I’ve written a few posts about the trees inside Thomas Piketty’s verbose tome, Capital in the Twenty-First Century:
Now it is time to look at the forest.
One reason that Piketty’s book deserves attention is that it is a book, not a paper. When a field is pre-paradigmatic, The Structure of Scientific Revolutions
(Kuhn) says that progress is made with books, not with journal papers. Is Economics a paradigmatic science like chemistry, biology, or physics? Due to its lack of predictive power, as evidenced by the fact that economists did not predict the Collapse of 2008 nor predict which countries would emerge from that event in the best shape, Econ is pretty plainly pre-paradigmatic (otherwise economists would be as rich as John Paulson). Piketty throws some rocks at his colleagues:
To put it bluntly, the discipline of economics has yet to get over its childish passion for mathematics and for purely theoretical and often highly ideological speculation, at the expense of historical research and collaboration with the other social sciences. Economists are all too often preoccupied with petty mathematical problems of interest only to themselves. This obsession with mathematics is an easy way of acquiring the appearance of scientificity without having to answer the far more complex questions posed by the world we live in. There is one great advantage to being an academic economist in France: here, economists are not highly respected in the academic and intellectual world or by political and financial elites. Hence they must set aside their contempt for other disciplines and their absurd claim to greater scientific legitimacy, despite the fact that they know almost nothing about anything.
Piketty reminds us continuously that much of the economic growth for which politicians take credit is simply population growth. And also that national borders are substantial barriers to efficient deployment of capital:
If the rich countries are so flush with savings and capital that there is little reason to build new housing or add new machinery (in which case economists say that the “marginal productivity of capital,” that is, the additional output due to adding one new unit of capital “at the margin,” is very low), it can be collectively efficient to invest some part of domestic savings in poorer countries abroad.
the income of Africans is roughly 5 percent less than the continent’s output (and as high as 10 percent lower in some individual countries). With capital’s share of income at about 30 percent, this means that nearly 20 percent of African capital is owned by foreigners:
According to classical economic theory, this mechanism, based on the free flow of capital and equalization of the marginal productivity of capital at the global level, should lead to convergence of rich and poor countries and an eventual reduction of inequalities through market forces and competition. This optimistic theory has two major defects, however. First, from a strictly logical point of view, the equalization mechanism does not guarantee global convergence of per capita income. At best it can give rise to convergence of per capita output, provided we assume perfect capital mobility and, even more important, total equality of skill levels and human capital across countries—no small assumption. In any case, the possible convergence of output per head does not imply convergence of income per head. After the wealthy countries have invested in their poorer neighbors, they may continue to own them indefinitely, and indeed their share of ownership may grow to massive proportions, so that the per capita national income of the wealthy countries remains permanently greater than that of the poorer countries, which must continue to pay to foreigners a substantial share of what their citizens produce (as African countries have done for decades).
if we look at the historical record, it does not appear that capital mobility has been the primary factor promoting convergence of rich and poor nations. None of the Asian countries that have moved closer to the developed countries of the West in recent years has benefited from large foreign investments, whether it be Japan, South Korea, or Taiwan and more recently China. In essence, all of these countries themselves financed the necessary investments in physical capital and, even more, in human capital, which the latest research holds to be the key to long-term growth.35 Conversely, countries owned by other countries, whether in the colonial period or in Africa today, have been less successful, most notably because they have tended to specialize in areas without much prospect of future development and because they have been subject to chronic political instability.
When a country is largely owned by foreigners, there is a recurrent and almost irrepressible social demand for expropriation. Other political actors respond that investment and development are possible only if existing property rights are unconditionally protected. The country is thus caught in an endless alternation between revolutionary governments (whose success in improving actual living conditions for their citizens is often limited) and governments dedicated to the protection of existing property owners, thereby laying the groundwork for the next revolution or coup. Inequality of capital ownership is already difficult to accept and peacefully maintain within a single national community. Internationally, it is almost impossible to sustain without a colonial type of political domination.
historical experience suggests that the principal mechanism for convergence at the international as well as the domestic level is the diffusion of knowledge. In other words, the poor catch up with the rich to the extent that they achieve the same level of technological know-how, skill, and education, not by becoming the property of the wealthy.
In other words, a rich country will continue to invest in its industries, schools, and transportation network even though a much better return on investment is available from investing in a poor country (building a new road to a growing city in Brazil should have more value than repaving an existing road in the U.S.; building high-speed rail in China at a low cost per mile is a much better investment than building high-speed rail in California).
Piketty also notes that the more capital is accumulated the lower the return on capital tends to be, in the same sense that the availability of 1 billion skilled workers in China will tend to lower wages elsewhere or the discovery of natural gas fields will tend to lower the cost of natural gas.
After explaining these factors, however, Piketty pretty much ignores them and posits that returns on capital going forward will be just as good as they have been in the past. And then adds that rich people and organizations will get an even higher return than average schmoes invested in the S&P 500 and other public equities.
Piketty has collected copious data that he says shows that wealth inequality is high right now, comparable to conditions prior to World War I. Critics have said that he is misinterpreting, misquoting, and mistranscribing the data. But let’s suppose that he is right. Piketty argues that this means we are about to enter an era of soaring wealth inequality, the likes of which the world has never seen, in which the rich run away with it all. The top 0.1 percent will taxi their Gulfstream G-650s down Main Street whenever they want to buy a quart of milk. But perhaps Piketty, like Karl Marx, will prove to be a better historian than prophet. The same data could also be interpreted as evidence that capitalism is inherently self-correcting and wealth inequality over 200 or so years has swung between limits despite radically changed circumstances, governments, and technology.
As noted in a previous posting, Piketty’s call to action/arms is based on his prediction that wealth inequality is a runaway process that will lead to a handful of people owning virtually everything on the planet within 100 or 200 years. This prediction rests on the following assumptions:
- rich people get a better return on their investments than regular investors
- governments will stop taxing dividend and capital gain income
- the world economy will grow at best slowly for the next 50-100 years
- the return on capital will be high
- rich people won’t consume too much (which means most of their income gets plowed into additional investment)
All of these assumptions are questionable. Regression toward the mean has been one of the safest bets in finance, calling into question Assumption 1. Piketty doesn’t cite any examples of governments that have willingly given up a rich vein of tax revenue. When rates are cut it is typically by politicians seeking to increase actual collections, not in an attempt to shrink revenue. Piketty’s book came out right about the same time that the U.S. added the 3.8% Obamacare tax to investment income, roughly a 25% increase in the tax on capital-based income (depending on one’s tax bracket and whether dividends were “qualified”). Finally, the U.S. actually already has a wealth tax. It is called the capital gains tax not adjusted for inflation. For example, suppose that you bought a stock for $1 million in 2000. The market hasn’t moved much since then, so let’s say that the stock has appreciated only at the official inflation rate. Now it is worth $1.38 million. If you sell it to rebalance your portfolio, you’ll pay federal, state, and Obamacare taxes of about 30%, depending on the state where you live. That’s a $111,400 tax on a non-existent gain, i.e., an 11.4% tax on the wealth that you had in 2000. If we use an inflation rate closer to reality for rich people, instead of the government’s CPI that is based on a lifestyle of consuming Chinese-made DVD players and Costco hot dogs, the stock might have gone up to $1.6 million and the tax would be $180,000 on what is, from the perspective of someone who is buying fancy houses, restaurant meals, hotel rooms, etc., a non-existent gain. That’s an 18% wealth tax.
World economic growth in the 20th century was led by the U.S., a country with poorly educated people according to the PISA test. Since human capital is an important driver of growth, maybe the 21st century will be as strong or stronger now that countries with high PISA scores have market-oriented governments. Thus Assumption 3 may be wrong. If Piketty is right about Assumption 4, i.e., that the return on capital will remain high, he needn’t have wasted his time scribbling out a 700-page book. He could be making literally infinite money in the swap market (since the rest of the folks in finance think that the return on capital going forward will be low).
Assumption 5, that rich people won’t spend, seems questionable as I sit here at the Teterboro airport looking out at a forest of Gulfstreams. It may be hard to imagine that the owner of an Embraer Phenom 300 craves a Gulfstream G-450 or that the owner of a Gulfstream G-450 craves a Gulfstream G-650, but somebody is always buying those fancier planes. As business jets, luxury houses, luxury cars, etc., all depreciate over time, this is spending, not investment. And when rich people bid up the price of houses and/or build new mansions, they end up paying out huge property taxes. Rich people may spend money involuntarily. Most of them will try to live the middle class dream of marriage and children, but this paper by Brinig and Allen predicts that they will be targeted
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