Capital

In 1873, Karl Marx published the first volume of his magnum opus Das Kapital (“Capital”, in English) which purported to describe the dynamics of a capitalist economy.  Although I have never studied Capital sufficiently closely to do justice to the work, the basic idea was that ownership of the means of production (capital) becomes increasingly concentrated in the hands of a small number of people and the vast majority of workers become increasingly impoverished and alienated.  Marx predicted that eventually, and inevitably, the workers would rise up and “cast off their chains.”

In what many people are calling the economics book of the year, or the decade, or maybe even the century, French economist Thomas Piketty’s “Capital for the 21st Century,” poses a similar question to Marx; namely, “Do capital dynamics lead to increasing inequality?”  The 700 page book, along with a 100 page technical appendix, is a towering achievement of empirical research.  Professor Piketty (TP) and colleagues have pulled together new databases on the distributions of income and wealth in various countries for multiple time periods, and have subjected them to careful analysis.  His conclusion is yes, the dynamics of capitalism tend to drive wealth inequality.

The fundamental reason, TP explains, is that the rate of return on capital (“r”) is over the long-term significantly greater than the rate of economic growth (“g”).  Wage income tends to grow at rate g and capital income tends to grow at rate r.   TP estimates that the historical rate of return on capital is 4-5% and should be expected to persist.  Meanwhile, he believes that the long-term outlook for the rate of economic growth is just 1-2%.  This is greater than the long-long-run average (pre-1800) of roughly zero growth, but is less than what has been observed in developing and developed countries over the past two hundred years.  The reasons for the projected growth slowdown are a combination of slower population growth and a slowdown in the rate of productivity growth.  TP argues that a consequence of the assumed differential between r and g is that both the ratio of wealth to GDP and the share of income from capital in total income will be high and rising.  Combining this with the assertion that wealth and capital income tend to be highly concentrated, TP concludes that the rich will continue to get richer.  Not only that, but it will become increasingly difficult for the non-rich to become rich.

During the first half of the 20th century, the concentration of wealth fell.  This was widely interpreted by economists, notably Simon Kuznets, to suggest that mature capitalist economies become more egalitarian over time as the benefits from innovations spread throughout the economy.  TP argues that inequality fell in that period due the negative impact on wealth of two major wars, hyperinflation in Germany, and the great depression.  In “normal” times, he believes, the natural tendency is for both wealth and the concentration of wealth to increase.  In support of this notion, since 1950 rising inequality trends have been re-established, and his prognosis is for more of the same.

I have not studied the data nearly as extensively as TP and his associates.  Still, I am interested in the process of wealth creation, am intrigued by the TP argument, and have a few thoughts.  First, rising wealth is not a bad thing.  It is the source of financing for new ventures and should result in greater productivity and higher wages.  If indeed wealth grows at a rapid rate, I think TP’s prediction of 1-2% economic growth will be too pessimistic.  Second, there is no guarantee that wealth-holders will earn 4-5% real returns after-tax, as TP assumes.  To achieve this requires taking on a lot of risk, and making intelligent decisions.  I think that returns like this are quite unlikely for most people, even for those people sufficiently affluent to higher expensive investment advisors.  There is a great deal of evidence to suggest that, after paying fees, expensive investment advisors do not outperform market averages.   So, TP’s assumption of 4-5% returns on capital for the typical rich guy is probably too high.

Third, even more than investment return, the key driver of wealth is your savings rate.  If rich people spend more than 3-4% of their wealth each year they are likely to dissipate that wealth, not increase it.  Of course, some people are so affluent that spending even 1% of wealth is close to impossible (think of multi-billionaires).  TP believes such levels of wealth will lead to dynastic wealth (“non-meritorious” is the translated phrase).  In fact, he conducts some analysis to conclude that a very high proportion of wealth will be owned by heirs, not by the original wealth creators.  But this flies in the face of the “shirtsleeves to shirtsleeves in three generations” process whereby even great wealth is dissipated by multiple heirs and profligate spending.  Anecdotally, the richest person in France is apparently an heir to the L’Oreal perfume fortune.  Perhaps this affects the TP perspective.  Meanwhile, in the U.S. the richest people are self-made – think of Bill Gates, Warren Buffett, the founders of Google, Facebook, etc. (granted, the children of Sam Walton, founder of Walmart, also show up in the ranks of the richest Americans).

Finally, there is nothing stopping the non-rich from becoming rich.  To me, this is the most important issue.  The key is to save a substantial portion of your income.  Although this is arguably difficult to do for those on a modest income, left-leaning Senator Elizabeth Warren, in her jointly authored book on financial planning, recommends a savings rate of 20% for nearly all families.  If you can save 20% of your income and invest so as to achieve market returns (and by doing so outperform the average highly paid investment advisor), you will build wealth and an earnings stream from that wealth.  Then you will be part of the increasing share of capital income in total income that has TP so worked up.

TP has received adulation from the left for his analysis and his policy recommendations to mitigate wealth inequality through dramatically higher tax rates on capital income and inheritance, and by introducing a global tax on wealth.  I applaud his scholarship and efforts to compile relevant and valuable data sets.  But I don’t think that higher tax rates on capital will increase the opportunity for the non-rich to become rich.  Instead, the effects of higher tax rates on capital would likely be to deter upward mobility.

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