Book review: Capital in the 21st Century by Thomas Piketty

Why is inequality rising—and will it now fall?
March 27, 2014
Over 1,000 people lie down on a San Francisco beach to spell out “TAX THE 1%” ©2011 John Montgomery
The early 19th-century founders of the classical school of economics reasoned that the distribution of a society’s income depended crucially on who owned its productive resources. David Ricardo identified three classes of producer, landlords, capitalists and workers. Each of these classes owned a factor of production—land, capital and labour. With land and capital scarce relative to labour, landlords and capitalists could claim a disproportionate share of the produce that they and the workers jointly produced. Workers’ pay would be forced to subsistence. Classical socialism, as Karl Marx conceived it, was a branch of this tree. Abolish private ownership of land and capital (and the power which this gave) and one would abolish the “rents” to their owners, enabling workers to receive their proper share of production. But towards the end of the 19th century, discussion of the class inequality of rewards faded away. The marginalist revolution— direct precursor of the mathematical economics of today—dropped the attempt at social realism, by positing a perfectly competitive market economy with numerous “agents,” each of whom would receive the value of his “marginal product”— the exact amount he added to economic value. The existence of power in the market was recognised only in the form of “monopoly”—a single firm in an industry being able to set the price of its product, a problem to be tackled by regulation or trust-busting laws. This new, marginal analysis was intended to bypass the unsettling distributional issues raised by the classical economists. The claim that the market paid every producer what he was worth undercut the socialist argument for redistribution. In his massive book, Capital in the 21st Century, Thomas Piketty, a professor at the Paris School of Economics, revives the economics of David Ricardo and Karl Marx. His thesis is simple. The growing concentration of capital in fewer hands has enabled its owners to keep it relatively scarce and thus valuable. Agricultural land has dropped out as a factor of production, but urban real estate has taken its place. Capitalist societies therefore have a natural tendency to generate a highly unequal distribution of wealth and income. This natural tendency to inequality was suppressed in the period between 1910 and 1960, as the two world wars and the Great Depression destroyed a mass of inherited capital, while trade union pressure, progressive taxation and welfare prevented its reconstitution. But from the late 1970s, with the decay of these countervailing forces, the natural inequality of the system has reasserted itself, so that today it is almost as great as it was before 1914. Piketty’s point here is that while the divergence of wealth and income under capitalism is natural, its “compression” is contingent on singular events plus policy reactions, which contrasts with the prediction of the American statistician Simon Kuznets, whose data—dating from 1955—showed inequality naturally diminishing over time. Though Piketty’s study focuses mainly on the USA, Britain, and France, the same U-shaped trajectory of inequality can be observed in most rich countries. Continuing high inequality is socially and economically destabilising, though it need not lead to Marx’s apocalypse. So what we need is another bout of social democracy especially in the form of progressive taxation. You may think that it doesn’t require 600 pages to get this message across. This would be wrong. The strength of Piketty’s book is his close attention to the different sources of inequality, the massive documentation underpinning his history and conclusions, and his impressive culls from sociology and literature, which exhibit the richness of “political economy” compared to its thin mathematical successor that has attained such prominence. But his main ideas do tend to be drowned by the data. Readability is sometimes sacrificed to authority. Unemployed men outside a soup kitchen in Chicago 1931 during the Great Depression ©2011 John MontgomeryThere are three components of inequality: capital ownership, the income to which it gives rise, and income from labour. Piketty defines capital as any non-human asset that can be borrowed or exchanged on some market, which is different from the textbook definition, where capital is just the tools used for production. So capital, or wealth, can include residential property and financial assets. Income from capital is not simply profit, but also rent, dividends and so forth. Income from labour is the usual: wages and bonuses. A big change from earlier times is that today, high income earners also tend to have a lot of capital. People earning high wages invest their money in property, stocks, and other assets, which yield a return. So high incomes from work are a means to capital accumulation. Before the First World War, this was not so true: people did not accumulate capital through work; they mainly inherited it. This was the rentier economy of the late Victorians so eloquently depicted by John Maynard Keynes, in which income came from rents and dividends. The job was then to preserve the family fortune by marrying well; real work was for the poor. Piketty points out that capital ownership has always been quite concentrated. A century ago, the richest 10 per cent in Europe owned about 90 per cent of the wealth. In the early 2010s, they owned about 60 per cent of wealth in Europe, and 70 per cent in the US. Despite the media hype surrounding the super-rich, this is considerably less than before, but it remains very significant. Inequality of capital ownership is even more striking at the level of centiles: today, the richest 1 per cent own about 25 per cent of wealth, which corresponds to €5m per person, as opposed to 50 per cent in 1900. It was the decrease in capital ownership for the richest 10 per cent, and especially for the top 1 per cent in the era of the two world wars, during which time much capital was destroyed, that enabled a middle class to emerge. Before the wars, the middle 40 per cent and bottom 50 per cent were indistinguishable in terms of capital ownership—each owned approximately 5 per cent of total wealth. But as a result of the wars the middle 40 per cent accrued more wealth, and the income to which it gave rise. Piketty describes the growth of a “patrimonial (or propertied) middle class” as “the principal structural transformation of the distribution of wealth in the developed countries [of the USA and Europe] in the 20th century.’’ Turning to income, we find 30 per cent of national income going to capital, with the remaining 70 per cent going to labour. Extreme income inequality can arise in two ways. It can come from a “hyperpatrimonial” society of rentiers. In this type of society inherited wealth, accumulated over several generations, attains extreme levels. Total income is then dominated by a small number of people getting very high incomes from capital. This was the pattern before the First World War. But excessive income inequality can also arise from a “hypermeritocratic society,” which is more characteristic of today, especially in the US. This society is characterised by extra large incomes earned by a small subset of labour, which is why it is also called a society of “superstars,” or more appropriately, a society of “supermanagers.” In the US, income inequality in 2000-10 regained the record levels observed between 1910 and 1920, with Britain trending the same way What has happened over the course of the industrial age is that we have moved from a “hyperpatrimonial” to a “hypermeritocratic” society, with a phase between when inequality was compressed. Between 1914 and 1945, the income share of the top 1 per cent fell from 20 per cent to just 7 per cent, which accounted for “roughly three-quarters of the decrease in inequality.” This made way for the new middle class. However, from the 1970s, the very rich started to race away not just from the middle but from the rich. “In all the English-speaking countries,” writes Piketty, “the primary reason for increased income inequality in recent decades is the rise of the supermanager in both the financial and non-financial sectors.” These are members of the chief executive class, who run global manufacturing businesses, investment banks, technology companies and so on. The super rewards to these supermanagers can’t be explained by their higher marginal productivity—that is, by the extra output that they produce. As Piketty says, “one would expect a theory based on ‘objective’ measures of skill and productivity to show relatively uniform pay increases within the top decile.” That is, the income of the top 1 per cent should not be rising faster than that of the next 9 per cent because members of the top 1 per cent are unlikely to be significantly more skilled and productive than the next 9 per cent. But the income of the top 1 per cent has risen substantially faster than that of the rest. So what does explain the extravagant rewards of the very rich? The short answer, says Piketty, is that, since the 1970s, “social norms” in the US and UK have allowed senior managers to set their own pay. “It is only reasonable to assume,” he remarks drily, “that people in a position to set their own salaries have a natural incentive to treat themselves generously or at the least to be rather optimistic in gauging their marginal productivity.” The business culture in Japan and Europe evolved in the same direction, but later and not to the same extent. At the same time, taxes on top incomes have been reduced supposedly to “incentivise” their earners to work harder. Piketty conjectures that “meritocratic extremism” or the “winners take all” culture of the US may be behind the shift to greater inequality. And one may add that where social superiority is conferred by birth, as it was in the past, one has less need to affirm it by conspicuous earnings and consumption. However, all of this is just a way of saying that distribution is increasingly fixed by power, not by the market. Although inequality has returned, the structure of contemporary inequality is different—hard work finally pays more than inheritance. Piketty explains how before the First World War “work and study alone were not enough to achieve the same level of comfort afforded by inherited wealth and the income derived from it.” This is why in Balzac’s novel of 1834, Le Père Goriot, Vautrin demonstrates to Rastignac that he is better off marrying Mademoiselle Victorine than becoming a royal prosecutor. There was a dramatic change after the Second World War—the people at the top of the income distribution were no longer aristocrats, but lawyers, doctors, and “supermanagers.” The question we can then ask is whether the recent financial crisis is likely to decrease inequalities in the same way as the Great Depression did. Piketty concludes that it will not, because the stock market euphoria prior to the crash was not the structural cause of increased inequality. To be sure, in the short run, the crash may have a “compressing” effect, but the short-term collapse in financial assets did “not alter the long-run trend.” This seems reasonable: the destruction of the wealth and prestige of the ruling class was much greater in the era of the two world wars and the Great Depression than anything we have recently experienced. Inequality will continue to increase, because inheritance will become increasingly important. “There is nothing to prevent the children of supermanagers from becoming rentiers,” and while the baby boom generation grew up with the idea that the age of inheritance was over, those born in the 1970s and 80s have already experienced the revival of inheritance and gifts. Demography plays an important role here. Piketty writes that, “Other things being equal, strong demographic growth tends to play an equalising role because it decreases the importance of inherited wealth: every generation must in some sense construct itself.” The problem is that we are now experiencing a return to a “low growth regime.” In the 21st century the distribution of income from capital will become even more unequal than capital ownership per se because there are economies of scale: people with larger portfolios achieve larger returns. One explanation is that certain investments, such as expensive property, are accessible only to the super-rich. Another is that only the wealthiest can afford to hire the best portfolio managers. Either way, past a certain threshold, “money tends to reproduce itself.” Piketty takes the example of Bill Gates and Liliane Bettencourt, whose fortunes increased at the same pace—$4bn to $50bn and $2bn to $25bn respectively between 1990 and 2010—despite the fact that Liliane Bettencourt never worked a day in her life. The historical record so painstakingly dissected can be summarised by what Piketty calls the “fundamental force for divergence.” When the return on capital exceeds the growth of the economy, inherited wealth grows faster than output and income, meaning that inequality increases. So if the return on capital is high for rich people, inequality will have a tendency to rise explosively. And the return to low growth, including low demographic growth, means that inequality will rise even more. Piketty predicts that growth will not exceed 1-1.5 per cent in the long run, whereas the average return on capital will be 4-5 per cent. Even if the total volume of inheritance regains past levels, it will not necessarily play the same social role as before. There are fewer very large estates of £30m, or even £5-10m and many more of £200,000- 500,000 or even £1-2m—not sufficient for heirs to give up work and live on interest The only way of limiting the acceleration of inequality, while preserving entrepreneurial spirit and economic growth, is, Piketty concludes, to impose a progressive wealth tax on the largest fortunes.


Deeply impressive in its style and learning, Piketty’s argument is nevertheless incomplete. His story is about the super-rich racing ahead of the rich (and everyone else) since the 1980s. He explains this by the power of the rich to set their own pay and the ease with which they can transform their super-salaries into capital. But there may be another explanation, which is that digital technology actually increases the marginal product of the top performers in all fields of endeavour, creating a global elite of superstars who are distinguished from the rest by their exceptional talents. This is the view of Erik Brynjolfsson and Andrew McAfee in their new book The Second Machine Age. To the extent that “technology increases the reach, scale, or monitoring capacity of a decision- maker,” it makes managers more “valuable.” This implies that supermanagers get higher pay because they are more productive, not just because they can set their own salaries. Digital technology can also boost rewards to superstar writers and performers. For example, digitisation and globalisation have “supercharged the ability of authors like JK Rowling to leverage their talents… Rowling’s stories can be captured in movies and video games as well as text, and each of those formats... can be transmitted globally at a trivial cost.” Whether it’s power or talent which makes the super-rich rich, the key point is that they can perpetuate their position by leveraging super-salaries into capital and living off the returns, as they did in the 19th century. However, this may be a transient opportunity, for one would expect that their supercharged salaries will eventually be competed away. In other words, it’s an open question whether present levels of inequality can perpetuate themselves. Piketty’s book is a timely intervention in the current debate about inequality and its causes. Everyone agrees that inequality has been growing. But does the growth of inequality matter? The quick answer is that it is bad economically and socially. It is bad economically because it narrows the consumption base on which investment depends; and it bad socially because, as Piketty says, it “undermines the meritocratic values on which democratic societies are based.” But few politicians have a clue what to do about it.   Capital in the 21st Century by Thomas Piketty (Harvard, £29.95)