Living with Inequality

Has Thomas Piketty really found "the central contradiction of capitalism"?


Capital in the Twenty-First Century, by Thomas Piketty, Belknap/Harvard, 685 pages, $39.95.

In Capital in the Twenty-First Century, the French economist Thomas Piketty claims to have uncovered "the central contradiction of capitalism." When a major scholar like Piketty—a man who has made genuine contributions to empirical economics—makes such a bold claim, it deserves to be taken seriously.

What is this flaw at the heart of the economic machine, a flaw that centuries of economists have overlooked? Simply that at some times and at some places, the interest rate is greater than the economy's growth rate. (Piketty correctly uses the term "interest rate" as a stand-in for the total average return on capital: profits, interest, and, when he has data available, capital gains.) Piketty sums it up with a simple equation: r > g. And if r > g for decades, he argues, capital contains the seeds of deep social conflict.

If the wealth of capitalists grows at the interest rate, and if that wealth grows faster than the overall economy, capitalists will take over more and more of the economy until something genuinely awful happens, Piketty says. He is vague about what this awfulness might consist of, but the memory of the last century brings to mind quite a few unpleasant scenarios that can happen when the average citizen gets upset at elites: anything from an overregulated banking sector to a Marxist revolution, with dozens of possibilities in-between. Meanwhile, ultra-wealthy economic elites can buy massive political influence, pushing the government to favor well-connected insiders and in the process slowing down the economy.

As a matter of politics rather than economics, there's little to disagree with in Piketty's prophecy. If (big if) there's a central contradiction in capitalism that makes the capitalists richer at a faster rate than the overall economy, then the miracle of compound interest promises endless opportunities for conflict between those with compounding wealth and those with slow-growing wages.

So is the central contradiction a thing? Barely. Even capitalists consume, and they can consume quite a lot. The typical person might not be able to imagine what it's like to be worth a billion dollars and have about $40 million a year in interest and dividend income to spend, but among private jets, new cars, the latest medical treatments, and gifts for his rich friends, a billionaire can spend that much just trying to keep up with his neighbors. Saving is mostly just delayed consumption, as generations of economists have taught, and the only way for capital to grow exactly at the interest rate is for nobody to consume it. Every bit of consumption pushes down the growth rate of capital.

The entrepreneur who earns a few billion from innovation might be frugal enough to pass on a massively compounded pile of capital. But between the possibility of spendthrift descendants who fritter away her fortune and the possibility of multiple descendants who divide it into tiny slices, there's good reason to expect the long-run trend will be for the capital of billionaires to grow at about the same rate as the overall economy. Since capital helps the average worker do her job, we should hope that the world's billionaires will be frugal rather than reckless, lending their capital to fund innovation the world over, but we are unlikely to be so lucky. Billionaire wealth can turn into multimillionaire wealth with just a few ill-judged marriages.

There's an extra reason to think that capital isn't going to permanently grow at a faster rate than the overall economy: Piketty says it won't. He places great weight on the mainstream economic idea that in the long run the natural tendency of market economies is for capital and the economy to both grow at the same rate, whatever that rate turns out to be. That "twin growth rate" might be high if population and technology are advancing quickly, or it might be low if both are in the doldrums, but there's no inherent tendency for capital to outpace the economy forever, even when Piketty's "central contradiction" of high interest rates holds.

The reason is simple. If the first machine is more productive than the second (i.e., diminishing returns), and if machines wear out and fall apart at a fairly predictable rate—a depreciation rate, in accounting-speak—then it's a safe bet that in the long run capital and the economy will grow at about the same rate. Double the machines mean double the machines wearing out, so at some point you have so many machines (and houses and outdated software and office buildings) wearing out each year that a nation spends an enormous economic effort just replacing them. And of course if interest rates are high, business owners look for alternatives to capital (such as workers); private demand for capital thus shrinks. So growing replacement costs and the quest for cheaper alternatives both make it hard to imagine capital growing as far as the eye can see.  I'll spare you the math, but it's getting harder all the time to see a central contradiction.

But while Piketty's contradiction is less an iron law and more a chalkboard speculation, there's still plenty of room for class warfare in our future. A final way to see if capitalists are going to exercise unprecedented influence in the economy is to see whether their share of the economy is at unprecedented levels. Here, Piketty's arduous historical research pays off. For the two countries for which he has data going back more than a century—Britain and France—the answer is clear: Capitalists are claiming a substantially smaller share of the economic pie today than they did in the mid-19th century. Back then capital income was a bit more than 40 percent of total national income. Now it's a bit under 30 percent. So if capitalists—savers, landowners, entrepreneurs, and all the rest—are going to become a bigger deal in the future, they've got a long way to go before they're at 19th-century levels.

In real life, of course, capitalists and wage-earners are overlapping categories, as everyone with an IRA or a 401(k) knows. But Piketty does a service in demonstrating just how concentrated the ownership of capital is among a smallish group of savers. Housing is a big exception in the U.S. and a few other countries, and Piketty does a more than adequate job showing readers that many people in the rich countries really do have substantial savings in one form or another: For instance, he notes that in European countries there is a "middle class of wealth"—those between the 50th and 90th wealth percentiles—who have an average of 175,000 euros per adult.  But the concentration is real. Even more important, it's perceived as real by progressive elites and by many voters.  A case in point: Piketty refers to the wealth of the European middle classes as merely "a few crumbs."

That brings us to questions of politics and culture. For the next decade or two, inequality will probably continue to increase in the rich countries. Even if capital inequality turns out to be less of a central contradiction and more of a bloggable curiosum, rising inequality in wages and salaries is certainly real. In his new book Average is Over, my colleague Tyler Cowen argues that we'll see ever more technology-driven wage inequality. While Piketty thinks that changing social norms are at least as important as technology, the source of the inequality may not matter much for politicians, voters, and bloggers.

Market-oriented economies that learn to live with inequality will reap the rewards: More domestic capital for workers to use on their jobs, more foreign capital flowing in to a country perceived as a safe investment, and a political and cultural system that can spend its time on topics other than the 1 percent. Market-oriented economies that instead follow Piketty's preferred path—taxing capital heavily, preferably through international consortiums so the taxes are harder to evade—will end up with less domestic and foreign capital, fewer lenders willing to fund new housing projects, fewer new office buildings, and a cultural system focused on who has more and who has less.

Clearly I'm rigging my comparisons here, but not by much: It's obvious that higher taxes on capital deter long-run investment and long-run planning. Reasonable savers care about after-tax returns on their savings, which explains why tax-free municipal bonds are often able to offer lower interest rates than taxable U.S. government bonds. The Boston University economist Christophe Chamley and the Stanford economist Kenneth Judd came up independently with what we might call the Chamley-Judd Redistribution Impossibility Theorem: Any tax on capital is a bad idea in the long run, and that the overwhelming effect of a capital tax is to lower wages. A capital tax is such a bad idea that even if workers and capitalists really were two entirely separate groups of people—if workers could only eat their wages and capitalists just lived off of their interest like a bunch of trust-funders—it would still be impossible to permanently tax capitalists, hand the tax revenues to workers, and make the workers better off.

Why? Because the tax on capital would shrink the supply of machines, which workers use to become more productive and earn more. In the (too) simple world of economic models, the Chamley-Judd result shows that, for instance, a capital tax that raised revenue equal to 1 percent of gross domestic product (GDP) would cut wages by more than 1 percent of GDP. It's impossible to "redistribute" income to workers in a way to raises the average worker's total income. What you gain from the government check is more than lost in your weekly paycheck.

Nonetheless, some combination of rising inequality and popular demand for social services for rich countries' aging populations will make the wealthy an ever-easier tax target. Our best hope is cultural change, a move toward calming the country's covetousness. Piketty draws repeatedly on 19th-century novels by Austen and Balzac to illustrate his points, but the poorest 10 percent of people in 19th-century France or England were much poorer than the poorest 10 percent in France or England today. Whatever argument there was in the 19th century for sacrificing long-run economic growth in order to help the poor, the argument is weaker now.

Instead of preaching to reduce inequality as a means to reduce social conflict, we should instead preach to reduce social conflict itself. The best way to defuse the situation is to teach tolerance for inequality. Piketty wants tolerance for merit-based inequality, for better workers earning more than others, for a reward to frugality, and the like. But we could also use tolerance for luck-based inequality: for the inheritor of a fortune, for the pretty-good CEO who gets an eight-figure bonus just because his company's product went viral on Vine. Political battles against inequality have too many invisible casualties—missing factories, unbuilt apartment complexes—even in the best of cases. And given the intense political world of the aging rich countries, we're unlikely to experience the best of cases.

That's why I propose the creation of the Tenth Commandment Club. The tenth commandment—"You shall not covet"—is a foundation of social peace. The Nobel Laureate economist Vernon Smith noted the tenth commandment along with the eighth (you shall not steal) in his Nobel toast, saying that they "provide the property right foundations for markets, and warned that petty distributional jealousy must not be allowed to destroy" those foundations. If academics, pundits, and columnists would avowedly reject covetousness, would openly reject comparisons between the average (extremely fortunate) American and the average billionaire, would mock people who claimed that frugal billionaires are a systematic threat to modern life, then soon our time could be spent discussing policy issues that really matter.

People who are genuinely materially desperate aren't the issue here. The Tenth Commandment Club has no qualms with a Jean Valjean stealing bread to feed his family. But the implicit emphasis of Piketty's Capital is with comparing the 1 percent (or 0.01 percent) to the typical person living in the G-7, a person who is, on average, more fortunate than most of the world's population and more materially fortunate than almost anyone living in the 19th-century novels that Piketty so loves to discuss. To paraphrase an old P.J. O'Rourke joke, just think about Mr. Darcy's visits to the dentist.

Piketty clearly prefers to talk about the wealth of European and U.S. elites, but he spends a few crucial pages talking about capital accumulation in developing countries. It's here that he notes what may be the most important fact in his book: According to his long-run forecast, "Asian countries should own about half of world capital by the end of the twenty-first century."

The high savings rates of Asian and particularly East Asian economies have been a puzzle that resists a complete explanation. Asian nations with young populations and old, those with fast-growing economies and the slower-growers, generally tend to have savings rates as high as or higher than those of similar economies outside Asia. If these countries keep saving at higher than average rates, it means a world of bountiful capital for decades to come. If capital flows stay free—if money can move to its highest return across the globe with few tax and regulatory fetters—that means there will be ever more homes and machines available across the world. And, a bountiful supply of capital tends to push interest rates in a direction that diminishes whatever is left of Piketty's central contradiction. The "global savings glut" that Ben Bernanke wrote about a decade ago may last quite a while, and that's good for global productivity.

Things could change at any time—culture and law are both hard to predict—but normal economics has a very strong prediction for what happens when some countries are (on average) more patient than other countries and when capital can flow freely the world over: In the long run, the patient inherit the earth. As long as nations differ (on average) in patience, the patient capitalists start by investing in the less patient countries and the less patient countries gladly and willingly borrow the cheap cash. The patient countries help increase the capital stock of their less patient neighbors, and—as long as there aren't legal barriers to foreign ownership—in the long run the patient nations end up owning essentially all of the world's capital and the less patient nations ultimately end up sending not only their profits but even most of their mortgaged wages to the patient nations.

One lesson of this story is that it's good to be patient. So let's start training ourselves and our children to delay gratification, to forego that great sound system on the new car, to eat at home a little more often. Another lesson is one that Piketty hits head on: If the world moves toward this outcome, where some rich nations own vast amounts of other rich nations' wealth, we can all expect a political backlash. An attack on foreign investment might show up as bans on foreign ownership, discriminatory regulations that end up as de facto bans, confiscation of foreign-owned assets, or something worse, something more violent.

Hence the need for tolerance. As Piketty reminds us, human beings can be pretty bad at living with economic inequality. But when it comes to capital, simple economic theory is right: the more, the merrier. And if we can reduce covetousness, we can say the reverse: the merrier, the more.