The field of political economy was born in the late 18th century when moral philosophers such as Adam Smith began to ask questions about how nations prosper? What kind of conditions ensure their wealth? and how should this wealth be distributed?
It is not a coincidence that the inception of ‘political economy’ coincides with the birth of the modern state and industrial capitalism in the 19th century. This was the beginning of what’s often called “capitalist development”.
Political economy studies the state-market relationship. In economics, the state is considered to “intervene” in the market to correct market failures, or to provide public goods. This is a rather restrictive definition. In political economy, the state is conceived as actively shaping the market, such that there is not such a clear dividing line between state and market, economy and society, economics and politics.
The contribution of the World Income Database to the study of political economy is to provide 200 years of data to track the history of ‘wealth and income distribution‘. The general conclusion that researchers have drawn from this data is that we are witnessing a level of within country inequality not experienced since the early 19th century.
But before we discuss the determinants of inequality, and the different theories of political economy that explain capitalist development (Lecture 4 and 5), it is important that we clarify some important political economy concepts, such as income and growth.
Part 1 of Capital in the 21st Century is titled Income and Capital. This is where the core definitions are laid out. These videos are a useful starting point:
The first concept to understand is national income.
- This can be defined as the sum of all income available to the residents of a country in a given year. Or more precisely, it is the total amount of money earned in a country. In this course we will use “Gross National Income (GNI)” rather than “Gross Domestic Product (GDP). This is particularly important in the Irish case.
Try to think about national income in real concrete terms. All socio-economic activity, and socio-economic production (whether it is teaching students, driving a bus, serving coffee, providing customer support, designing websites, cleaning roads or manufacturing iPhones) must eventually be distributed as earnings i.e. income.
There are two ways these earnings will be distributed: labour income and capital income. It will be either distributed as labour income (in the form of wages, salaries, bonuses) or capital income (in the form of profit, dividends, and royalties).
National income = labour income + capital income in a given year.
The core critique of the 1% is that their wealth is increasingly accrued not through earnings or profit (entrepreneurs) but through unearned capital income.
Unearned income is the interest/rent accrued from owning property or financial assets.
The income/rent received by virtue of owning an asset (i.e. housing) tends to yield a higher return than income earned through work/employment. It is this observation that underpins Piketty’s theory of R>G, which I will explain later.
If the ownership and inherited power of wealth and capital matter much more than than hard work and human capital (skills), then the normative justification for liberal market economies becomes increasingly problematic.
We will come back to this later, as it’s a controversial argument.
Many economists argue that what matters today in shaping the trajectory of economic development is human capital skill (which is heavily influenced by talent/education/training). But what is corporate capital matters a lot more?
- For now, the crucial point to remember is that national income = capital income + labour income (this is the same whether we are looking at the accounts of a multinational company, a small family firm, a government or the global economy). The definition of national income (all money available) is an accounting identity.
But what exactly is wealth and why does Piketty used the term wealth and capital interchangeably? Capital is a stock, income is a flow. National wealth is the total amount of capital stock (buildings, real estate, land, stocks and bonds) in a country.
Think about it this way: capital/wealth is something you own, and which generates an income. For example, housing is capital (stock), and the rent accrued to a landlord is capital income (flow). The purpose of owning a house to rent is to earn an income.
When you go to work, you earn a monthly wage. This is a flow. When you put aside some of this money into a bank account, it becomes a stock. It’s small form of wealth.
This definition of capital as a stock of wealth is important because Piketty’s conceptualisation of capital has come in for a lot of criticism.
- Capital is accumulated wealth. For definitional purposes, you can define it as the sum total of non-human assets that can be owned and exchanged on some market. It can be either publicly or privately owned. The value of capital is decided by the price someone is willing to pay for it (the market).
Or more precisely:
- Capital/wealth is the sum total of non-financial assets (land, buildings, real estate, industry, machinery) and financial assets (bank accounts, mutual funds, stocks, bonds, insurance and pension funds ) less debt.
Generally speaking, capital or wealth is something that is not immediately consumed. It is something that is owned, and therefore it is defined by property laws.
But not every country defines property in the same way (think about the ownership structure of German firms, and compare them to US firms). It’s a legal construct.
What capital is worth is ultimately determined by market value.
If the market collapses, so does the price of assets and the value of wealth. Think about the spectacular rise and fall (and rise again) of house prices in Ireland. The houses did not burn down. They remained in place. But their market value (price) fluctuated widely.
When the price of a house falls by thirty percent, the person owning that house is likely to feel less wealthy. When the price rises by 50 percent, they felt wealthier. This observation is important because it has a big impact on electoral preferences toward government redistribution policies. Nobody who owns a mortgages wants prices to fall.
Or to put it another way, nobody who owns any form of capital/wealth/property/asset wants the price value to fall, because they will, by definition, lose wealth. Hence, the policy response to the financial crisis was designed to stabilise market prices.
Other examples: think about recent events in Argentina and Turkey. Or think about the value of a Damien Hirst painting. What determines the price of the painting?
The market value might say 100 million, even if the aesthetic value is zilch.
Capital/wealth can be public or private. In theory, all capital/wealth could be owned by the state. In market economies, capital/wealth is almost entirely privately owned.
- National wealth= public wealth + private wealth. Private wealth accounts for most national capital in all of the twenty countries mentioned or studied in the book.
- Public wealth (such as UCD) constitutes a tiny portion of national wealth.
Figure 5.1 captures this disparity in private and public wealth.
Note something very important in this graph: the fluctuations in the value/price of national capital tends to correspond to fluctuations in private wealth.
Given that most wealth is privately owned, and most political economists are not communist, it is perhaps no surprise that scholars focus on fiscal policies to tax wealth, and unproductive assets, rather than calling for them to be nationalised.
Think about the current housing crisis in Dublin. In theory, the state can issue compulsory purchase orders (CPO’s) and take private property into public ownership (as was done in Mayo on behalf of Shell, when the state issues CPO’s on farming land). Alternatively, they can use the fiscal tools of the state, and tax derelict property, such that the owners are forced to sell the property into the market (rather than hoard it).
For Piketty, the best way to analyze the importance of capital/wealth in a society (i.e. capitalism) is to measure the amount of capital (stock) as it relates to income (flow).
Dividing the total capital stock (measured by the market) by national income gives us the wealth/income ratio (β). This is also called the capital/income ratio.
Imagine all the capital in Ireland (housing, land, financial assets). Now imagine the value of all that in terms of a price (billions). Now divide that price by national income. This gives you the ratio, which we tend to express in terms of percentages.
Wealth/income ratios provide us with a comparable quantitative measure to analyze capitalist development across time (history). It allows us to measure whether or not wealth has grown in importance when compared to wages and labour income.
It allows us to observe the structural importance of capital/wealth in society.
However, it tells us nothing about whether that capital/wealth is being put to productive use or not. Nor does it tell us anything about the ownership of capital. For example, housing-capital might be worth billions, but if these are empty, what use are they?
- If a country’s total capital stock (wealth) is equivalent to 6 years of national income we write β = 600%. β is a shorthand to say the capital/income ratio. If it is equivalent to 4 years of national income, we write 400%.
- This graph shows the evolution in the capital/income ratio for Germany, Britain and France.
Back to the case of Ireland, if income per capita is 33k, and wealth per capita is 200k we simply divide the two to find the capital/income ratio (i.e. 6, which we write as 600%).
On a macro-social level we find that, on average, wealth is 6 times average national income. We then say that the capital/income is 6 (or 600%). But remember this tells us nothing about the distribution of wealth. Most people don’t own any wealth at all!
Keep that in mind: 50% of the population are propertyless, or owe significant debt.
In theory, a high capital/income ratio (more wealth) is a good thing. What matters is how it is distributed, and how it’s used. This is the core critique of rising wealth inequality today. Societies are privately wealthy, but publicly poor.
Scholars are concerned that the rise in wealth-income ratios means that wealth is concentrated in fewer and fewer hands, and that it’s not being used productively.
In the book you are reading, Piketty proposes a theoretical mechanism to explain the rise and fall of the capital/income ratio. The theory is R>G.
He suggests the following:
- When the rate of return on capital (r) is equal to economic/wage growth (g) then the capital/income ratio remains stable.
- When the rate of return on capital (r) exceeds economic/wage growth (g) then the capital/income ratio rises. Wealth accumulates.
This is what we observe in the USA and Europe since 1980.
R>G leads to rising capital/income ratios. This suggests ‘private capital is back’. It’s is an implicit critique of the economic theory of skills-based technological change.
It suggests that those who own wealth and property may be entrepreneurs, but over time, they become rentiers. What this means is that over time, as wealth accumulates, inheritance matters more than hard work in the process of wealth accumulation.
Piketty has come in for a lot of criticism from those who argue that the rise in capital/income is mostly accounted for by rising house prices. It is the rise of a property-owning middle class that distinguishes the 21st century, and the type of wealth that most middle class people own is housing. As it’s price rises, so does national wealth.
For example, when we begin to analyse the structural transformation of the composition of wealth over time, from land (18-19th century) to industry (19th-20th century) to finance (21st century), what we will observe is that “financialisation” is intimately connected to the mortgage-debt market, and the buying/selling of houses.
House prices have been rising much faster than wages/income, leading to an increase in the capital/income ratio, and housing is the asset of the middle classes.
From a political science perspective, think about the following question:
What matters more in shaping electoral preferences: home ownership or labour income? Do people who own housing vote differently to those who do not own housing? Why might property owners vote differently to the propertyless?
Lets think about these definitions in real concrete terms. How much does the average person in Europe own in terms of capital/wealth?
- In most western European countries, average private wealth is around €180,000.
- This means that, on average, each person in Europe will own €180,000 worth of capital (think about your savings account/or your parents house).
- This will be divided roughly into €90,000 from residential dwellings (housing) and €90,000 in stocks, bonds, savings and investments.
Remember, these are averages, and just give you a rough sense of what’s going on.
In reality, more than half the population own nothing at all. As we will see, in the US, the top 1% own 80% of all wealth. 50% of the population own nothing.
If the remaining 40% do own any wealth, it is usually nothing more than some savings in a local bank account, which they may have inherited, or received as a gift.
Most wealth/capital is highly concentrated at the very top of the income ladder.
As we will see, and which is completely intuitive, wealth is far more unequally distributed than labour income. Most people work. Most people don’t own capital.
In terms of income:
In France, Germany, Italy, Britain (reflecting an average for Europe) and the USA, national income per capita (per person) is around €30-35,000.
Again, this is an average and hides enormous disparities amongst the population.
Most people earn significantly less than €2,500 a month from their labour income.
Income and capital
- Take the average Irish person.
- If per capita national income is €30,000 per annum (it’s actually higher). According to Piketty this mean that €21,000 will come from labour income (70%) whilst €9,000 will come from capital income (30%).
- If each citizen owns €180,000 in capital this figure of €9,000 equals a rate of return of 5%.
Most people obviously don’t earn €9,000 in capital income because they don’t own any wealth. These are averages.
Most people will pay their landlord rent, and/or pay interest to their creditors (banks) for borrowing i.e. to pay their mortgage debt.
Rate of return
But how exactly do we calculate the rate of return on capital (i.e. capital income)?
- On the basis of historical analysis, Piketty finds that on average, in the long-run, economic growth averages 1-2%, whereas the rate of return on capital is 4-5%.
The book you are reading does not really explain why the average rate of return on capital is 5 percent, which is a major blindspot.
But one way to think about this is in terms of how much interest one can generate from owning a capital asset. Lets go back to the example of owning residential housing.
Owning real estate or property can generate a return of between 3-4 per cent interest. Owning stocks in a firm can generate between 7-8 per cent. Owning German issued government bonds can yield around 1-2 per cent interest. The yield varies.
In Dublin, housing can yield up to 12%! Hence, it should be no surprise that those with money (international investors) are investing in Dublin real estate.
Generally, the riskier the asset, the higher the yield (return). For example, investing in a start-up company. You could lose all your money, or if the firm becomes a success, earn a fortune. Just think about the value of a company such as Apple, or Alphabet.
You should now have a clear sense of what it means to talk about national income, labour income, capital income, national wealth, wealth-income ratio’s, and the rate of return on capital assets.
But even if you know what national income is, this will not tell you about how national income is distributed. Similar, even if you know what national wealth is, it won’t tell you who owns the wealth.
In this course, when we discuss the distribution of national income, and national wealth, we will do so with reference to distributional tables.
In the study of inequality, researchers usually divide up the population into quintiles (bottom 15%, top 20% and so on), or deciles (top 10%, bottom 10%).
- Quintile = 20% of the population
- Decile = 10% of the population
- Percentile = 1% of the population
We will mainly make reference to the bottom 50%, middle 40%, top 10%, and top 1%.
Discussing inequality with reference to distributional tables provides a much more visceral understanding of how income and wealth is distributed.
The most important concepts to remember for this course are:
- Capital/income ratio, also called the wealth/income ratio
- Public/private wealth
- Capital income (income derived from owning assets)
- Labour income (income derived from wages)
- National income (the total income of a country, which flow from the factors of production)
- The rate of return on capital (interest accrued from ownership of property)
- Distribution tables (50/40/10-1).
To understand these concepts think about a 19th century Jane Austen novel, such as Pride and Prejudice.
The aristocratic characters in these stories revolve around the landed gentry of 19th century England. They constantly remark that the rate of return on land in their rural societies is around 4-5 per cent.
They are perfectly aware how much land/wealth they need to live well (or marry into). In this period, almost all wealth was bound up in land. Wealth was land.
How much does one need to live well today?
How would you generate that income: from work or from owning capital?
Next week will talk about the evolution of economic growth. This is crucial because the slow down in economic growth is often considered the most important determinant of the the re-emergence of a rentier society. Why?
- Slow-growth economies are wealth-dominated societies. Think about Italy.
This is why many scholars argue that inherited wealth has become more important than hard work, much like the 19th century societies of patrimonial capitalism in Jane Austen.
In our democratic market societies this is difficult to justify, as it undermines a culture of meritocracy, which is the normative justification for capitalism.
In rich countries individuals are healthier, live longer, have better access to public services and better educated. Why are some countries rich and some countries poor?
Why does this matter? Is economic growth coming to an end? What do economists mean when they talk about secular stagnation? Is economic growth always a good thing?
To explain these contemporary dynamics, and to answer some of these questions, it is worth taking a longer term perspective.
The first thing to note is that measuring “growth” requires examining both population and economic growth. It is the latter (better referred to as productivity growth) that tends to improve aggregate standards of living.
This data shows global economic growth since the industrial revolution.
The law of cumulative growth
It is important to note that a small percentage change compounded over a long period of time accumulates very quickly. A generation of economic growth can spur huge social change. Just think about what Ireland looked like in the 1950’s, then compare it to the 1980’s. Now compare it to 2017. They are literally “generations” apart.
For example, an annual growth rate of 1 per cent is equivalent to a generational growth rate (30 years) of 35 per cent. An annual growth rate of 2.5 per cent is equivalent to a generational growth rate (30 years) of 110 per cent. For purely conceptual purposes, you can think of the latter as a 100% change over a generation.
In contemporary political discourse, politicians and policymakers often assume that a growth rate of 2 per cent per annum is small, and insufficient. But when compounded over 30 years, it can lead to a huge amount of socio-economic change.
Economic change can spur both positive innovation and social dislocation. But it can also create huge societal problems (i.e. housing stock not keeping apace with demand). Relying on the market is not necessarily good public policymaking.
Measuring compound change is called the law of cumulative growth.
When thinking about it in terms of wealth accumulation (as opposed to economic or population growth), it basically means that the annual rate of return (capital income) compounded over several years automatically results in a very large increase.
Hence, if wealth grows faster than wages, we tend to see a divergence in who benefits from economic growth.
- Table 2.2 captures what this means in concrete terms and can be applied to anything from the rate of return on capital, population growth, household income or economic growth.
This is crucial for understanding Piketty’s argument on the inequality R>G.
A small gap between the aggregate economic growth rate (which gives a sense of wage growth) and the rate of return on capital (which gives a sense of wealth accumulation) can accumulate over many years, creating a deep structural divergence in society.
Most economists in the 20th century assumed that there would be a perpetual decline in wealth inequality, and assumed that economic growth would lift all boats (often called trickle down economics). Economic growth was considered something that equalised standards of living, as ultimately, in the end, everyone would benefit.
This is the normative foundation of democratic capitalism: everyone benefits, everyone gains, and not just the elite. Piketty is suggesting this is no longer the case.
Let’s look at population growth for the moment, from antiquity to the present, to get a sense of just how much has changed over time.
- Figure 2.2 depicts the growth rate of the population from year 0 to 2100. The demographic growth rate from year 0 to 1700 was less than 0.1 per cent. But in the end, much of this growth in the population was wiped out by famine and disease.
Population growth increased significantly with improvements in medical technology and sanitary conditions. Demographic growth accelerated significantly from 1700 onwards.
But there was huge variation between countries.
The USA went from a population of less than 3 million in 1780 to 300 million in 2010, whereas during the same time period, in France, it only doubled from 30 to 60 million.
According to UN forecasts the annual population growth rate will fall to 0.4 per cent in 2030 and then 0.1 per cent in the 2070’s.
This is not a course in demography, and we are not interested in demographic growth for its own sake. We are interested in population growth because it has implications for the structure of economic growth, and wealth and income distribution. As Piketty states:
Strong population growth, as in the USA, tends to play an equalizing role in wealth distribution. It decreases the importance of inherited wealth in the sense that every society must reinvent itself.
What does he mean by this? Put simply: if you are one of fifteen children, it is probably not a good idea to rely on inheritance from your parents to generate income and wealth. Conversely, if you are one child, then you’re likely to benefit from inheritance.
The same logic applies on a population wide aggregate basis.
This observation (the equalizing role played by the law of accumulated growth) makes more sense when we extend it to economic growth. Ireland is a good example here.
If you live in a country that is growing rapidly, such as 4 per cent per annum (with wages growing 3 percent), over a generation (30 years), you would be wise to get working, to take advantage. Hence, inward migration to countries with growing economies.
Conversely, in a country with stagnant population and slow economic growth, and with poor employment and wage prospects, inherited wealth and capital accumulated from the past (i.e. from the hard work of your grandparents) takes on much more importance in society. Think about Italy.
This is why people emigrate to fast growing economies.
This is the crucial point for Piketty. The data suggests that western economies are slowing down rapidly but remain rich in wealth. They are capital-asset rich societies, with slowing productivity growth. Hence, the past impacts on the present.
Low growth economies are societies dominated by inherited wealth, and accumulated assets from the past (think Italy or France). Private capital that is owned tends to be saved and hoarded, rather than put to productive use in the real economy (i.e. investing in infrastructure). Think about an empty building in the city centre.
- See table 2.5 for a breakdown of per capita economic output by global regional blocs.
For Piketty, declining economic/productivity growth at the macro-level is the main factor leading to rising wealth inequality over the long-term (the inequality R>G).
Slow growth defined the 18th and 19th century. The fast growth in the 20th century changed this. Piketty suggests it has re-emerged today in the 21st century.
It is crucial to note that it was only during the 20th century that economic growth became a tangible benefit for everyone. Why? Access to health and education were central to this shared growth. The birth of the social state re-distributed growth to the benefit of society.
It was the birth and complement of liberal markets, and democratic welfare states.
In particular, the strong economic growth that swept Europe from 1945-1975 enhanced the possibility of social mobility for those whose parents did not belong to the elite of a previous generation. It also funded the emergence of the ‘social state’ in Europe.
The social state primarily refers to the brith of social rights: universal provision of education, healthcare, eldercare, and in some countries, childcare and social security.
In the post-war period of strong growth, new business models were created. New skills and capabilities were developed. Capital and labour were put to work in different ways.
Economics, however, tells us very little about the distribution of growth. This is a question of politics. Trade unions, for example, played a significant role in making sure the growth was compensated with a strong wage-productivity push, as pointed out by Larry Summers.
If societies want to ensure that the gains of productivity growth and technological innovation are distributed fairly (i.e. not captured through rents by the elite) then this requires an inclusive set of political institutions.
Democracy enables market capitalism because it widens the opportunity space for innovation and inclusion. See the work by Acemoglu and Robinson.
What institutions and public policies are likely to lead to inclusive economic growth? Is it better to live under a dictatorship with a home and a job, than to be unemployment in a democracy?
It is this emphasis on democratic institutions, public policy and electoral choice that defines large parts of contemporary political economy.
Markets are viewed as variegated, and subject to radical mutations and adaptations (not a deterministic techno-economic paradigm), and primarily shaped by politics.
Conversely, Marxist economists anticipate a never ending crises of capitalism (such as the great recession) that will lead to its collapse.
But what about recent events? Does Piketty’s data suggest that perhaps Marx was partially right? Yes and no. We will discuss this next week.
The major impact of technological growth in the 20th century has been in the structure of employment. The structure of economic growth has a huge impact on jobs.
- See table 2.4 on changes to the labour market.
Over 70 per cent of the population in the western world now work in services; even in countries as diverse as France and the USA. This is a broad category and includes high-skill and low-skill service jobs, traded and non-traded.
The defining characteristic in all advanced capitalist economies of the western world is the decline in manufacturing (and low to medium skills more broadly).
What we are witnessing is a growing divide between high and low skilled jobs, with medium skilled jobs (bank clerk, manufacturer etc) in decline. For economists, this is largely driven by the impact of globalisation, and technological change.
Think about the impact of technology on the labour market. For example, consider the impact of the Uber on taxi-drivers, robots on car manufacturing, computers on office clerks, washing machines on cleaners etc.
Here comes the bad news, most research would suggest that the structural shift from ‘manufacturing to services’ has significantly slowed down productivity growth rates, and that these are unlikely to increase in the near future.
Most forecasts suggest that the thirty post-war years of strong economic and productivity growth in Europe were the exception rather than the norm.
The implication is that liberal democracies cannot rely on economic growth to realize their democratic aspirations. This has major implications for electoral politics.
Further, as we will discuss in later lectures, some economists suggest that the determinants of economic growth (technology and productivity improvements) may be in perpetual decline. This is often referred to as ‘secular stagnation‘.
Capital/wealth is running out of places to invest. It’s being hoarded/saved.
Since the 1990’s the policy response to low growth has been to remove the political constraints that inhibit free markets: liberalization, tax cuts, capital mobility, hard currency and austerity.
This is what popular commentators, such as Paul Mason, among others, call the crisis of neoliberalism.
The golden age
- Figures 2.3 shows the comparative evolution of economic growth rates in Europe and North America.
Per capita output surpassed 4 per cent every year in most European countries between 1950-1970. If we exclude Britain it was even higher.
Now think about this in terms of the law of cumulative growth. This was the golden age of capitalism, it’s your parent and grandparents generation.
Note the difference between Europe and the USA from 1940-1975. This difference might explain why Americans do not have the same nostalgia for the ‘golden age of democratic capitalism’, or socialist democracy, as many Europeans do (again, think France).
UN and OECD data now suggests that Europe and the USA look set to enter a new period of low-growth.
Any discussion on the history of growth must, however, include an analysis of inflation. If growth is 3% per annum and inflation is 2% then we say real growth is 1%.
Between 1913 and 1940 inflation in Germany was 17% per annum. Prices rose by a factor of 300. Inflation was widely used to reduce the public debts accumulated during the world wars.
In 1720 England the average income was 30 pounds. Fifty years later, it was barely 40 pounds. Think about the average income in France today compared to the 1950’s.
The crucial point to remember is: monetary markers are stable when economic growth is slow.
Inflation is largely a 20th century phenomenon. It can be explained by distributional politics rather than economic science. See figure 2.6.
We will have more to say about this later in the course.
- Figures 2.4 and 2.5 show that global growth over the past three centuries can be pictured as a bell curve with a very high peak.
Western economic growth peaked from 1940-1975 and then declined. With the ‘neoliberal’ revolution in the 1980’s growth picked up again in the 1990’s, and has since declined again.
As we will see, the period of liberalisation (post 1990’s) was made possible by FIAT money; new credit formation and the financialisation of debt.
The question many scholars are asking today, in the aftermath of the international financial crisis, and the subsequent “great recession”, is whether we will see a new paradigm shift in the architecture of our political economies?
If so, what will define the period of growth over then next 30 years? Will we see the emergence of a new economic paradigm? What will be the structure of economic growth? How will this impact upon the politics of economic inequality?
We have now mapped the history and explained the core concepts.
In the next lecture, I will discuss political economy theories on the determinants of capitalist development, before trying to explain why inequality has increased so rapidly since 1970.
Week 2 slides: Week 2