Sunday, 11 May 2014

Piketty: right or wrong?

In his book "Capitalism in the Twenty-first Century", Thomas Piketty claims that capitalism has an embedded inequality feature. If not corrected by government intervention, a socially unsustainable level of inequality will be reached, putting not only democracy at risk but eventually leading to the collapse of capitalism.

Marx had argued something similar in the second half of the XIX century. He was proven wrong. Does it mean that Piketty is wrong as well?

He is wrong and right:

1. Piketty is wrong

His assumption that r > g, can't hold true in the long-run (note: r = return on capital; g = economic growth) unless the savings rate is zero and the capital stock stays constant over time (meaning: all income from both capital and labour would be spent on consumption), which in a society with a high concentration of wealth can't be the case - capital owners will save and reinvest part of their capital income leading to an increasing stock of capital.

Keeping in mind that GDP is the sum of the production factors' remuneration - remuneration of capital (including remuneration of land) and remuneration of labour - let's assume (an extreme example, but in-corrections are always easier to detect at the extremes) that

g = 0


r > g
(with part of the income from capital being saved and reinvested leading to a continuous increase in the stock of capital).

This would mean that the share of the remuneration of capital in GDP would increase steadily over time until it reached 100%, leading to a 100% unemployment rate in the long-run. Put differently: all the productivity gains - generated by the increase in the stock of capital (e.g. investment in technology) - would be passed entirely to the owners of capital, who would save and reinvest them and keep substituting labour with capital, people with robots, until there were no more people to be substituted (let's forget for an instance that capital can never fully substitute labour).

This is not possible.

Way before we reached "full unemployment", either

(A) a social revolt would take place and capital start to be massively taxed bringing r down and leading to r = g (with g increasing above 0 as the additional taxes would be transferred directly or indirectly to labour leading to an increase in private consumption, aggregate demand and GDP. I.e. taxation would pass part of the productivity gains to labour)


(B) the productivity gains would have to be directly passed to a large extent to labour. Meaning: reduced working hours / reduced working week (e.g. 4 day work week) / more holidays for employees while keeping their salaries untouched. This would keep the share of the remuneration of labour in GDP constant and, obviously, the share of the remuneration of capital in GDP constant as well. As GDP remained constant (g=0), so would the total absolute remuneration of capital. But as r > g implies an increase in the stock of capital (part of the remuneration of capital is saved), this would result in a decrease of r until it converged progressively to g.

Yes, the law of diminishing marginal returns is like gravity: we may not notice it, but it does exist.

2. Piketty is right

Given that

i) in the long-run we are all death

ii) (A) is surely not a scenario we want to go through while alive

iii) (B) won't happen easily and fast enough on its own

we can't sit on our hands and wait that g converges to r. Otherwise, (A) will happen. And rightly so.

So, the government must act. By taxing income above USD 500k at 80%? No, the Laffer curve with income tax rates above 50% stops being Hollywood fiction to become reality, i.e., bad for growth. With an up to 10% global wealth tax? Not really a good idea. To start with, because it would never be complied with on a global scale.

What to do then? This:

1. Broaden the ownership of capital via government top-ups of pension funds and savings accounts

2. Reform the tax system to one more tilted towards a very progressive income tax instead of indirect taxation to avoid that a large, socially disruptive inequality develops in the first place.

3. More public spending on high quality education and R&D. Education is the best tool to ensure social mobility. Education and R&D combined an effective way to generate sustainable economic growth.

4. Limit the leverage in the financial system. Big capital owners are the ones that have access to large scale financing as they have the resources to put up as collateral. Nothing wrong with this, as long as the financing is used for productivity enhancing activities. However, to a large extend that's not the case and the financing ends up being used for highly leveraged, highly risky financial bets with limited positive impact on the economy's overall productivity. Then again: even this would be perfectly legitimate if when the bets went wrong - pushing their returns over the entire economic cycle down to mediocre levels - the ones pursuing them were held accountable for their mistakes. It would reduce their willingness to pursue them in the first place. Sadly however, and as we all know, when large scale systemic accidents occur, the taxpayer foots the bill - not the ones that freely took the decision to pursue the bets. Thus, creating the incentives for a large scale mis-allocation of resources in the first place. By forcing banks to have much higher equity buffers we would limit the financial leverage in the system and end up with a financial sector both more resilient as well as a more efficient allocator of financial resources to the economy. Productivity would benefit. Sustainable economic growth would be higher and so would be living standards. Socially disruptive inequality contained.

5. Making sure that a fair share of productivity gains is transferred to labour. Besides being able to pursue other interest outside work from which the whole community benefits (any hidden Shakespeares or Picassos out there?), employees with more leisure time and cash in their pockets are a nice source of consumption and aggregate demand. And therefore a positive contribution to g, making the convergence r = g happen at a higher level. And everyone happy.

6. Remember that population aging is a demographic variable. But pension age is not - it is a political one. Raising the pension age is unavoidable if our developed world welfare systems are to remain sustainable. With part of the productivity gains being transferred to labour, it will be easier to persuade employees to accept later retirement: why not work 4 days a week until 75 years of age instead of working 5 days a week until 65? The alternative is to continue to retire at 65 and transfer all the productivity gains, via taxation, to the "young" pensioners to keep the welfare system afloat. You choose.

By the way, transfer of productivity gains to labour and related higher employee remuneration, reduced working hours and increased leisure is what happened since the XIX century in the developed world. It created a broad middle class and proved Marx's prediction of capitalism's collapse wrong.

Piketty may not be right in everything he says, but the inequality debate and its impact on social stability and consequently on sustainable economic growth and general living standards was overdue. Once we understand that the market does, in general, a great job in allocating scarce resources efficiently and is therefore a fantastic wealth creation mechanism, but that it is not able to ensure on its own a socially sustainable distribution of the wealth created putting thus at risk its very and precious existence, the advise can only be one inspired by Henry Ford:

Capitalists of the developed world, unite! Let's bring on the 4-day working week and prove Marx wrong again.

PS Why Henry Ford is a true master of capitalism and source of inspiration:

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