Books that make an impact lasting for decades – even centuries – are rarer than hens’ teeth. In economics, they can be counted on one hand: The Wealth of Nations by Adam Smith, Karl Marx’s Das Kapital, Keynes’s The General Theory of Employment, Interest, and Money and perhaps Friedrich Hayek’s The Constitution of Liberty or The Road to Serfdom or Milton Friedman’s Freedom and Democracy.
Rarer still is to see a work ascend to the status of a classic almost instantaneously following its publication. Such a work is Thomas Piketty’s Capital in the Twenty-First Century. It is almost certain that its impact will last for decades. A century hence, it may be a cornerstone of economic and political debate and discussion, much as Smith’s, Keynes’s and Hayek’s works are today.
Piketty’s work swiftly catapulted to prominence in the United States. A red carpet had inadvertently been rolled out for it – almost, it seems, in anticipation that a monumental work would enter the stage – by a groundswell of articles, debate and hand-wringing about inequality. The Occupy Wall Street movement and its slogan, “We are the 1%,” largely fizzled out for lack of an agenda, but it drew the attention of a significant number of sympathetic economists and public intellectuals. Driven chiefly by the writings of economics Nobel laureate Joseph Stiglitz, inequality has become a central focus of discussion – especially among those of the political left – and even served as the subject of a speech by President Barack Obama. It was this theme that led to Bill de Blasio’s election as mayor of New York City.
Piketty is clearly an intellectual of the political left, but that is not why his weighty tome will achieve the lasting impact that it is certain to have. Those who focus on what they think are the book’s political goals are missing the point – though so far, surprisingly few have done so. The book uses data to develop a framework for its analysis that will embed it firmly in the intellectual history of the coming decades, if not the coming centuries.
What Piketty’s book is not – and why it is not
In the book’s introduction, Piketty recounts his history of having been hired by a university “near Boston.” (It was MIT, though he doesn’t mention it.) There, he says – perhaps euphemistically – he found the work of U.S. economists “not … entirely convincing.”
He looked forward to returning to his home country of France, he says: “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. … In France, I believe, economists are slightly more interested in persuading historians and sociologists, as well as people outside the academic world, that what they are doing is interesting.”
His work thus falls not into the field of economics per se, but into the field that used to be called political economy. He uses almost no mathematics. Yet as I will show, the mathematics that he does use is crucial.
Piketty justifiably attacks the heart of U.S. economics, criticizing both its mathematical pretense and its vaunted evidence-based scientific discipline:
For far too long economists have sought to define themselves in terms of their supposedly scientific methods. In fact, those methods rely on an immoderate use of mathematical models, which are frequently no more than an excuse for occupying the terrain and masking the vacuity of the content. … Economists today are full of enthusiasm for empirical methods based on controlled experiments. … But these new approaches themselves succumb at times to a certain scientistic illusion. It is possible, for instance, to spend a great deal of time proving the existence of a pure and true causal relation while forgetting that the question itself is of limited interest.
In contrast to many economics papers, articles and books, Piketty’s 577-page book, followed by pages of notes, focuses on only three simple formulas:
- α = r × β, which he calls the “first fundamental law of capitalism,” where α is the share of income from capital in national income, r is the rate of return on capital and β is the capital/income ratio.
- β = s / g, the “second fundamental law of capitalism,” where s is the savings rate as a percent of income and g is the rate of growth of national income.
- r>g, which is not a law but an empirical observation that he claims to show by theoretical arguments to be usually true.
Piketty’s methodology and chief findings
I recommend that you read the book itself because there is so much meat in it. That makes it slow reading however. You’re tempted to mull over almost every sentence. But it is not difficult or nearly impossible reading like much of The Wealth of Nations or The General Theory of Employment, Interest, and Money. It is quite readable, if a little dry.
On the other hand, you can find an excellent shorter synopsis on the Economist blog (may require subscription). Alternatively, this discussion in the New Republic by Nobel prizewinner in economics Robert Solow, a professor emeritus at MIT, is also excellent and a little shorter. (Solow plainly admires the book, even though he himself appears to have been slighted in one of its passages. It is clear that Piketty has little use for American economists, though many of them are treating him as a hero now.)
More than one reviewer has observed that Piketty is trying to piece together a “grand unified theory” of economics. In physics, a grand unified theory is one that unifies all the forces (electricity, magnetism and nuclear forces) under one model. That is what Piketty is trying to do – and he largely succeeds, using only those three simple formulas.
At the center of his formulation is the wealth-to-income ratio, which in his formulas he labels β. The handy thing about this ratio is that it is independent of inflation. Values of β can readily be compared over long periods of time without adjusting for an inflation rate that may not always be available or reliable.
Piketty and several colleagues, including fellow countryman Emmanuel Saez and British economist Anthony B. Atkinson, have laboriously compiled a rich database of economic information reaching back to 1700 and beyond.
This information has been subsumed by Piketty into several widely-circulating graphs. For example, Figure 1 shows the wealth-to-income ratio for Germany, France and the United Kingdom since 1870. (Piketty uses “capital” and “wealth” interchangeably, even though by some definitions they are somewhat different.)
Note the obvious dip from the 1910s to the 1970s. Since then the ratio has started to come back up – and it has continued its rise since 2010, nearing, according to Piketty, the levels of the late 1800s when wealth and privilege in Europe were predominant. (Piketty documents this using passages from novels by Jane Austen and Honoré de Balzac, among other things.)
This drop in wealth was due to a variety of impacts from the two World Wars and the depression, including the destruction of physical capital, establishment of progressive taxes to finance the wars, a fall in stock market values, a fall in real estate values due to the institution of rent controls, low national savings rates and losses of foreign assets (e.g., colonies).
In the United States, the wealth-to-income ratio slumped during that period also, though not to the same extent, largely because the wars did not take place on its territory. However, Figure 2 shows that income inequality – the share of the top decile of incomes in total national income – experienced a low period from about 1945 to 1980, then rose again. It is now reaching heights that were achieved only just before the Great Depression.
The implication from these graphs (and other data and arguments Piketty presents) is inescapable: the period from 1914-80 was an aberration in human history. During the interwar period, European countries experienced an unprecedented drop in the wealth-to-income ratio and in economic inequality, and then they experienced unprecedented growth from 1950-80. A similar – though not quite coincident – pattern exhibited itself in the United States.
Using data going back to the year 0 A.D., Piketty shows that high population growth and high economic growth are recent – and probably fleeting – phenomena. From 0-1700, both population and world economic output grew at only 0.1% per year. From 1700-2012, world output grew 1.6% a year, equally divided between population growth and per capita GDP growth (0.8% from population growth and 0.8% from per capita GDP growth), but most of that growth took place in the 20th century. From 1700-1820, world population grew only 0.4% per year and per capita output only 0.1%. From 1820-1913, growth started to pick up: 0.6% population growth and 0.9% per capita output growth. From 1913-2012, growth soared: 1.4% population growth and 1.6% per capita output growth.
Population growth has slowed in recent years, especially in developed countries, but it has slowed in emerging economies as well. Piketty expects economic growth to moderate. His estimate is that world per capita growth will decline to 1.5% and then drop below that.
And here is where his formulas start to enter the picture. In addition to the projection of 1.5% per capita growth, Piketty assumes a 10% annual savings rate as a percent of income. The second fundamental law of capitalism, β = s / g, therefore says that β, the wealth/income ratio, will (asymptotically, not instantaneously) approach 10/1.5 or almost 7 times in both Europe and the United States. That would be a higher ratio than at any time since the patrimonial societies of old Europe (the world of Austen and Balzac, in which the upper classes were idly at leisure and it was much better to have a substantial inheritance than to work).
Piketty believes this level of wealth/income ratio will be unpalatable or dangerous and that there is virtually no limit to how high it can go. Either the world will be owned by a small group of wealthy families or there will be a popular uprising against them. He believes the situation calls for amelioration and proposes a progressive wealth tax. This is the aspect of his book that has received the most play in the press. Although Piketty seems to firmly believe in such a tax, it is not his main point by far. He is free of false modesty about the effort that he and his colleagues have made to collect their data, but he is modest about its implications:
The sources on which this book draws are more extensive than any previous author has assembled, but they remain imperfect and incomplete. All of my conclusions are by nature tenuous and deserve to be questioned and debated. It is not the purpose of social science research to produce mathematical certainties that can substitute for open, democratic debate in which all shades of opinion are represented.
It will be Piketty’s data and framework, not his conclusions or policy recommendations, that propel his book to the center of discussion and debate about economics and our economic future. The above is only one example of how Piketty uses that data and methodology to draw tentative conclusions about the pattern of economic and demographic history and to make speculative projections.
A wealth of interesting examples and anecdotes
In providing this framework, Piketty’s and his colleagues’ investigations and compilations of data create interesting ways to view a variety of topics. Piketty believes that the ratio of wealth to income tends to be higher with higher levels of inequality. For example, using data on the market value of slaves in the United States in the late 18th and early 19th centuries, Piketty finds that the market value of slaves was roughly equal to the total value of farmland. When the market value of slaves is included, the value of southern capital in the United States exceeded six years of the southern states’ income, while in the slave-free north, total wealth was barely three times annual income, or half as much as in the south. As a result, the North was “relatively egalitarian,” while the South was more patrimonial and “inequalities of ownership took the most extreme and violent form possible,” according to Piketty.
One fascinating insight can be better appreciated by viewing a video of a portion of a panel discussion featuring Piketty and Nobel economists Paul Krugman and Joseph Stiglitz at City University of New York. Starting at about 34:00 in the video, Piketty states his belief that soaring concentrations of wealth could be threatening to our democratic institutions and that the best solution is a progressive tax on net worth. In anticipation of the obvious objection that such a thing is politically impossible, he states, “the history of taxation is full of surprise” – and then goes on to prove it with the graph in Figure 3.
In about 1900 or 1910, Piketty says, there were plenty of people in the U.S. saying a progressive tax would never happen, and still it happened. He says that the United States invented progressive taxation to avoid becoming “class-ridden Europe.” Irving Fisher, the president of the American Economic Association in 1919, warned that there was “a risk that we become as unequal as Europe and this is the biggest threat to the American economy,” according to Piketty. The only time when Germany had a very high top tax rate of 90% was in 1946-48, when America set Germany’s tax rates.
Setting the terms of the debate for the next 25 years
Already, a number of economists and policy experts, especially on the political right, have been questioning, challenging, and debating many of Piketty’s key assumptions and conclusions — as he encourages all readers to do.
But those challengers, who have in many ways dominated the discussion for at least 25 years, will now have to debate Piketty in the terms of the new framework he has advanced. This is because they made the fatal mistake of framing their arguments in “sophisticated” language and arcane mathematics known and understood only by them. For example, dynamic stochastic general equilibrium (DSGE) models, which have occupied much of the efforts of academic economists, are incomprehensible in their assumptions, impenetrable to non-economists and unable to stand up to scrutiny. By contrast, Piketty’s framework is accessible to anyone, not only economists.
Whether or not the ongoing debate comes to the same conclusions that Piketty does, it will take place in his terms for a long time to come – and that is a good thing.
Michael Edesess, a mathematician and economist, is a visiting fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong, a partner and chief investment officer of Denver-based Fair Advisors and a research associate at EDHEC-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, will be published by Berrett-Koehler in spring 2014.
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