrong reason. The main point of the estate tax is not to raise revenue, nor even to slow the creation of outsized fortunes per se; the tax does not interfere with creativity or creative destruction. The key point is to block the formation of dynasties.”
Australian economist John Quiggin is less pessimistic than Galbraith about the possiblities for a clamp down on global tax evasion:
“The latest news from the OECD is remarkably positive. All members of the OECD (even evader-friendly jurisdictions like Austria, Luxembourg and Switzerland) have agreed to a system of automatic information exchange for tax purposes…it may be that the share of income accruing to the 1 per cent has grown so large that governments have no alternative but to tax it.”
In any event, just as Galbraith suggests that Piketty’s solution of increasing tax rates is not viable because of globalised plutocrats, it is also arguable that supporting unions (at least those operating in trade exposed industries), taxing capital gains and dividends, and introducing more competition are policies that have also become more difficult for similar reasons.
The New Deal was ushered in by Franklin Roosevelt with the support of a far stronger trade union movement and social movement than exists in the USA today. It was a movement that made it abundantly clear to Roosevelt that it was no longer willing to tolerate pre-New Deal levels of inequality. It was also a movement that existed within a context where domestic protection and insulation from external competition was far higher than in today’s globalised economy.
Writing in the Guardian, David Graeber suggests that it was not just the wars and great depression that contributed to greater equality within capitalism. This “golden age” also broadly coincided with the period when capitalism faced a global rival in the Soviet bloc, revolutionary anti-capitalist movements from Uruguay to China, and stronger social movements at home. This led to capitalists feeling the need to “buy off” at least some portion of the working classes, placing more money in ordinary people’s hands, increasing consumer demand and leading remarkable rates of economic growth.
Supporters of capitalism typically promote levels of competition that the system seems increasingly incapable of delivering because of the economies of scale and market share that are often required for effective global competition.
Moreover it is surely one of the great ironies of capitalism, that the benefits of competition are expounded in every realm, with the exception of benefits that might be derived from competition from different political-economic systems.
It is surely not beyond the realm of possibility that, no matter what the failures of the Soviet system were for its own people, the perception that there might be viable alternatives to capitalism ended up benefitting capitalist societies in the way that Graeber describes.
This is not to suggest that the Left should promote political-economic systems like the old Soviet model. But surely there must be more beneficial ways in which production can be successfully organised than concentrating ownership, and outrageous levels of executive remuneration, in a small class of politically powerful super-rich. For example, policies might be adopted that promote workers owning their own enterprises. I do not mean tokenistic employee share ownership schemes that retain existing power structures. But models that invert the traditional employee-employer power relationship so that employees employ management instead of vice versa. This is the model adopted by the highly successful Spanish multi-national co-operative enterprise Mondragon.
One of the first effects of the Mondragon model is to compress, though not eliminate, income inequality. The compression is to a ratio of 1 to 6 or 8 instead of a ratio of 1 to over 300 which typifies income differentials in large capitalist firms. Moreover the return to capital as a cause of inequality is immediately diminished because the return on investment is shared amongst the workers who own the co-operative, rather than a more concentrated class of external shareholders.
The Mondragon model does not remove incentives, competition or innovation. In fact it appears to enhance them. It follows that even if the co-operative model became the pre-eminent system of organising production in a society, it would not entirely remove the need for central government to adopt redistributive taxes, social services and transfer payments. But it should reduce the need for these interventions because less inequality would be produced to start with.
This is important because taxation and social transfer policies tend to be divisive. They result in endless controversies over the extent to which taxation affects incentives or competitiveness, as well as the extent to which transfer payments or services should be targeted or universal.
There are exceptions, but in general, the more targeted a transfer payment or service the more redistributive it is but the more difficult it is to sustain politically. Thus expenditure on public housing, is highly redistributive, but has declined due to the small proportion of citizens likely to directly benefit from it. By way of contrast Medicare is more universal, and therefore more politically sustainable.
- Housing is productive to the extent that home owners do not have to pay rent and the owner of an investment property will earn rent exactly as does the owner of some piece of “productive” capital equipment;
- Capital functions as a store of value, and not simply as an input to production;
- If housing were not counted as part of capital in Piketty’s analysis then the wealth distribution patterns he explores would be even more skewed.