Raphaele ChappeThis week's Worldly Philosopher, Raphaele Chappe, writes on the increasing inequality in free-market dynamics.

Inequality is rising in most developed economies. At the peak of the housing bubble in 2007, the richest 1% held 34.6% of wealth in the U.S.1 The drop in household wealth following the crisis affected the median household more than the top 1%2 so that the wealth distribution is now even more unequal. Robert Reich points out that since the start of the recession, the share of total U.S. national income going to labor has plunged (while profits in the U.S. corporate sector are now at a 45-year high), and that 2013 has been the year of "the great redistribution."3 In 2012, the top 10 percent of U.S. earners took more than half of total income – the highest level recorded in a century.4

chartThomas Piketty's new book, "Capital in the Twenty-First Century" (Piketty, 2013)5 suggests that these trends are the natural result of free-market dynamics – with the prosperous decades that followed the Great Depression and World War II are an exception to the rule and are unlikely to be repeated. In the tradition of the worldly philosophers, this ambitious work is nothing short of an attempt to characterize the laws of motion for the process of capital accumulation and income distribution for advanced capitalist economies.

Piketty's hypothesis is that the main driver of inequality is the tendency of returns on capital6 to exceed the rate of economic growth (this is Piketty's key inequality relationship r>g), producing high capital/income ratios (β).7 If r is to remain at its historical rate of 4-5% p.a., while advanced economies continue to experience low growth rates8, we are headed back to the 19th Century in terms of inequality -- a time where inheritance was so important that it arguably made more sense for the ambitious and talented to marry well than to work hard.9

So are we doomed to revert back to the world described by Charles Dickens, where glaring poverty and inequality were the social norm? Piketty's framework is not entirely deterministic. There are counteracting tendencies that may slow the process of capital accumulation, for instance the diffusion of knowledge and know-how. There are also factors that are political in nature, and external shocks that may lead to a decrease in β. For example, Piketty argues that the decrease in inequality that followed World War I (until the late 1970s) was the result of the physical destruction of capital, and high taxation to support recovery efforts from the Great Depression and World War II.

This view differs from standard economic theory, according to which the wealth distribution is a result of earning differentials. It is also in sharp contrast to the optimistic hypothesis advanced by Kuznets that market forces will ultimately reduce inequality as a country experiences industrialization and economic growth, and arguably closer to the gloomy predictions of Karl Marx. Yet Piketty's arguments, backed by a strong reliance on empirical data (see the above chart to illustrate the point) and a sweeping reinterpretation of economic history, are convincing.

Are they entirely so? We may ask why r is to remain at its historical rate of 4-5% p.a. – would an increase in capital stock not drive r down? Would financial crises not affect it as well? What of the changing role of labor income since the 19th Century? Where does the developing world fit into the analysis? Is it possible that global economic growth will be higher than Piketty predicts, due to the ongoing convergence of developing economies?

Regardless, the book should place distributional issues at the forefront of the public debate among economists, highlighting the need for changes in policy to reduce inequality. In my next blog entry, I will discuss the policy debates that we face if Piketty is right.

1 See Wolff (2010)
2 36.1 percent drop in wealth compared with 11.1 percent - Wolff (2010)
This development, of course, is not without political significance. Wealth can bring about considerable political privilege and power, so that the wealth and income distribution is deeply relevant to the distribution of power in a representative democracy.
See Emmanuel Saez's recent study or, more generally, the work of Edward Wolff.
The book is based on a unique data collection covering 20 countries and spanning (for some) three centuries. For a review of Piketty (2013), see Milanovic (2013).
Note that Piketty uses "capital" interchangeably with wealth.
The theory can be exposed with a few simple equations. First, a simple fundamental equality: by definition, the share of total national income flowing to capital income (α) is equal to the rate of return on capital (r) multiplied by the ratio between capital and annual income (β). In the long run, we also have β=s/g. Recent low growth rates have led to a rise in β in advanced economies (though less so in the U.S. than in Europe and Japan). If r>g, then β increases, in turn leading α to increase (by virtue of the above equality). This process is fueled by a positive feedback loop: as they earn a higher share of income, capital owners can save more, which increases r.
In Piketty's estimate, it is unlikely that g will exceed 2.5% p.a. for advanced countries in years to come (the rate of technological progress of 1-1.5% p.a. plus 1% population growth).
Piketty uses the society portrayed in the novels of Jane Austen and Honoré de Balzac to illustrate the point.

Milanovic, B. (2013). The return of 'patrimonial capitalism': review of Thomas Piketty's Capital in the 21st century. Forthcoming in a June 2014 issue of The Journal of Economic Literature. http://mpra.ub.uni-muenchen.de/52384/1/MPRA_paper_52384.pdf

Piketty, T. (2013). Le capital au XXIe siècle. Paris: Seuil. http://www.seuil.com/livre-9782021082289.htm

Reich, R. (2012). A diabolical mix of US wages and European austerity. Financial Times. Retrieved from http://www.ft.com/cms/s/0/7b84f1c8-a977-11e1-9772-00144feabdc0.html - axzz2pTSSy2a8

Reich, R. (2014). The year of the great redistribution. Retrieved from http://www.economonitor.com/blog/2014/01/the-year-of-the-great-redistribution/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor Highlights%3 A Easy Money and Silver Bullets

Saez, E. (2013). Striking it richer: The evolution of top incomes in the US (updated with 2012 preliminary estimates). Retrieved from http://elsa.berkeley.edu/~saez/saez-UStopincomes-2012.pdf

Wolff, E. N. (2010), Recent trends in household wealth in the United States: Rising debt and the middle-class squeeze - an update to 2007. Working Paper No. 589. Annandale-on-Hudson, NY: The Levy Economics Institute of Bard College. http://www.levyinstitute.org/pubs/wp_589.pdf


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