A classic on issues of inequality

K. SUBRAMANIAN

Special ArrangementCapital in the Twenty first century by Thomas Piketty

Piketty says there are no automatic stabilisers to correct destabilising and inegalitarian forces

The publication of Thomas Piketty’s book “Capital in the Twenty First Century” in March has created waves among the academia, the media and social activists. The excitement over the book has spread to many corners of the world and it is being described as Pikettymania. Indeed, it is not a passing fancy. The impact of the book will be deeper and long lasting.

When he visited the U.S. early in April, he was greeted by a number of Nobel Laureates such as George Akerlof, Robert Solow, Paul Krugman and Joseph Stiglitz. Many more have lavished praise on his work. At another level, there are critics who have criticised him over data crunching and assumptions underlying capital/labour ratios. Against these developments, it is difficult to attempt another review. The idea here is to highlight some of his insights on the subject of inequality.

Mainstream economists have never been at ease with the issue of inequality. For the hardcore neocon theorists, the issue does not arise. They feel that when the market is in equilibrium, all the factors of production get paid fair value for their contribution. Income differences, if at all, could arise only due to ethnic, cultural or skill (technology) endowments. Elaborate mathematical models (production functions) were built around the working of the market. These had no social content.

Piketty’s flair for data modelling was known early in his career. He had a stint at the Massachusetts Institute of Technology when he was only 22. Recognised as a prodigy, he was expected to churn out econometric models like a machine. But he was disenchanted. For him, inequality is a social and historical phenomenon embedded in the larger canvas of wealth flows and income distribution and he wished to study them in the manner that classical economists like Ricardo, Malthus and Marx studied. As he says, “For far too long, economists have neglected the distribution of wealth, partly because of Kuznet’s optimistic conclusions and partly because of the profession’s undue enthusiasm for simplistic mathematical models based on so-called representative models.”

Debunking Kuznet’s Curve

He was more keen to study the historical dynamics of wealth distribution. While he made use of tax data dating back to three centuries to study wealth/income trends and their inter se relations, he notes, “The history of inequality is shaped by the way economic, social and political actors view what is just and what is not, as well as the relative power of those actors and the collective choices that result.” This idea is analysed at length in several parts of the book. He does not believe that there are any automatic stabilisers to correct the growing destabilising and inegalitarian forces.

The most significant contribution made by Piketty is the destruction of faith in the so-called “Kuznet’s curve”. For too long, this faith served as an anodyne to salvage the conscience of economists and policymakers, including those in the IMF/World Bank. Indeed, as Piketty argues, it served a useful role during the cold war in warding off criticism against capitalism.

As Piketty pointed out, Kuznet’s study of U.S. data was confined to the period from 1913 to 1948 and it suggested a bell-shaped curve for income distribution. In short, inequality rises during the early years of growth and falls in later years. No wonder, it became a cliché among conservatives who began to talk about “rising tides lifting all boats.” All that those who are currently denied higher wages have to do is to wait for higher growth when the benefits will percolate. Piketty also observed that it coincided with the Glorious Years of post-Second World War capitalism which he considers as an aberration due to wars, economic shocks, depression, high taxes, etc. He extended Kuznet’s work across more decades and countries and focussed on wealth and income data taken from tax records. He published his findings along with Emmanuel Saez of Berkeley in 2003. The data yielded a U-shaped curve over the course of the 20-century and disproved the underlying faith in Kuznet’scurve.

The other valuable contribution made is the study of the relative shares of capital and labour. Conventional assessment of income inequality is made on the basis of incomes such as wages, salaries etc. By broadly defining capital (for which he has been criticised by purists) Piketty lumps all forms of capital (wealth) which yield income streams. Then he offers a simple formula: r > g, where r stands for the average rate of return on capital such as profits, dividends, interest, rents) and g stands for the rate of economic growth. His studies show that the rate of return on capital has been between four and five per cent, while the growth rate has been lower, between one and two percent. It is interesting that across the globe, except in Africa, he does not expect g to rise above 2 percent in the coming decades! Piketty ascribes capitalism’s principal destabilising force to this relationship between capital and labour.

Inequality and investment

Income inequality gets aggravated further by the saving and investment habits of the rich. They save more. They earn more through their capacity to invest in complex financial products and by dodging taxes through recourse to tax havens, etc. His comparison of the earnings of the rich with the performance of U.S. university endowments suggests that the larger the size, the higher the rate of return on investments. Similarly, his study of oil and mineral exporting countries which are owners of sovereign wealth fund provide grist to the financial market and rich operators. These developments distort the traditional functional distribution of income. As Piketty argues, “the entrepreneur inevitably tends to become a rentier, more and more dominant over those who own nothing but their labour... capital reproduces itself faster than output increases. The past devours the future.”

The horror that haunts him is that if these trends continue, there is the looming prospect of the emergence of “patrimonial capitalism” of the early centuries. Piketty repeatedly makes references to the hereditary society described in the novels of Jane Austen and Honore de Balzac. They are the distant cousins of the Zamindaris in India.

Piketty is highly critical about executive compensation, a factor in income distribution which had led to extreme inequality in recent years, especially after the crisis of 2008. He ridicules the “illusion of marginal productivity” on which huge payments are determined. He devotes several pages on this issue. His argument is that in large corporations it is impossible to assess the contribution of individual executives. The managements or boards follow the herd or the ongoing social norms followed in sister (rival!) corporations and approve large packets. He observes that the demand for higher executive compensation grew louder only after the tax rates were substantially lowered. This is double jeopardy for income distribution!

There is a tendency among U.S. economists to look upon inequality as offering opportunities (social mobility) to rise higher through entrepreneurship. He has no patience with these arguments. His study of data suggests “that social mobility has been and remains lower in the United States than in Europe.” He is able to show that only the children of richer classes could afford the cost of education in elite universities. Likewise, there is also social filtering in the job market.

Piketty has elevated many issues to a higher level by making the study of inequality as one of political economy embedded in history, data and configuration of socio-political groups. As he forcefully argues, “the fundamental force for divergence … can be summed up in the inequality r>g, which has nothing to do with market imperfections and will not disappear as markets become freer and more competitive. The idea that unrestricted competition will put an end to inheritance and move toward a more meritocratic world is a dangerous illusion.”

While Piketty has offered deep insights into the issues governing inequality, especially how they are inextricably connected with politics, he has not offered suggestions to remedy the imbalance. He has some view on taxation, especially of property or estates and a global tax system. He himself admits that they are utopian. But there is no reason why in future political leaders cannot devise tax systems to redress inequality. Piketty wants us “to study the state, taxes and debt in concrete ways and to abandon simplistic and abstract notions of economic infrastructure and political superstructure.”

This book has all the makings of a classic. It has already changed the way economists think about inequality. One hopes that these ideas will percolate into the chambers of policy-makers in governments and lending institutions and bring about changes in their policies to reduce inequality. It may be long time in waiting. But a beginning has been made. Piketty has dared to raise them as a scholar.