Lecture 15: The future of global wealth inequality

Introduction

Should democratic societies be concerned about wealth concentration?

In market democracies, the assumed equality of rights of all citizens contrasts sharply with the real inequality of living conditions among people.

The normative justification of this inequality rests upon the assumption of merit.

Figure 11.11 illustrates why Piketty is concerned about inheritance.

This has a tendency to undermine merit. In 1893, Durkheim assumed that liberal democracies would abolish inheritance and property at death.

screen-shot-2016-11-09-at-12-36-46-p-m

Inheritance 

The graph shows that for those born around 1970-1980, 12-15 percent of individuals will inherit the equivalent of what the bottom 50 percent of the population earn in a lifetime.

Piketty suggests that inheritance and rent are problematic in a democracy but inevitable in a market economy. Why? Because in a context of R>G, inheritance will predominate over savings, and earned income.

When Mario Draghi took over as president of the European Central Bank (ECB) his proposal to resolve the Euro crisis was to “fight against rents” in Europe. What he meant by this was the fight against monopolies.

For economists, the term ‘rent’ is usually pejorative as it is assumed to equal the lack of competition in a market, particularly in the non-traded services sector: Construction, real estate, taxis, hairdressers, pharmacists.

But historically ‘rent’ was a term that was used to describe any income that was earned from owning a capital asset.

What is Piketty getting at here? 

For Piketty ‘rent and inheritance’ are not an imperfection in the market. Rather they are the logical consequence of capital accumulation.

He is highlighting that market and economic rationality have nothing to do with democratic rationality. Democracy and social justice require specific institutions of their own, and these cannot be justified in terms of market competition.

When universal suffrage was instituted in the 19th century (and property voting abolished) it ended the legal domination of politics by the wealthy.

But it did not abolish the economic forces capable of producing a society of rentiers.

Global inequality 

Let’s move on to examine why this matters at a global level.

Financial globalization and the inequality of R>G leads to a greater concentration of capital ownership. This automatically contributes to a structural divergence in the ownership of wealth, particularly at the very top of the income distribution.

One way to observe this (the impact of the R>G inequality among the top centile) is to examine global wealth rankings (ranking of billionaires) and global wealth reports.

Both of these rankings illustrate that the rate of return on the largest fortunes has grown significantly faster than average wealth. See the latest Crédit Suisse report here.

It suggests that there are two worlds at the top.

Global wealth

Global inequality of wealth in the early 2010’s is comparable in magnitude to that observed in Europe in 1900-1910.

The top 0.1 percent own 20 percent of global wealth, the top 1 percent own 50 percent of global wealth and the top 10 percent own between 80-90 percent of wealth.

If the top 0.1 percent (4.5 million people) enjoy a 6 percent return on their wealth, whilst average global wealth grows at 2 percent a year, then after 30 years, their share of global capital will increase to 60 percent.

Is this compatible with democracy?

Global tax

Piketty suggests that this type of market regime is not compatible with democracy, and therefore it requires some sort of political intervention.

Hence his proposal for a global wealth tax.

Other mechanisms to redistribute include: inflation, expropriation, nationalisation.

The unequal returns to different types of capital assets (which is heavily dependent upon the initial portfolio size), and the fact that the highest fortunes grow significantly faster than average wealth, amplifies the inequality R>G.

All large fortunes, whether inherited or entrepreneurial in origin, tend to grow at extremely high rates.

Once a fortune is established, the capital grows according to a dynamic of its own.

Money reproduces itself.

But more importantly, inherited wealth accounts for more than half the total amount of the largest fortunes worldwide.

Hence, the entrepreneurial argument does not justify all inequalities of wealth. Fortunes can grow far beyond any rational justification in terms of social utility. This is Piketty’s justification for a progressive annual tax on capital-wealth.

To quote him directly:

Every fortune is partially justified yet potential excessive. Outright theft is rare, as is absolute merit. The advantage of a progressive tax on capital is that it exposes large fortunes to democratic control.

University endowments 

Another way to observe whether greater the endowment/size of capital, the greater the return, is to examine the capital endowment of US universities.

Table 12.2 reports the findings.

The average real rate of return for Ivy League US Universities was 8.2%. The higher rate of return is an outcome of very sophisticated investment strategies.

Most of these top universities invest in high yield assets such as private equity funds, foreign stocks, derivatives, real estate, natural resources and raw materials.

They tend not to invest in US government bonds.

These large returns on capital endowments largely account for the prosperity of the most prestigious US universities.

Should the US government tax these institutions higher and redistribute to poorer colleges? Or should they let billionaires build their own universities?

Sovereign wealth funds 

Consider now the case of sovereign wealth funds and petroleum states. Unlike US universities we don’t know what the investment strategies of these funds are.

The Norwegian sovereign wealth fund is worth about 700 billion. 60 percent of money earned from Norwegian oil is reinvested into the fund, while 40 percent goes to government public services and expenses.

The financial reports of the next two biggest sovereign wealth funds: Abu Dhabi Investment Authority and Saudi Arabia, are more opaque.

Abu Dhabi boasts an average return of 7 percent, whilst Saudi Arabia is approximately 2-3 percent. This is because Saudi Arabia primarily invests in US Treasury bonds.

At a global level, sovereign wealth funds hold total investments that equal $5.3 trillion, of which $3.2 trillion belongs to petroleum exporting states.

This is the same as the fortune of all the worlds billionaires.

Petro states

As oil becomes more scare and its price increases, the inequality R>G would imply that the share of global capital going to petro-states could reach 10-20 percent.

This would not bode well for democracy, as it implies growing economic dependence on oil-producing states.

Their populations are often tiny but their investments are huge.

Can we imagine a democracy blocking sovereign wealth funds from buying up real estate or other assets in a country?

China

A large portion of the global capital stock is accumulating in Asia, particularly China.

In borderless capital-markets, inward Chinese investment is causing some political tension. See figure 12.5.

The big difference between China and the small Arab oil-producing monarchies is that Asian populations are huge. Most of their future investment is likely to be spent on their own domestic populations.

The total real estate and financial assets, net of debt, owned by European households is 70 trillion whereas the sovereign wealth fund in China is less than 3 trillion.

Rich countries are being taken over by domestic oligarchs not China.

Conclusion

Wealth in most western democratic countries is private and cannot be mobilised by governments for public purposes.

For example, during the euro crisis, the Chinese recommended to the EU to mobilise private capital within its borders to solve the Greek debt crisis.

But the EU cannot regulate, tax or mobilise the capital and income it generates within it’s member-states. Small states are competing with each other to reduce capital taxation at the very moment when demand for public expenditure is increasing.

Cautious estimates suggest that unreported financial assets held in tax havens amount to nearly 10 percent of global GDP. Most of this belongs to residents of rich countries.

To overcome these contradictions Piketty proposes a global tax on capital wealth, particularly within the European Union.

Is this feasible?

Discussion 

Is Piketty (among many other scholars) right to be concerned that domestic wealthy oligarchs are in a position to distort democracy?

The slides:lecture-15

Advertisements

Lecture 14: Wealth Inequality in Europe and the USA, 1810-2010.

Introduction 

In this lecture we are returning to the question of wealth inequality.

This is the inequality that arises from the ownership of capital. In 2016, global wealth was estimated estimated to be $262 trillion.

Almost 50% of this is owned by 1% of the world’s population.

In lecture 12, we concluded that the only reason why income inequality declined in the 20th century was because the income arising from capital ownership declined.

This implies that the overall fall in income inequality in Europe, during the 20th century, was almost entirely explained by the fall in capital-income.

It is therefore essential that we understand how this compression in the inequality of wealth came about, and why it is rising again.

Revision

Table 7.2 shows that in all known societies the poorest half of the population own nothing (generally 5% of wealth).

The world of 2016 is no different to the world of the 19th century in this sense.

capital-ownership

The top decile have generally owned between 60-90% of wealth.

The middle classes have generally owned between 5-35%. The emergence of a property owning middle class transformed wealth distribution in the 20th century.

Let’s take a look at these empirical trends in Europe and the USA overtime.

France 

Figure 10.1 depicts trends in wealth inequalities in France from 1810-2010.

What we observe is that the top decile owned between 80-90% of wealth from 1810-1910, which has declined to about 60-65% today.

This longitudinal data is available because of the introduction of an estate tax in 1791 on all forms of wealth: property, assets, bonds, savings, land.

Looking at these trends in capital ownership, it is interesting to ask what would have happened had there been no war? The shocks of the two world wars disrupted the dynamics of wealth distribution because it ushered in the era of capital taxes.

Inequality of capital ownership remained stable at an extremely high level throughout the 18th and 19th century. The top decile owned 80-90% whereas the top centile owned 50-60%. The French revolution had very little impact on this.

France was a patrimonial society, characterised by a hyper-concentration of wealth. This was generally the case throughout Europe.

When the top decile’s share of wealth in the 20th century declined, it went exclusively to the middle 40 percent of the population. The poorest 50 percent owned nothing in the 19th and 21st century. This has not changed.

Britain and Sweden 

Figure 10.3 and 10.4 show that the same extreme concentration of capital ownership and wealth existed in Britain and Sweden. Germany was also very similar.

In Britain, the top decile owned 80-90 percent of total wealth in 1910, which has declined to about 70 percent today.

In 1910, Sweden was just as unequal. It was nothing like the egalitarian country it became during the 1970’s.

The essential difference today is that there is a home owning middle class, who own about one third of national wealth, and most of which is bound up in housing capital.

Much like in France, the wealthiest 10 percent lost to the middle 40 percent during the period of strong growth in the 20th century (the period of democratic capitalism).

Nothing went to the poorest half of the population.

USA

Figure 10.5 shows that in the USA the top 10 percent owned 80% of total wealth in 1910, and which has remained more stable, and equates to about 75 percent today.

We are accustomed to the fact that the US is more unequal that Europe, and that public opinion in the US is more tolerant of inequalities. But this was not always the case. A century ago, the US prided itself on the fact that it was more egalitarian than Europe.

From 1910-1930, the US pioneered a progressive income and wealth tax to limit growing inequalities. In the early 20th century, high levels of inequality were deemed incompatible with the democratic values of the free-world.

Hence, perceptions and attitudes toward inequality and redistribution have changed a great deal over the 20th century. Why? Does the media have a role to play?

Europe/USA

Figure 10.6 compares capital ownership and wealth inequality in Europe and the USA.

The decline in Europe during the 20th century created a perception that capital had been tamed, and that the role of the state was to guarantee social rights, and that inherited wealth mattered less than hard work and merit.

Keep in mind the history, post WW1, there was an assumption economic inequalities created a sharply divided class society, and that this was to be relegated to the past.

The Mechanism of Divergence: R>G

What explains the hyper-concentration of wealth and capital up until WW1, it’s subsequent decline, and it’s rise again?

For Piketty, the fundamental macro-social driving force is the inequality R>G.

These were low-growth societies (G), where rate of return on capital (R) was markedly higher than economic growth. Capital income outstripped labour income.

If G=1% and R=5% then fortunes grow faster than the economy. Capital accumulates and concentrates. This is an ideal condition for an ‘inheritance society’.

Most wealth during the 18th and 19th century came from inheritance. This is what Piketty calls ‘Patrimonial Capitalism’. He also think this is the future of the 21st century.

Why?

It is important to note that the inequality R>G is a historical-empirical observation and not a logical necessity. It can always be otherwise. Figure 10.9 illustrates the point.

The rate of return on capital (pre-tax) has always been higher than the world growth rate.

Throughout human history the rate of return on capital has generally been 10-20 times greater than economic growth (and income). The gap narrowed in the 20th century because of politics, and those public policies that were explicitly aimed at reducing class inequalities. Absent political and fiscal intervention, it will rise again.

Global growth is set to slowdown, as successive IMF reports suggest. This correlates with a rapid rise in wealth inequality, documented in this recent Oxfam report.

In a context of slow growth, high-capital returns and rising wealth inequalities, it is easy to see why Piketty proposes new taxes on wealth/capital to reduce the R-G inequality.

The argument against this fiscal policy proposal is that increasing taxes on wealth and capital discourages economic and income growth/investment. But does it?

Taxes and growth

Before WW1 taxes on capital, profits and property were very low. This changed after WW1.

Since 1980, and with heightened international competition for capital investment, they have become very low again.

Piketty hypothesises that the logical end goal of corporate tax competition between nation-states is a 0% capital tax regime.

Figure 10.10 and figure 10.11 hypothesise what will happen if taxes on capital continue to decrease  (intensified capital tax competition) into the 21st century. R>G will return.

What the data suggests is that the after-tax return to capital fell from 1913-1950 (higher capital taxes) and continued to decline from 1950-2010 (stronger economic growth).

During the 20th century, and for the first time in history, the net return on capital was less than the income-growth rate. It was better to work that rely on inheritance.

The social state

This was the period during which the social (welfare) state, committed to providing certain public services and income protection, as a social right, was born.

Democracy gave birth to “social’ rights” not market competition.

The social state is now under increasing strain because of growing international market constraints to both increase public expenditure and cut taxes.

This is often described as the crisis of fiscal democracy i.e. who is going to pick up the bill to pay for democratically enshrined social rights and electorally demanding services?

The role of politics 

Figures 10.10 and 10.11 rely on the assumption that there will be no political intervention to alter the trajectory of financial globalisation over the coming century.

But is this plausible? Will democracies accept rising wealth-income inequalities?

The R>G inequality is a logical outcome of free and competitive capital markets, but it is also institutionally embedded and shaped by public policies, politics and institutions.

To reverse the R>G inequality, economic growth would need to exceed 2 percent over the coming decades and/or taxes on capital would need to reduce the net return to below 3 percent. Absent this, capital/income ratios will continue to grow.

There is no equilibrium distribution of wealth. Left to its own devises, the market will ensure that the inequality in capital ownership and wealth will grow indefinitely.

The freer the capital-market, the greater the inequality of wealth.

Impact of war

We still need to explain why wealth inequalities have not returned to 19th century levels?

One of the most important reasons was that WW1 and WW2 brought an end to inheritance.

A new generation did not have the luxury of inheriting fortunes that would enable them to live as their grandparents had, which in some cases was +100 times the average.

  • The rich/elite lost a lot of their capital assets (not least in their foreign colonies).
  • Governments defaulted on the sovereign debt owned to wealthy individuals.
  • Industrial firms were closed or nationalised.

This meant that those at very top of the wealth distribution were disproportionately effected by the shocks of the war, and the subsequent public policies that were instituted.

Taxation 

Total private wealth, measured in capital/income ratios, has now regained the level it attained on the eve of WW1.

The reason why it is has not become as unequally distributed is because governments now tax capital (and capital income) at significant rates.

Up until WW1 there was no tax on corporate profits.

If capital grows at 5% and the average capital tax rate is 30% then the net after tax return to capital will be around 3.5%.

Taxes on capital do not modify the accumulation of wealth. Rather they affect the distribution of wealth. Think about the case of Apple.

Did Ireland’s fiscal policy impact on Apple technology and production? No. But it did impact how their profits were distributed.

Conclusion

Wealth inequalities grew throughout the 18th-19th century because of the inequality R>G. The birth of the democratic state put an end to this.

The 18th-19th century was a period of ‘patrimonial capitalism’. In the 20th century, Europe and the USA instituted a new regime of democratic capitalism. Many suggest that this regime came to an end with financial globalisation, from the 1980’s onwards.

Wealth inequalities declined in the 20th century because of the shocks war and the creation the social state, in addition to the emergence of a property owning middle class.

Piketty suggests wealth inequality will increase to 19th century levels again because of:

  • The return of the inequality R>G (slower growth)
  • Increased tax competition among nation-states in a global financial market.

On this basis, it should be obvious why Piketty proposes a global wealth tax. He considers this the only option to defend democracy against wealth inequalities.

Question/discussion: is the R>G inequality plausible as an explanation for wealth inequalities? How does he measure the rate of return on capital?

Does IT adequately address the comparative differences we observe between countries?

Class discussion: do societies trust the state to raise new taxes and deliver services?

Slides: Lecture 14

Lecture 13: Explaining Rising Inequality; Winner Takes All Politics?

Introduction

Last week we discussed the rise in income inequality in the USA and its relationship to the global financial crisis. We noted that the rise in income inequality has occurred everywhere, but it is particularly pronounced in the USA and the UK. We also noted that this is directly associated with the rise in the incomes of the top 1 percent.

But what caused this rapid rise in income inequality, when measured as the rise in incomes of the top 1%, and stagnation of working/middle income wages?

Most economic explanations tend to emphasise apolitical processes of economic change: education, skills and technology. These certainly matter in the long run. Education and technology are perhaps the most important long term drivers of productivity improvements.

But most economic accounts of technological change cannot explain:

  1. The extreme concentration of income gains at the very top of the economic ladder.
  2. The role of public policy in creating a winner takes-all pattern.
  3. The change in the collective and organisational landscape of politics.

Winner takes all politics

The concept of “winner-takes-all politics” is a critique of the conception of democratic politics that emphasises the “median voter”. This perspective emphasises the role of “organized interests” in shaping electoral politics and the process of policymaking.

Jacob Hacker and Paul Pierson (2010) have long argued that political economists are wedded to a conception of public policy that assumes the electorate shape economic policy outcomes. From their perspective, economic policy is predominantly shaped by corporate-business elites (i.e. business interests outside the electoral process).

They start with the question: If electorates determine economic policy, then why don’t the poor soak the rich (given that most people earn below the median wage)?

They argue that to explain the phenomenon of rising economic inequality in the USA we need to analyse policymaking as “organised combat” between organised interests.

For Hacker & Pierson, the winner takes-all dynamic (i.e. where most income gains go to the top 1%) is rooted in how four different institutions shape public policy outcomes:

  • Financial markets
  • Corporate governance
  • Workplace relations
  • Taxation

I will return to these later. But before we discuss these policy spheres, we need to understand why countries differ in terms of their national models of capitalism.

National models of capitalism 

Piketty also acknowledges the important role of political and economic institutions (chapter 9) in shaping the cross-national variation in patterns of income inequality.  But in the end, he gives priority to different ideas of fair compensation.

It is important to note that the explosion in wage inequalities is predominately an Anglo-Saxon phenomenon. In particular, it is a UK and US phenomenon. Why?

Figures 9.2, 9.3 and 9.4 show the share of the top percentile in Anglo-Saxon, Continental and Northern European countries. Note the variations.

This family resemblance in different countries should not obscure important differences between countries. But there is a clear clustering effect. English speaking countries are significantly more unequal than their continental and Scandinavian neighbours.

There are 3 important characteristics of the Anglo-Saxon dynamic of inequality:

  1. Gains have been highly concentrated. The top percentile in the US have seen their share of national income rise from 9 to 23.5 percent.
  2. Gains have been sustained, regardless of the partisan nature of government.
    • Figure 1 in Hacker & Pierson (2010) shows that this concentration began with Ronald Reagan and continued under every subsequent administration, regardless of whether it was a Democrat or Republican president.
  3. Gains have not resulted in a trickle down effect. Wages at the bottom and middle have stagnated for a long period of time.

Between 1979 and 2005 the average incomes of the poorest fifth of US households increased by 6%. The middle classes saw their incomes rise by 21%, whilst the after-tax income of the top 1 percent rose by 230%.

So, ask yourself: Can different levels of education and skill  explain this outcome?

The macroeconomist, Gregory Mankiw, argues that the “golden ticket” of elite education is what grants grants access to the 1%, and that this is a meritocratic process, driven by market competition. But is it? Is it not more related to politics and social class?

Compatibility with democracy

Is this extreme rise in economic inequality compatible with democracy?

In most political economy models, median voter theories would suggest that the majority of the electorate should vote for governments who favor redistribution. This, however, is not the case. People don’t just vote in pure economic self-interest.

This is what’s often called the “Robin Hood” paradox.

Median voter models of behavioural science are useful for explaining general trends but they are less capable of explaining the Robin Hood paradox.

But if voters do not run the show, who does?

As mentioned above, answering this question requires going beyond the voter-party relationship, and analyzing politics as a form of “organised combat” between competing interest groups, particularly the “quiet politics” of corporate influence.

This perspective gives priority to the business-politics relationship over electoral politics, and makes three important claims about who actually makes economic policy decisions:

  1. Government involvement in the economy is broad and deep.
    • Governments do not simply redistribute what markets produce. They actively structure markets in ways that shape economic outcomes. The role of the state in the market varies significantly between countries.
  2. The transformation of policy occurs through drift.
    • Policymakers can effect change by not taking decisions. This suggests that policy change does not occur primarily because of entrenched interests and political vetoes in the policymaking process. Lobbying results in non-decisions.
  3. Shifts in the balance of organised interests as the driver of policy change.
    • What governments actually do (make policy/legislation) is a long hard battle between competing organised interests that often takes place outside the media and electoral spotlight.

Politics as a form of organised combat 

Organised interests influence and build coalitions of interest within and between political parties in government. Political parties are anchored in various interest groups, and agents of societal interests.

The implication is that political parties have become more responsive to the concerns of economic interest groups, and less the preference of the median voter.

Drift is the cheapest way to abandon the median voter.

But ask yourself, is this true? Whilst recent empirical studies tend to support the hypothesis (Bartels et al 2005, Osberg et al 2006) that national policy generally reflects the preferences of high income over low income voters, surely governments don’t only make policies that benefit the highest earners?

Why?

Another crucial empirical finding in the literature is that voter participation is generally lower when economic inequality is higher (Solt et al 2009). This begs the question: Does low voter turn-out increase inequality, or is the causal mechanism the other way around?

The most important process institutional change from the 1970’s onwards is the rapid rise in corporate-business lobbying and the decline of organized labour.

Declining mass membership

Economists usually focus on how trade union membership contributes to greater equality through their bargaining effect on lower wages. Low to median income earners who are members of a trade union earn more than their equivalent in non-union firms.

Over the past 30 years, mass membership organizations (trade unions, political parties) have atrophied and been replaced by the professional management of advocacy/lobbying groups. The organizational capacity of business has expanded, whereas the organisational capacity of labour has declined.

unions

But can we conclude that this socio-structural shift has led to major changes in the governance of political economy, and rising economic inequality?

Hacker and Pierson (2010) say yes, for the USA.

Winner takes all

Their empirical research demonstrates that change in the following four policy arenas has contributed toward rising inequality:

  1. Fiscal/Taxes. Most tax cuts for super-high incomes were the outcome of successful lobbying by anti-tax groups and free market think tanks, such as the Cato Institute.
  2. Labour relations. Private sector unionisation has virtually collapsed in the US. Public policies have never been updated to stem this decline. Governments actively avoided intervening to stem the decline.
  3. Corporate governance and executive compensation. Total compensation for the top three executives in the US has skyrocketed since the 1980’s. There has been no-intervention from government to stem the rising power of managerialism.
  4. Financial de-regulation. The rise of finance is virtually synonymous with the rise of winner takes-all. In 2005, five hedge fund managers made $500m. The average managerial salary of the top 500 S&P is $30 million. FIRE (finance, insurance and real estate) have more lobbying and campaign finance resources, and have actively shaped policies of financial regulation.

Conclusion

Explaining the winner takes-all dynamic (the growth in the share of the top decile/centile in national income) requires a political perspective that sees modern capitalist markets (big firms) and electoral democracies (state/party elites) as deeply interconnected.

This is what we call the study political economy.

On the one hand, governments (and political parties) actively shape and influence markets through a range of public policies. But on the other hand, private business interest groups actively shape how political authority is exercised.

Economists generally explain rising wage inequalities as the outcome of impersonal market and technological forces (markets). Recent political science research give priority to the role of the median voter (politics).

I have suggested that economic policymaking is more related to how corporate-financial interests are capable of shaping public policies (taxes, finance and labor markets) to advance their own economic interests (business-state relations).

The decrease in the top marginal tax rate of very high incomes in the US is a case in point. This is  what Pepper Culpepper (2016) calls  ‘quiet politics’, whereby ‘instrumental power (lobbying)’ and ‘structural power’ (capital-resource dependence) influence decision making. This “power” cannot be directly observed in electoral behaviour.

In the Irish case – think about the role of the IFSC Clearing House Group (now called the Industry Advisory Group) in shaping the Irish governments policy on whether or not to accept a coordinated financial transaction tax in Europe. Or think about the influence of the private real estate companies/lobby groups in housing policy.

Lecture slides: Lecture 13

Lecture 12: Inequality and the 1% in Europe and the USA

Introduction

The increase in income inequality since 1970 has not been the same everywhere. Why?

Political and institutional factors play a key role in shaping cross-national variation between countries. Explaining this difference is a core part of the study of comparative political economy.

To illustrate this, let’s examine the evolution of top incomes in France and the USA.

Figures 8.1 and 8.2 depicts the share of the upper decile (and centile) in national income in France (the trend in France is broadly similar for most continental European countries).

The reduction of inequality in France

Four observations stand out from this data:

  1. Income inequality has greatly diminished in France since the Belle Époque. The share of the top decile in national income declined from 45-50% on the eve of WW1 to 30-35% today. This does not mean France is an equal society but it shows that the society of the 19th century was deeply inegalitarian.
  2. The compression of income inequality was entirely due to diminished top incomes from capital. If we only look at wage inequality we’ll see that this has remained stable over time. The least well paid have always received around 25-30 percent of total wages. This has not changed that much over time.
  3. In particular, the share of the top centile (the 1%) in national income has greatly declined over the 20th century. If top incomes from capital (the 19th century rentier class) had not diminished, income inequality would not have declined the 20th century. Hence, it’s the fall in capital income that explains the fall in inequality.
  4. There is no natural equilibrium in the shape of the income distribution. It is shaped by politics, public policy choices and institutions.

The reduction in inequality in France during the 20th century can be explained by what Piketty calls “the fall of the rentier” and the collapse of very high incomes from capital. No generalized structural process of wage inequality compression has occurred.

Piketty suggests that war rather than democratic rationality erased the past and allowed European countries to begin anew.

The different worlds of the top decile

Figures 8.3 and 8.4 depicts the composition of incomes for the top decile in France in 1932 and 2005.

We can see that a significant change has occurred. Today, one has to climb much higher up the social hierarchy before before income from capital outweighs income from labour.

Income from capital only assumes decisive importance in the top one thousandth or 0.1%. The top decile has changed from one occupied by land owners to those employed as ‘super managers’.

In the top 9 percent in France you will mainly find individuals who earn 2-3 times the average monthly wage ($2,000). In other words, this group earns, on average between $4-6,000 a month.

These are mainly private sector managers, doctors, lawyers, senior officials and university professors.

  • Remember it is pre-tax!

To make it into the top half of the 9 percent requires attaining an income 4-5 times the average monthly wage ($8-10,000 a month).  This includes a lot of senior business-finance managers and corporate lawyers.

To make it into the top 1 percent it is necessary to earn an income that is 7-10 times larger than the average monthly wage ($15-20,000 a month). But to make it into the top one thousandth, it is only those who substantial amounts of financial capital assets are only like to reach this level of income.

Labour market changes

Sometimes the quantitative must become qualitative to understand the social world within which we live.

Previously, the lowest  wage earners were farm labourers and domestic servants. Today the lowest-paid jobs are in the service sector: retail, catering, hotels, leisure, security and cleaners.

The occupational composition of the labour market has been fundamentally transformed  over time, but the structure of wage inequality has barely changed at all.

The bottom 50 percent still take the same share of national income.

The 1 Percent

The top decile always composes two different worlds: the 9% in which income from labour dominates, and the 1% in which income from capital becomes progressively more important.

This is not to say that someone in the 9% earns nothing from capital.

A manager on an income of $5,000 per month might rent out an apartment at $1,000 per month, and/or hold shares in his/her firm. This is a monthly income of $6,000. 80% of his/her income will come from labour and 20% from capital.

Most capital-income that supplements labour-income among the 99 percent comes from real estate. In the top 1% it is primarily business and financial: dividends and interest from mobile capital. In the top one thousandth it is almost entirely a return on financial dividends.

Large fortunes primarily consist of financial assets (stocks and shares in partnerships).

Tax evasion

It is important to note that figures 8.3 and 8.4 are pre-tax returns and therefore the estimates are based solely on income from capital that is reported in national tax returns accounts.

Actual capital income is, therefore, probably completed under-estimated, owing to large scale tax evasion (it is much easier to hide investment income than it is is to hide wage income).

This can be achieved by using foreign bank accounts in countries that do not cooperate with the country in which the taxpayer resides and using quasi-legal tax-exemption strategies on whole categories of capital income.

It is extremely difficult to measure capital income. Very large capital income fortunes are often inherited.

France since 1980

The long-term stability in wage inequality should not mask short-term fluctuations.

For example, after May 1968 Charles De Gaulle’s government increased the minimum wage by 20%. It was then indexed to the average wage such that the purchasing power of the low paid increased by more than 130 percent between 1968′ and 1983′.

Figure 9.1 shows the evolution of the minimum wage in France and the USA.

This political effect this had on the labour market led to a significant compression of wage inequalities.

The turn toward fiscal austerity and wage competitiveness from the 1980’s, particularly under Mitterand, meant that this compression was reversed. Wages were frozen and profits increased.

From the late 1990’s, when the purchasing power of the bottom 50 percent stagnated, it increased for the top decile, primarily because of a new phenomena: super salaries at the very top (where purchasing power increased by 50 percent).

It’s also related to occupational upgrading.

Inequality in the USA

screen-shot-2016-10-19-at-11-44-20-a-m

Figures 8.5 and 8.6 represent the share of the top decile (and centile) in national income in the USA.

The most striking fact is that the USA has become much more inegalitarian than France (and Europe). It is quantitatively as extreme as Old Europe in the first decade of the 20th century.

Inequality was at it’s lowest from 1950-1980 in the USA where the top decile took 30-35 percent of national income (the same as most of Europe today).

This is what Paul Krugman describes as “the America we love”, the period of the TV series Mad Men.

The explosion since 1980

Since 1980 income inequality has exploded. The shape of the curve is impressively steep (from 35 percent to 52 percent today). If it continues it will go beyond 60 percent in 2030.

Remember, this most likely under-estimates the returns to capital income because of tax evasion strategies.

The financial crisis did not impact on the structural increase in inequality at all.

Figure 8.6 shows that the bulk of the increase in inequality came from the 1% whose share in national income rose from 9 percent in the 1970’s to a staggering 20 percent today.

The top 1 percent include those making $352,00 a year. The 4 percent earn between $150-350k, and the 5 percent between $108-150k. The top 0.1 percent earn $1.5 million a year (US academic economists are usually in the top 4 percent).

Hence, the largest fortunes are in the top 0.01 percent.

Cause of the financial crisis?

Given that US income inequality peaked at extremely high levels in both 1929 and 2007 it seems reasonable to ask whether it was a causal factor behind the financial crisis of 2008?

This is a tough question to answer. But it is not unreasonable to assume that it contributed to financial instability. Inequality meant a virtual stagnation of the purchasing power of low to middle income earners. The implication is that low income earners had to substitute their declining wages with rising credit-card debt.

This debt was repackaged and recycled into complex and increasingly uncertain financial markets.

Larger share of the pie

From 1977-2007 (the eve of the crisis), the richest 10 percent appropriated three quarters of all economic growth.

The top 1 percent absorbed a staggering 60 percent of the total increase of US national income during this period.

For the bottom 90 percent the rate of income growth was less than 0.5 percent per annum. Is it possible to imagine a democratic society accepting such divergences between social groups for long period of time?

To get a sense of how this compares to Europe, see Figure 9.8.

The rise of the super-manager

What caused this rapid rise in inequality in the USA?

For Piketty, it was largely a result of rising wage inequalities and the rise of top salaries for super managers in large US firms (something we will discuss more next week). This accounts for two thirds of the increase. One third is associated with capital income.

For example, Anthony Noto, the COO of Twitter, received a total compensation package of $74 million in 2014. This is for a company that doesn’t even make money!

Is this skills-based remuneration (and therefore based on merit) or favourable tax treatment for the rich (i.e. based politics)?

Figure 8.9 and 8.10 depicts the precise composition of top income in the upper centile.

In 1929 income from capital was the primary source of income for the top 1%. In 2007 one had to climb into the top 0.1% for this to be true.

Qualitatively, who are all these people?

60 to 70 percent of the top 0.1 percent ($1.5m per annum) consisted of top managers. Athletes, actors, and celebrities make up less than 5 percent. It is more about super managers, and corporate executives, than it is about super stars.

Who are these super managers in the 0.1 percent? 20 percent work for banks and financial institutions whilst approximately 80 percent work in the non-financial sector.

Conclusion 

The debate that tends to dominate from a macroeconomic point of view (regardless of whether you think rising inequality is justified or not) is the stagnation of wages and productivity for the majority, rather than the exponential increase at the top.

Why does Piketty focus so much on top incomes?

Market economies require mass consumption. There are only two ways this can happen: wage growth or private debt (credit cards). Hence, there are huge macro economic implications for to rising income inequalities. It undermines capitalism.

Next week we will examine the role of politics and institutions in explaining the cross-national variation in different models of capitalism in Europe and the USA.

lecture-12-3

 

Lecture 11: Income Inequality in Europe and the USA

Introduction 

In all societies income inequality can be unpacked into three interactive terms:

  • inequality in income from labour
  • inequality in income arising from the ownership of capital
  • and the interaction between these two terms

The causal mechanism, and normative justification, underpinning each of these is different.

What is Vautrin’s social lesson to Rastignac in Balzac’s Père Goriot? Why does Piketty use this story to explain the difference between work, merit and inheritance?

Vautrin explains to Rastignac that it is illusory to think that social success can be achieved through study, talent and effort.

He explains to Rastignac what income he can expect to earn, and what career paths he can expect to pursue in the various professions in France at the time, such as medicine or law, where learned competences/skills are more necessary than inherited wealth.

Vautrin claims that even if Rastingnac is talented and learns brilliant skills, he will never become wealthy. By contrast, the best strategy for social success is inheritance. On this basis he encourage Rastignac to marry Mademoiselle Victorine.

But to do this he must first murder her brother, to ensure that she gets the inheritance. Rastingnac is prepared to marry without love but not quite prepared to commit murder.

The key question being proposed by this moral dilemma is whether it pays to work if dishonesty, petty crime, inheritance and corruption matter much more for success. If such deep social inequalities exist, why should anyone bother to follow societal norms and market rules?

The structure of wealth and income hierarchies in 19th century Europe meant that the standard of living of the wealthiest greatly exceeded that of those who earned their income from labour.

Under such conditions why not be immoral and appropriate capital by whatever means?

The key question: work or inheritance? 

In these societies (which existed in all European countries until World War 1) the question of work/labour/skill did not arise. All that mattered was the size of one’s wealth and the size of one’s fortune, whether acquired through inheritance or marriage.

The shock of WW1 brought these patrimonial societies to an end. But Piketty suggests that rising wealth inequalities today mean they are making a comeback.

Democratic capitalism is founded on the normative belief that those inequalities that are based on merit, talent and hard work are more justified than other inequalities, such as inheritance.

For example, it is probably safe to assume that those who work the hardest in this class will most likely get the best grades. Everyone would rightly abhor a situation whereby grades were distributed on the basis of favour or social class.

Inequalities need normative justification.

Liberal capitalism is justified on the basis that free markets encourage fair and open competition, and that rewards are distributed on the basis of hard work, not corporate influence and power.

The core question to ask yourself over the coming weeks is whether we live in a society where social class matters more than hard work and merit? Do we live in a meritocracy? Does this vary by country, region and city?

For example, ask yourself which countries have the highest levels and lowest levels of social mobility.

Inequalities with respect to labor and capital

To answer these questions we need to distinguish between those inequalities that arise from selling labour and owning capital. Lets remind ourselves of some basic trends and concepts.

  • Income can be expressed as the sum total of all income from labor (usually wages and salaries) and capital (usually rent, interest, capital gains).
  • Total income inequality is the result of adding up these two components: inequality of income from labour and inequality of income from capital.

The more unequally distributed both of these are, the greater the total level of income inequality.

It is not always true that individuals with high income from labour/wages have a high income from capital, and vice versa. Jane Austen’s heroes owned so much capital (land) that they did not have to work. They had no labour income. They didn’t need a wage.

The difference 

There are two reasons why we need to understand these differences.

  • First, for normative reasons, the justification of inequality arising from labour effort is totally different from inequalities associated with inherited wealth and owning capital. There is probably only one Messi in the world. We tend to accept that it is justifiable that he earns a huge labour income from his very particular footballing skills (but not his tax avoidance).
  • Second, the causal mechanism that explains how rising wealth and wage inequalities, and how they change, are totally different.
    • In the case of wages/labour, what matters most is the supply and demand for different skills within a given labour market; the quality and type of the educational system in place; the rules and institutions of the labour market; the strength of trade unions and the structure of collective bargaining.
  • In the case of the inequality that arises from income from capital, what matters most are cross-national differences in the organisation of capital/finance markets; savings and investment behaviour;  laws on inheritance; and the operation of rental and housing/land markets.

Inequality has multiple dimensions and different mechanisms and cannot be adequately captured in unidimensional indicators.

Synthetic indices such as the Gini coefficient (ranging from 0-1) tend to lump all of these different things together. We are going to use distribution tables, which express inequalities in terms of social class. To quote Piketty directly:

distribution tables allow us to have a more concrete and visceral understanding of social inequality. They emphasize the shares of national wealth and income held by different groups, as well as an appreciation of the data to study these issues…the Gini coefficient gives a sterile and atemporal view of inequality.

Inequalities: some orders of magnitude 

There are two regularities/trends in the study of income inequality.

First, capital income is always more unequally distributed than labour income. This is the case in all time periods and all countries, without exception. The ownership of capital is significantly more concentrated than labour. Therefore, by definition, it is more unequally distributed.

Second, the concentration of capital ownership is explained mainly by inherited wealth and its cumulative effects (it is easier to save if you inherit an apartment and don’t have to pay rent).

inequalities with respect to labour income (wages) always seem moderate whereas inequalities with respect to capital always seem more extreme.

In public discourse we tend to think and talk more about wage inequality, primarily because most of us don’t experience capital inequality in the same way. Just think of the media coverage given to the Dublin Bus drivers wage demand, and the coverage given to massive increases in asset/capital prices.

Inequality of income distribution 

Tables 7.1, 7.2, and 7.3 chart the distribution of inequality from labour income, capital income, and total income.

They give an indicative picture of low, medium and highly unequal countries. Note: they are before taxes.

The top 10% of the labour income distribution usually receive 25-35% of total labour income, whereas the top 10% of capital owners usually receive 50% of all wealth (and in some societies as much as 90%).

Lets examine each of these distribution tables in turn (inequalities of labour income, capital income and the sum total).

Table 7.1 illustrates that in societies where labour income inequality is low (Scandinavia in the 1970’s), the top 10% received 20% of labour income, the middle 40% took 45% of labour income, and the bottom 50% took 35%.

In real terms: if average pay is €2,000 per month, the top 10% would take €4,000 (the top 1% would take €6,000) the bottom 50% would take €1,400 and the middle 40% would take €2,250.

Labour income is almost entirely earned wages and constitutes around three quarters of all national income. Most people live off their wages, not income earned from owning capital.

Piketty uses deciles (10 percent) and centiles (1 percent) to discuss distribution and inequality. These may lack the poetry of peasants, nobles, elites, workers and bourgeoise. But they enable us to make clear statistical comparisons across time and space.

Top decile/centile 

When discussing the top decile it is essential that we distinguish between the top 9 and 1 percent.

This was one of the major innovations of Piketty. He demonstrates that it is the top 1 percent, or more precisely the top one thousandth, where most of the change (inequality) has taken place, over the past 30 years.

Remember the top centile is the top 1 percent. This means that in the USA, with a population of 320 million, the top centile is 2.6 million individuals (adults). This is a numerically large group of people, capable of significant political influence.

The USA

The one country that stands out from table 7.1 is the USA,  where the inequality of labour income has broken historical records.

In real terms, what this means is that in the USA if average pay is $2,000 per month:

  • The top 10% would take $7,000 ($24,000 for the top 1 percent),
  • The middle 40% would take $2,000
  • The bottom 50% would take $1,000.
    • If these trends continue the top 1 percent could effectively employ the bottom 50 percent as domestic servants.

Think about these magnitudes. In Sweden the bottom half of the population earn $1,400 whereas in the USA it is $1,000.

This is a 40 percent difference, which is a significant amount. If we take into consideration the difference in the price of third level education, and the cost of public services, this income difference is likely to have a significant impact on equality of opportunity (and social mobility).

Women are significantly over-represented in the bottom 50 percent. What this suggests is that class-based inequalities are also gender-based income inequalities.

Looking at table 7.1 we can probably conclude that it is better to be a low wage earner in western Europe than to be a low wage earner in the the USA.

Why do different countries have different attitudes toward social inequalities?

Inequality of capital ownership

Table 7.2 shows that inequalities with respect to wealth and capital ownership are even more extreme.

In Europe the top decile typical own 60% of wealth, the middle class own 35%, whereas the bottom 50 percent own 5% of wealth.

In the US, the top decile typically owns 70% of wealth, the middle class own 25%, whereas the bottom 50 percent also own little more than 5% of wealth.

It is important to ask whether an optimal distribution of capital ownership can exist? Can normative political theories inform these debates (on preferences toward efficiency and equity). Think  about John Rawls.

In real terms, if average net wealth is $200k (divided into real estate and financial assets) this would imply that in the US:

  • The top decile would own capital worth $1.2 million
  • the top centile would own capital worth $5 million.
  • The poorest 50 percent would have net wealth of less than $20,000.

The importance of housing as a form of wealth decreases the further one goes up the income distribution. Housing is the asset of the middle class, whereas true wealth/fortune almost always consists of financial and business assets.

The growth of a propertied middle class was the principle structural transformation of the distribution of wealth (and politics) in the 20th century.

In the 19th century, and right up to WW1, there was no middle class. Almost 90 percent of national wealth was owned by the top 10 percent. The vast majority of a society’s assets were owned by an elite minority.

Nevertheless, despite the emergence of a middle class, table 7.2 shows that inequality in the ownership of capital remains extreme (the top decile own 60 percent of national wealth in Europe and 70 percent in the USA).

Inequality of total income

Table 7.3 shows inequality of total income (and the one that you will most often hear in public debate) with corresponding Gini coefficients.

Is it possible to imagine a society where the concentration of income is much greater than this? Could we imagine a democracy where the top decile appropriates 90 percent of all national income?

Democratic societies are clearly capable of accepting high levels of wealth inequality, probably because capital-income only constitutes one quarter to one third of national income.

But if the same level of inequality (top decile owning 90 percent of all output) applied to total income then surely a democratic revolution would occur? Or would it?

Table 7.3 shows that the USA may set a new record on income inequality in 2030. The top decile may take 60 percent whereas the bottom half of the population would barely get 15 percent.

Conclusion

Lets return to our opening question on merit versus inheritance. How are each of these inequalities justified? It is the justification of inequality that matters most in a democratic society.

One way to think about this is to compare high-inequality societies, such as the US today, with Europe in the 19th century.

19th century Europe was a hyper-patrimonial society where high incomes from capital (and inherited wealth) dominated.

The new high levels of inequality in the USA  emerge from high incomes from labour (super-managers).

If these co-evolve, as Piketty suggests they will, the 21st century will reach levels of inequality not seen since the 19th century. This is why the original title of the book was “the return of patrimonial capitalism”.

Growing inequalities in labour income are assumed to be justified on the basis of merit (better skills and new technologies). But is this true?

Next week we look at the composition of top incomes in Europe and the USA.

Lecture slides: Lecture 11

Lecture 10: The growth of capital income.

Introduction 

In this lecture, we bring to an end our analysis of the wealth/income ratio and turn our attention to the distribution of national income between labor and capital income.

Let’s remind ourselves of some important concepts:

  • Income can be broken down into two sources: income from labor (wages, salaries, bonuses) and income from the ownership of capital (rent, dividend, interest, profit).
  • Income from capital is any income earned from the mere fact of owning property, whether it is land, a government bond, a stock, a firm or a piece of real estate.

All capital assets will yield an income, although at very different rates.

If you retire and own $1 million in assets (government bonds and real estate) and the rate of return on these assets is 3%, you will earn a capital income of $30,000.

If you graduate and have a debt of $80,000 (US tuition fees) you will have negative wealth, but you might get a job earning $85,000. You will have a good wage income. But from this you will have to use a significant percentage to pay off your student loan.

One way to analyze the importance of wealth in society is to measure the amount of capital/wealth as it relates to national income. This is called the capital/income ratio (β).

Last week, we discussed that the long-run capital/income ratio (β) depends on the savings rate (s) and the economic growth rate (g).

But it also depends on the short-term fluctuations in the market for capital assets, and the boom-bust cycle of capitalist development.

Rate of return on capital income

Piketty is arguing that when the rate of return on capital exceeds the rate of return of economic/wage growth, wealth inequality grows (captured by increased β).

But what determines the rate of return on capital?

Different types of capital-assets yield different rates of return. The yield on the riskiest assets (for example, shares in an emergent high-tech firm) might yield 6-7+%. Real estate can be as low as 3-4%, whereas your savings accounts can yield less than 0.1%.

Figures 6.3 and 6.4 illustrate the pure annual rate of return on capital from 1770-2010 in France and Britain. You’ll see that the long-term average is between 4-5 percent.

Pre-tax returns

There are three important observations to remember about this long-run trend on the pure rate of return to capital (which went from 6-7% in the 19th century to 4-5% today).

  1. They are pre-tax returns. The average tax rate on income accrued from the ownership of property in most rich countries, is around 30 percent.
    1. Companies adopt a whole variety of tax strategies to reduce this.
  2. There are huge disparities between capital-assets. The average pure rate of return is found by dividing the total capital stock by the annual flow of income from capital. But not all capital-assets are the same. Savings accounts are a form of ‘wealth’ but they yield very little. If the interest rate today is 0.05% it make more sense to spend.
  3. These are ‘real’ rates of return and do not deduct inflation. Nominal assets such as buying a government bond or your savings account (non-indexed) are subject to real inflation risk. This is not the case with real estate for example, given that house and rental prices generally rise with (or faster) than the consumer price index (CPI).

What factors lead to changes in the rate of return to capital?

In general,  economists would argue that there are two driving forces:

  1. Technology (what is capital used for?)
  2. Capital stock (too much capital kills the return on capital)

Political economists, however, attach importance to the politics of economic resources. The distribution of who owns societies resources is dependent upon public policy.

The capital stock

The stock of national capital/wealth in a country usually fulfils two dominant functions: it provides housing services (and the rate of return can be measured by the rental-value of dwellings) and it serves as a factor of production in producing goods and services (tools, machinery, equipment, land, computers, intellectual property etc).

If you have a farm and you want to produce goats cheese, you need land, tools, machinery, goats and workers. Combined they produce your product.

The logic is the same if you are producing an iPhone. You need labour and capital.

In theory, the purpose of the financial and banking system is to find the best possible use of capital and money (think of it as the country’s national savings), such that each unit of capital is invested where it is most productive (or where it is most profitable).

This is the ideal of a perfectly efficient capital market. It allocates money efficiently.

In the real world, we know that financial markets are far from ideal. They are ridden with waves of speculation, irrationality, instability and bubbles. Most banks don’t lend for productive investment. They lend to buy and sell existing assets (such as housing).

In the USA/UK, most high risk capital is invested by venture capital funds, not banks.

Technology and innovation 

The second driving force behind the price of capital is that too much capital kills the return on capital. What does this mean?

It can be captured by thinking about the value of land and land rents in the USA during the 19th century. There was so much land that it did not yield much of a return. It was cheap and plentiful, such that landed capital wasn’t really worth that much.

The same would apply to housing. If there were 1,000 houses in Dublin for every person, the price of real estate would fall, significantly.

This leads to an important contradiction: Why does an increase in β (capital/income ratio) not lead to a decrease in R (rate of return on capital)?

Everything depends on technology and the extent to which society can substitute capital for labour, and labour for capital in the production process.

For example, think about the extent to which robots are replacing workers in low and medium tech manufacturing, such as the automobile industry.

There are always new ways to find new uses for capital (i.e. solar panels as a replacement for oil). This is what’s called innovation.

But profits, rents and capital-income accumulate (and it is accumulating fast). Therefore, for Piketty, the volume effect will always outweighs the price effect.

It also depends on the ownership of capital. If a tiny percentage of society owns all of the economic resources in society, they can do nothing and live off the interest, and spend it on luxury goods and services (yachts, football clubs and expensive watches).

It is for this reason that many political economists support a wealth tax. This would allow governments to tax idle capital, and use it for productive investment (it’s a bit like a grandfather taking away some of his daughters money, and investing it on her behalf).

The labour-capital split

This brings us to the division of national income between income that is accrued through labour (wage income), and income that is accrued through the ownership of property (capital income).

Figures 6.1 and 6.2 present the long-term trend in Britain and France. You’ll see that there is a 70-30 split. Most national income is produced, and accrued through labour.

Capital income absorbed around 35-40 percent of national income in the late 19th century, which is rather huge, before falling to approximately 20-25 percent in the mid-20th century, and then increasing to 25-30 percent in the 21st century.

Note: this corresponds to an average rate of return to capital of 5-6 percent.

Calculating the rate of return

If you won the lottery, and invested $1 million of your winnings, and ended up earning $50,000 per annum, your rate of return would equal 5%. How is all this calculated?

Remember Piketty’s first law of capitalism α = r X β. This is not a law, but an accounting identity, to determine the ratio of capital income as a percent of national income.

  • a = capital income,
  • r = rate of return on capital
  • β = capital/income ratio.

The percent of capital income in national income can be found if we multiply the rate of return on capital (r =5)  by the capital/income ratio (β = 6). The outcome is 30.

What remains is labour income, which equals 70 percent.

Figure 6.5 shows the increase in the share of capital income in national income from 1970. This has increased even faster since 2010. Why?

The growth in the share of capital income in national income can be explained by the fall in labour income as a percentage of national income.

The share of economic growth going to wages/salaries have been declining. As the pie of national income grows, the gains are increasingly absorbed by capital-asset holders.

Hence, there is an upward distribution of income. Productivity gains are increasingly going to the owners of capital (think Apple shareholders).

The stability of the capital-labour split

The stability of the 70-30 split, however, doesn’t really tell us anything about how capital or labour income is distributed. Very few people earn an income from owning property because the majority of people don’t own any capital assets.

As we will see next week, the top 10 percent of the US population own 70 percent of wealth (capital), whereas the top 1 percent own 52 percent of wealth (capital).

This means a small percent control a large part of economic resources in society.

It is this 1 percent of the population that tends to gain when the share of capital income in national income grows. Hence, if the share of capital income in national output increases, it’s likely to only benefit 1% of the population.

The stability of the 70-30 split is usually attributed to the increased importance of human skills, with the implication that many economists think that capital doesn’t really matter anymore. It is all about human capital (i.e. high-tech skills). It’s not about capital rents.

Do you agree? Ask yourself whether it’s money, financial assets, and the ownership of property, or human skills, that shapes the dynamics of capitalist development?

Explaining the rise in capital income

From a political economist perspective,  the growing share of capital income (in national income ) that we observe since 1970 is related to shifts in economic bargaining power between societal interest groups, and changes to capital-tax laws.

It is more about politics than markets. This is something we will discuss in later weeks.

Further, the stability of capital’s share in national income in no way implies a stability in the capital-income ratio. This is what we have been analyzing over the past two weeks.

The contribution of Piketty is to shift our attention toward the evolution of the capital-income ratio rather than the capital-labour split.

Why is this shift so important?

It allows us to assess the overall structural influence of wealth in a society.

Conclusion 

Looking to the future: a wealth/income ratio that equals 7-8 years of national income, and an average rate of return to capital of 4-5 percent, means that capital’s share of global income could grow to 30-40 percent by 2050.

Free-market optimists suggest that technological change will favor a shift to labour-income (human capital and work) rather than capital-income (to the owners of assets/rent/interest). This is certainly plausible. Just think about Silicon Valley.

Many political economists suggest otherwise. They argue, including Piketty, that the tech giants of the world are becoming the rentiers of the world. They own an important part of society – communications infrastructure – and this means they claim the rents.

If the rate of return on capital (5 percent) grows faster than economic and wage growth (2 percent), then wealth from the past will accumulate in importance. This means inheritance will matter more than entrepreneurship.

Ultimately, what this suggests (and it’s up for debate) is that progress toward economic rationality (more efficient and more competitive markets) does not imply progress toward democratic and meritocratic societies.

There is a clash between capitalist-markets and social-democratic rights.

Ask yourself: Has technology changed the deep structural influence of wealth over society? Economic resources continue to be unequally distributed. Has this changed? If wealth means power, how does this concentration of wealth impact upon politics?

From next week we analyze the actual distribution of income and wealth at the individual and household level.

The slides can be found here. Lecture 10

Lecture 9: Capital Strikes Back in the 21st Century

Introduction 

In this lecture we will seek to answer three questions:

  • Why the wealth-income ratio has returned to historically high levels?
  • Why it is structurally higher in Europe than the USA?
  • What does this suggest about the future of wealth accumulation in the advanced industrial economies of the western world?

The determinant of wealth/income ratio

To answer these questions we have to identify the determinants of the capital/income ratio over the long-term.

Piketty’s core claim is that the capital/income ratio is related to the savings rate and growth rate.

The relationship is so strong that he calls it the second ‘law’ of capitalism,  β = s / g .

β = s / g means that the capital/income ratio is equal to the savings rate divided by the economic growth rate.

  • β = capital/income ratio
  • S = savings rate
  • G = growth rate

If a country saves 12 percent of its national income every year and it’s economy grows by 2 percent, the long-run capital income ratio = 600% (12 divided by 2).

Basically a country that saves a lot, and grows slowly, will accumulate a large stock of capital relative to income. In turn, this will have a significant effect on the structure of society and the distribution of wealth. It’s a neoclassical perspective.

For Piketty, low growth and a higher-savings rate (by households and corporates) is responsible for the variation in the capital/income ratio between Europe and the USA, and the main explanation for rising capital/income ratios since WW2 (in the long run).

If the economic growth rate falls to 1 percent and the savings rate remains 12 percent, β will equal 12 years national income or 1200% (12 divided by 1). But if the rate growth increases to 3 percent then β will equal 4 years income, or 400% (12 divided by 4).

For Piketty, this is the long term driver of wealth accumulation.

Note: I tend to disagree. Political institutions are, arguably, far more important in  explaining the distributive effects of economic growth, whilst asset price fluctuations (price effect) are just as important as the volume effect (savings rate).

But it all depends on the time period under examination. Asset prices matter more in the short run (30 years), but maybe less so over the long run (100 years). Hence, it is questionable whether “laws” across time/space exist at all. It’s all about politics.

The case of Ireland

But what does all of this mean, in real terms, for the structure of political economy ?

Is it not the case that a high capital/income ratio, and a large stock of wealth, benefits society? Does it not imply that there will be more investment and more jobs?

Not necessarily. It all depends on the distribution of capital, and whether or not the owners of societal resources have the incentive to use capital productively. This brings us back to the conflict between public and private capital ownership.

For example, a country will not gain from a high capital/income ratio if it is all tied in up in housing capital (i.e. rising house prices are not necessarily a sign of a rich country).

From a political perspective, if wealth is concentrated in a few hands, then the economic resources of a society are not efficiently distributed. It is not likely to be put to productive use. It might be hoarded by the rich to consume luxury goods.

Think about it another way, how much of Ireland’s capital from 1998-2008 was invested in productive investment?

Between 2000-2008, the total capital stock in Ireland increased from  €228 to €477 billion. According to Davy Stockbrokers only €50 billion was spent productively.

72 percent of the increase (or  €188 billion) went into housing.

Of the €50 billion that went into productive investment, two thirds of it (€33bn), was invested by the state: roads, education, energy, water-waste management.

Productive private sector investment (those investments that contribute to long-term productivity gains, and hence long-term improvements in living standards) made up a meagre €17bn of the total capital stock.

Davy Stockbrokers conclude that the Irish private sector, during the boom years of the Celtic Tiger, for the most part, wasted valuable societal resources. Today, the capital stock is rising again, and once again it is almost entirely driven by the rise in house prices.

See the CSO data.

The two supposed ‘laws’ of capital

β = s / g provides a logical historical account of the structural evolution of capital. It’s worth studying, and considering. So let’s take it for granted, for the moment.

The US has a higher demographic growth rate and lower savings rate than Europe, leading to a lower capital-income ratio.

It is important to note that this matters in the very long-run. The real accumulation of wealth takes time, particularly at the country-level. History will matter a lot.

Further, it is only valid if asset prices evolve in tandem with consumer prices. This means that it assumes capitalism, in the long run, is a stable market economy, and not driven by boom-bust cycles.

It is also dependent on certain assumptions about the savings rate (s).

Furthermore, it does not explain the short-term shocks to capital (which are deeply political!).

Capital income

But what about the amount of income accrued from the ownership of capital-property as a percent of national income (i.e. the amount of income that comes from the ownership of property as opposed to wages)?

Piketty proposes another “law” to explain this.

He says that the ratio of capital income in national income (a) is equal to the average rate of return of capital (r) times the capital/income ratio.

a = 30 percent, when r=5 and β=6

We can write this as follows: α = r X β  Note: it is a pure accounting identity.

Capital since 1970

Figure 5.3 indicates the annual change to private capital in the eight richest countries from 1970-2010.

For Piketty this data suggests that β varies constantly in the short-run but tends toward an equilibrium in the long run.

Capital asset prices (stocks, finance and housing prices) are  volatile. They can make a country look wealthy. But over the long-run, for Piketty, these balance out.

But the price of capital is not a ‘natural’ phenomena. It is a human construct. Think about the different valuation of German firms vis-a-vis US firms.

In the study of political economy there is a tradition, which can be traced back to Hyman Minsky that suggests the fluctuation in boom-bust cycles of wealth is consubstantial with the history of capitalism itself. Markets are defined as erratic, not in equilibrium.

This is because the ownership of societal resources is conflictual, not harmonious.

Just think about the impact of quantitative easing (QE) on the price of assets since 2008. Or think about the Japanese speculative bubble in the 1990s, and the bursting of the dot-com bubble in the US in the early 2000’s.

Discuss:

Is Piketty right to assume there is a long-term trend toward an equilibrium in the capital/income ratio?

Moving on…

What the data does reveals, however, is that since 1970 private capital has returned. Piketty calls it the re-emergence of patrimonial capitalism (the original title of the book).

Keep in mind Piketty’s critique: he is suggesting that wealth matters more than hard work in shaping the politics of distribution today.

There are three reasons for this return of capital (measured in terms of higher capital/income ratios):

  1. Slower economic growth and higher savings (primarily retained corporate earnings) – long-term
  2. The privatisation of public wealth since the 1970’s – short-term
  3. The acceleration of real estate and stock market prices since the 1990’s – short-term

Savings since 1970

Table 5.1 indicates the average value of growth rates and savings rates in the eight richest countries from 1970-2010.

The lower population growth and the higher savings rate in Europe and Japan explains why wealth-income ratios are higher in these regions of the world, when compared to the USA.

Over a period of 40 years, these savings and growth differentials will accumulate and create deep structural differences within societies (remember the importance of the compound rate of growth-interest). This is an automatic consequence of β = s / g 

It is crucial to note that that there are two components to private savings: corporate (retained earnings) and households.

See table 5.2 for the percentage difference in these savings rates within national income. Note the big differences between the UK/USA and Germany.

Retained earnings are profits of a company that are not distributed to shareholders.

They allow companies to reinvest in themselves; rather than pay out profits as dividends to their shareholders, which are usually more heavily taxed.

In the last few years, Silicon Valley increasingly use their profits as “share buybacks”. Basically, they buy their own shares to drive up the stock (market value) of their firms.

Privatisation 

The second complementary factor that explains the comeback of capital is privatization. 

Figure 5.5 shows the ratio of public and private capital to national income in the eight richest countries of the world. The data suggests that the revival of private wealth is partially due to the privatization of public wealth.

  • The decrease in public wealth equals approximately an increase of around one fifth or one quarter the increase in private wealth.

The case of Italy is particularly clear.

This reflects an increase in the debt owned by one portion of the Italian population, and their claim on another portion of the population.

Instead of the wealthy paying taxes to fund the deficit they lend government money at interest – increasing their own private wealth.

At a global level, the most extensive privatizations took place in the former Soviet Bloc.

The stock of capital in these countries was the same in the 1970’s and 2000’s (3-4 times national income) but the public-private split was completely reversed.

The rise of Russian Oligarchs obviously had nothing to do with the β = s / g  and was purely driven by privatization (and asset stripping), and close state-business ties.

The rebound of asset prices

The third complementary factor that explains the comeback of capital  is the historic rebound of asset prices, associated with global financial liberalisation.

The increase in asset prices from 1950-2010, largely compensated for the decline in asset-prices from 1910-1950.

The price of capital-assets is heavily influenced by political decisions, policy choices, and economic institutions, such as rental control laws (real estate) and corporate governance laws (corporations).

Remember our discussion about Germany two weeks ago. There is no such thing as a natural market price. Private property is a human regulatory-legal construct.

Multinationals are political actors that actively shape the market.

We don’t know where capital prices are headed in the future. For example, we don’t know if house prices will tumble. But we do know that they cannot increase indefinitely.

This is why many critics of Piketty argue that he is overly reliant on the concept of “equilibrium” and does not appreciate the boom-bust nature of the capitalist cycle.

Prices as a human construct 

The market value of a firm is its stock market capitalization.

The accounting value of a firm is it’s assets (such as buildings) minus liabilities, net of debt. These are usually the same when a company is created. But they diverge over time.

The divergence is largely dependent upon whether financial markets are pessimistic or optimistic about the profitability of the company.

The ratio between market and book value is known as Tobin’s Q. This has tended to increase in all rich countries.

The main point to remember is that:

  • The rebound in capital-asset prices (stocks and real estate), since the 1970’s, accounts for between one third and one quarter of the increase in the capital/income ratio (but with significant variations between countries).

In terms of the capital/income ratio, Japan set the record set in 1990, but was recently beaten by Spain, where private capital equalled 8 times national income.

In both cases, the rapid rise in wealth/income ratios can be explained by the emergence of a housing-property bubble. Ireland was similar.

Summary 

Hence, for Piketty the comeback of capital, measured by rising wealth/income rations, can be explained primarily by (1) and complemented by (2) and (3).

  1. Slower growth, higher savings (primarily retained corporate earnings) – long-term
  2. Privatisation of public wealth since the 1970’s – short-term
  3. Acceleration of real estate and stock market prices since the 1990’s – short-term

Global imbalances

Finally, it is important to note that the sharp increase in national capital is primarily an increase in domestic capital.

Figure 5.7 shows that it is only really Germany and Japan that have accumulated net foreign assets. This accounts for between 50-70 percent of their national income (and an automatic consequence of their large trade surpluses).

International cross-national investments are particularly important in Europe. If we look at capital flows within the Eurozone, post-2000, we get a pretty disturbing picture.

In a global world of financialisation and cross-border capital movements every country, to some extent, is owned by another country to some extent.

Net international investment positions reflect this.

In the 1970’s, the total amount of financial assets and liabilities owned by households and firms barely exceeded four times national income. By 2010 this had increase to a staggering 15-20 times national income.

Within Europe this inevitably leads to perceptions that countries (Greece) are owned by other countries, such as ‘German banks’.

Ireland’s net international investment position is staggering.

This is primarily because of the impact of the IFSC. These debts-liabilities are in part related to fictious financial flows, associated with corporate tax avoidance strategies.

Conclusion

How important are economic ideas in explaining socio-political changes?

To conclude, what about the future?

What will the global capital-income ratio be in 2050? The law β = s / g implies that it will logically rise and could reach 19th century levels by the end of the 21st century.

See figure 5.8.

The lecture slides can be downloaded here. Lecture 8

Lecture 8: The Shocks to Wealth in the 20th Century

Revision 

Lets remind ourselves of Piketty’s core argument. He suggests that wealth inequality is growing because capital is accumulating faster than income, in Europe and the USA.

This can be measured by the rise in wealth-income ratios.

As we seen last Wednesday, national wealth is equal to 5-6 years national income in most European countries (national income is around $2.5 trillion in France, hence multiply it by 6 to get a sense of the total capital stock).

What we observed in the last lecture is that the ratio of wealth to income over the long-run has remained table in Europe since 1800, with the exception of the period 1950-1980. This is where we observe a decline in capital-income ratios, or a shock to capital.

What we also observed is that despite the stability in capital-income ratios, the composition of capital (and wealth) has fundamentally changed. Housing-real estate and domestic/finance capital have replaced agricultural land. Capital has been transformed.

Introduction

In this lecture we will look at:

  • the shocks to capital in Europe from 1950-1980
  • the evolution of the wealth-income ratio in the USA
  • the importance of slavery in the origins of US capitalism

Figure 4.5 depicts national wealth in Europe from 1870-2010. This long term trend is useful as it captures the two waves of globalization that have shaped capitalist development (1870-1910 and 1980-present).

Germany, France and the UK are only three countries, but they can be considered representative of Western Europe, given that they constitute more than two-thirds of national income in Western Europe.

All the available estimates reveal a similar capital/income ratio for Spain, Italy, Austria and the Netherlands (Spain experienced a more rapid rise due in their capital/income ratios, much like Ireland, due to it’s housing bubble in the 2000’s).

The shock to wealth

What caused the shock to capital in Europe during the 20th century, which can be observed in the decline in wealth-income ratios?

One obvious answer is the physical destruction of buildings, factories and infrastructure during the two world wars.

In France, physical destruction was equal to one year of national income. In Germany, it was one and a half years national income. In Britain it was less than one years national income. Hence, physical destruction only explains part of the decline.

The budgetary and political shocks of the two world wars proved far more destructive to capital than war itself.

The loss of foreign capital-assets, the low savings rate and physical destruction explain two thirds of the loss of wealth, whereas the new forms of property ownership, and new forms of rental-regulation, explain the final third.

  • Capital regulations, decline in real estate and stock market prices = 25-33% of decline
  • Low national savings, loss of foreign assets and physical destruction = 66-70% of decline

It is very important to remember this, as it will help us to explain the rebound of capital-income ratios from the 1970’s, especially in the 1990’s and 2000’s.

The rise in capital-income ratios in the 21st century, I will suggest, can largely be explained by rising commercial and real estate prices. It is a price effect, associated with the liberalisation of financial markets.

Public policies

The period 1914-1945 was a dark period for the wealthy in Europe: The Bolsheviks defaulted on French loans, Nasser nationalized the Suez canal, and wealthy individuals across Britain were forced to sell their foreign colonial assets to make up for lost savings.

Those owning stocks and bonds lost a fortune when Wall Street crashed.

But from the 1950 onwards, it was not the external shocks that shaped the nature of capitalist development rather it was government fiscal and socio-economic policies, which reduced the market value and economic power of those who owned capital-assets.

Post war Europe was a form of state-directed capitalism, which gave birth to different national models of capitalism across North, West, East and Southern Europe.

In the West, real estate prices fell relative to the price of goods and services.

House prices stood at historically low levels, owing primarily to rent control policies, which not only meant that housing became significantly less expensive, but that landlords earned less on their properties.

The stock value of corporations and firms also fell to historically low levels.

The state nationalised industries, across various sectors of the economy. Dividends and profits were heavily taxed, whilst shareholders were weakened vis-a-vis other stakeholders, such as workers.

It was the period of “Keynesian demand management”, or “mixed market” economies, where the state took responsibility for guaranteeing employment.

This radical new role for the state can be observed directly in rising tax revenues (measured as a per cent of national income).

Post war Europe gave birth to the social state: public provision of health, education and eldercare, in addition to other social security policies.

The USA 

But what about the evolution of capital/income ratios in the USA? Figure 4.6 shows that “wealth” mattered less in the New World  (USA) than the Old World (Europe).

National capital was worth less than 3 times national income from 1770-1810, whereas it was worth 7 times in Britain and France.

What explains this divergence?

It can primarily be explained by the price of agricultural land. There was so much land in the US that its market value was worth very little. The volume effect outweighed the price effect (remember Ricardo’s scarcity principle).

Domestic capital was also worth much less. This is because the US population were predominately immigrants. They arrived without houses, businesses, machinery, tools or factories. It takes years to accumulate this type of capital.

Hence, from the beginning, the influence of accumulated (inherited) wealth was less important in America when compared to Europe. Land cost little and anyone could become a landowner.

All of this has probably contributed to the Jeffersonian ideal of the ‘small landowner, riding out west, free and equal’. The American dream was born.

But by 1910, national capital had begun to accumulate rapidly, particularly in real estate and industrial capital, such that it amounted to 5 times national income.

The US had become capitalist, and industrial, but inherited wealth still had much less influence over the economy than in “old” Europe.

The shocks of the 20th century also struck America with far less violence.

Capital shocks in the US

Capital-income ratios were far more stable, fluctuating between 4-5 times national income from 1910 to 2010.

It was only after the Great Depression and World War II did the structure of capital change. This was primarily because Franklin D Roosevelt specifically adopted policies to reduce the influence of private capital, such as introducing rent controls.

But unlike in Europe, the US did not adopt policies of nationalisation. It was not the same type of “state directed capitalism” that occurred in Europe.

Rather, from the 1940s onwards, a series of public investment programs were launched, in addition to sweeping changes in progressive taxation. Public debt increased to fund the war effort but this eventually returned to a modest level in 1970.

Figure 4.7 shows that America continues to have net public wealth i.e. its assets exceed public debt.

Overall, the capital-income ratio in the US is far more stable than in Europe. This might explain why Americans tend to have a far more benign view of capitalist development than Europeans.

In 2010, capital in the USA was worth around 4.5 times national income. National income in the US is around $17 trillion, whilst in the EU it is around $18 trillion. Hence, multiply 17 trillion by 4.5 to get a sense of what the overall value of national capital/wealth is (measured in terms of market prices).

Slavery

It would be a mistake to conclude our analysis on the structural transformation of wealth, and capital accumulation, in the USA and Europe without discussing slavery.

Thomas Jefferson didn’t just own land in Virginia, he owned 600 slaves. Slavery was eventually abolished in 1865.

In 1800 slaves represented 20 percent of the US population: roughly 1 million slaves out of a total population of 5 million. In the South, slaves represented 40 percent of the population: roughly 1 million slaves out of a population of 2.5 million.

By 1860 the slave population had fallen to 15 percent or 4 million slaves in a population of 30 million. This can be explained primarily by population growth in the north and west. In the south it remained above 40 percent.

What was the price of a slave?

Figure 4.10 shows that the total market value of slaves represented 1.5 years of national income in the early 19th century (this is equal to the total value of farmland).

Remarkably, this implies that slave-owners in southern US states controlled more wealth than the aristocratic landlords in old Europe.

Black slaves and the land they worked equalled 4 times national income in southern states. The northern (land capital) and southern states (slave capital) is the USA during their period were completely different worlds.

Remember southern blacks were deprived of civil rights until the 1960’s. Racial tensions in the US, arguably, goes a long way to explaining the peculiar development of the US welfare state, and the type of inequality that the US experiences today.

Further, it’s important to acknowledge that slavery was a significant factor that led to the particular trajectory of capitalist development in the US, as suggested by this research.

Next week we will analyze the comeback of capital and wealth inequality since 1970. Lecture 8

Lecture 7: The Structural Transformation of Capital/Wealth in Europe Since the 19th Century

Revision  

Over the last few weeks we discussed the main stages of income and economic growth since the industrial revolution. We also discussed the history of ideas underpinning classical and critical political economy.

In weeks 1-2, we found that, on average, the economy has grown by 1-2 percent per annum whereas the rate of return on capital is 4-5 percent. This means that in the long-term, the importance of capital (wealth) will increase relative to income (real economy).

This is not a market failure.

What it suggests is that when markets are left to their own devices they will produce the inequality R>G. The more ‘perfect’ the capital market the greater the R>G inequality.

This week we are going to analyze the structural transformation of wealth (public and private) in Britain, France and Germany, from 1870-2010.

To do this we will need to analyze the importance of public debt in shaping the dynamics of private wealth. Public debt is private wealth.

Introduction 

One way to analyze the importance of capital (wealth) within a society is to measure the total amount of capital stock as it relates to national income. This is expressed as the total amount of capital owned at a given point in time, divided by total yearly income.

This calculation gives us the capital/income ratio, denoted by the greek symbol β.

If a country’s total capital stock is equal to six years of national income, we write β = 6 (or 600 percent). If the stock grows, wealth grows. This in-itself is not a problem. It becomes a problem when the wealth/capital is owned by a small group of people.

Why? Because it suggests that important economic resources in society are privately owned by a small group of people, who may or may not use it productively.

When the rate of return on capital exceeds the rate of return to national income, the capital/income ratio, β, grows. Note that the capital-income ratio in most western capitalist democracies, today, is between 500-600 percent (or 5-6 times national income).

This means that in the UK, national wealth/capital equals 5-6 times, or 2.4 trillion dollars.

In the novels of the 19th century, the rate of return to capital (wealth) was widely discussed. Wealth was a stable monetary marker. In Jane Austen’s novels , wealth usually takes two forms: land and/or government bonds.

This form of wealth may seem old fashioned in a period of “dynamic entreprenurial capitalism”. But have things really changed that much? Think about housing.

Private/public wealth

Owning a capital asset has one purpose, and this hasn’t changed at all. The purpose is to produce a reliable steady income.

That’s exactly what land and government bonds provided in the low growth, zero-inflation economies of the 18th and 19th century. Given low growth, and low inflation, these countries had high and stable capital-income ratios.

They were wealth dominated societies.

For Piketty, the implication of this, particularly during the 19th century, is that low growth economies are capital-dominated societies. Capital income from owning wealth (land/government bonds) accumulates faster than labour income.

But what exactly is a government bond that made these Jane Austen characters so wealthy?

It is a claim of one portion of the population (those who lend to government and receive an interest/yield) from another portion of the population (those who pay taxes to the government).

Government debt is always another person’s private wealth.

In the aftermath of the international financial crisis, taxpayers are regularly reminded that their state is in “debt”. But to whom exactly do taxpayers owe this money?

Ask yourself the following question: Has the structure of capital from the 19th century become more dynamic and less rent-seeking?

For Piketty, capital at its inception is always risky and entrepreneurial but evolves into rent when it accumulates into larger amounts.

To make this point he uses the character of Père Goriot (a classic Balzac novel). Goriot gets rich as a pasta manufacturer, and then invests his wealth in government bonds, only to be deceived and abandoned by his daughters.

Capital in Britain and France

Figures 3.1 and 3.2 illustrate the wealth/income ratio in Britain and France from 1700-2010, and demonstrate three important social facts about the economic structure of British and French society from the 18th-20th century (the countries for which we have the longest data).

  • First, the wealth/income ratio followed a similar u-shaped curve.

The total market value of national capital fluctuated between 6 and 7 times national income between 1800-1914.

After WW1, and up until 1970, it collapsed to 2 and 3 times national income.

It has since climbed back up to 6 times national income in 2010.

These are very large swings and reflect the serious distributional conflicts during the 20th century, when the ownership of wealth and capital was highly contested, politically.

Think about Acemoglu’s theory of social conflict in explaining economic institutions.

  • Second, despite the stability of wealth/income ratios, the structural composition of wealth has totally changed over time.

Capital-assets are no longer agricultural. They have been replaced by buildings, business, financial and real estate.

Remember national capital = farmland + housing + other domestic capital + net foreign capital.

What figures 3.1 and 3.2 demonstrate, most clearly, is the collapse in the value of farmland. But ask yourself what has replace this?

The collapse in agricultural land was replaced by a rise in the value of housing and domestic capital (the industrial/financial assets of private firms and government).

As I will suggest later in the course, Piketty under-estimates the significance of the price effect of housing capital as a determinant in rising capital/income ratios.

This is important, because it housing impacts political preference formation.

  • Third, net foreign capital was highly significant in the 19th century but not anymore.

British and French citizens could yield a significant income through colonial ownership.That is, rich citizens of these countries could increase their wealth through owning assets in their colonies.

The advantage of owning another country’s resources is that you can consume and accumulate without having to work. The colonies produced and the colonizers consumed.

With decolonization these foreign assets evaporated. The role of Western imperialism in capitalist accumulation, throughout the 20th century, is a core factor in explaining western European wealth. This is rarely acknowledged in economic textbooks.

Inference

The core inference from all of this is that national capital has preserved its value in terms of annual income but it’s composition has totally changed (from land to real estate and finance).

But does this structural transformation of capital imply that wealth has become more dynamic and more entrepreneurial? This is an important question to ask yourself.

Before we explain the revival of capital since WW2, we need to analyse the politics of public debt. To do this, we need to examine whether national capital (wealth) is publicly or privately owned.

Government debt

The division of property rights between government and private individuals (states and markets) is a very important political question. We usually only ever hear about government liabilities or government debt. But what about state/public assets?

Public assets (wealth) can be financial (think about the oil-producing sovereign wealth funds underpinning the Middle Eastern monarchies) or non-financial (think about this university). For the most part, states have more public debt than public wealth.

Britain and France offer two very different case studies on the relationship between public debt and private capital.

  • In Britain, at the end of WW2 (and after the Napoleonic wars) public debt was over 200 percent, but Britain never defaulted.

The British monarchy never collected enough taxes to pay for their wars.

Rather they raised revenue by borrowing from rich private individuals (thereby increasing the private wealth of their richer residents and in turn: rising capital/income ratios) rather than taxing them. Taxation was a 20th century phenomenon.

Britain’s economy grew at a steady rate of 2-3 percent from 1815-1914, so after a century, they eventually reduced their debt-GDP ratio, which was accumulated in the 19th century. In the 20th century they primarily got rid of public debt through inflation.

  • In France, at the end of WW2 (and after 1798), the French government defaulted and cancelled all of its public debt.
    • They choose to create a large public sector instead.

This meant that they took capital/wealth away from the private sector and placed it in the public sector.

Discussion

Think about the recent financial crash, and the post-crisis policy response in Europe, and the relationship between private wealth and public debt.

The Irish bank bailout cost 64 billion (40 percent of GDP), and was designed to cover the private liabilities of six financial institutions: AIB, Bank of Ireland, EBS Building Society, Irish Life & Permanent, Anglo-Irish Bank and Irish Nationwide.

The cost of the bank bailout was approximately €8,956 per person.

How does the Irish government (taxpayer) repay this debt?

Or more precisely, who pays it?

From a market perspective, it is far more advantageous to lend to governments and receive an interest/payment, than to pay higher taxes without compensation.

Inflation

Investing in public debt (buying government bonds) at 4-5 percent interest in a context of slow growth and zero inflation is a pretty good investment.

In the 20th century many governments, particularly those in France, borrowed from private investors to fund public services. The purpose of increasing public debt was to redistribute resources to lower-income households.

But this debt was evaporated (paid off) by inflation.

From 1914-1950, French inflation was approximately 13 percent per annum. This meant that a government bond bought in 1913 was worthless twenty years later.

Inflation enabled the French government to ‘inflate it’s debt away’, whilst simultaneously re-building their social state.

Germany did the same.

None of this is meant to suggest that redistribution by inflation is a good idea, or an optimal strategy to manage the public-private wealth dynamic. It cannot work indefinitely. But it is important to note that public debt is a vehicle of redistribution whether it is repaid or not. It’s a strategy to mobilise private wealth for public gain.

Public assets

Enough about public debt, what about the evolution of public wealth/assets?

Figures 3.3 and 3.4 reflect a steady expansion, albeit modest, of the economic role of the state in France and Britain.

The total value of public assets (primarily public buildings, national industry and infrastructure) rose from 50 percent of national income in the 19th century to approximately 100 percent in the early 21st century.

These public assets peaked during the interventionist years, from 1950-1980, and were then followed by major waves of privatization after 1980.

Figure 3.6 is indicative of the interventionist years in France.

It is important to keep in mind the changed ideational climate after WW2. The period of laissez-faire during the first era of globalisation, (1870-1913), was widely considered a policy failure that contributed to war and recession.

The French nationalized many parts of their banking and automobile sectors (the owner of Renault was arrested as a Nazi collaborator in 1944) after the war, giving rise to an economic system of ‘dirigisme‘.

From an economic ideas perspective, France considered the weakness of their state a causal factor behind German invasion, therefore they wanted to strengthen the state.

By 1950, public wealth in France was worth one year of national income whereas private wealth was worth two years of national income. The government owned 30 percent of the nation’s wealth.

France had a mixed economy, or capitalism without capitalists. The biggest firms were public not private. This all changed from the late 1980’s and 1990’s when the new era of Europeanization, liberalization and privatization was instituted.

Germany

How does all of this compare with Europe’s other ‘great nation’, Germany?

Figure 4.1 shows that the evolution is very similar.

  • First, agricultural land gave way to residential and commercial real estate.
  • Second, the capital/income ratio has grown steadily since 1950.

But note one important difference. Germany never had a net foreign asset position during the 19th century (it was not a colonial power), but it has amassed substantial foreign assets over the past few decades, primarily because of it’s large trade surpluses.

Germany’s net foreign asset position is equal to 50 percent of national income, a significant amount, and over half of this has been accumulated since 2000.

  • Germany, like France, got rid of its public debt throughout the 20th century via inflation, which averaged 17 percent between 1930 and 1950.

The hyper inflationary strategy during the 1930’s destabilized German society. This arguably underpins the paradoxical situation in Europe today. Germany is opposed to any price increase that exceeds 2 percent per annum, despite being the country that resolved its public debt in the past via the inflation mechanism.

Britain, on the other hand, always repaid it’s debt, and does not have the same fear of politically induced inflation. For example, the UK is happy to allow its central bank to buy a substantial portion of its public debt (monetary policy), regardless of the asset-price inflation effect.

Germany also engaged in large asset purchases of its banking and automobile sectors during the interventionist years of 1950-1980. The government owned almost 30 percent of national wealth during the decades of postwar reconstruction.

The state of Lower-Saxony still owns 15 percent of Volkswagen shares today (and therefore 20 percent of voting rights, given corporate governance and co-determination laws in Germany).

Conclusion

Figure 4.4 compares Britain, France and Germany. National wealth is equivalent to 4 times national income in Germany, compared to 5 and 6 in France and the UK.

But national savings are higher in Germany. What explains this paradox? How can a country with high-savings have a lower capital/income ratio?

It can be largely explained by two factors.

First, the very low price of real estate in Germany, which is kept in check by strict rental control regulations. Second, German firms have a lower stock market valuation, which is lower because workers have a stronger claim on the ownership of German firms.

This reflects the German ‘Rhenish’ or ‘stakeholder’ variety of capitalism, whereby firms are owned not just made up of private shareholders (the Anglo-Saxon model) but stakeholders such as trade unions, consumer associations and regional governments.

Lower stock market valuation does not imply lower social valuation, nor does it imply less economically efficient firms. Rather it reflects a politically different way to organise the market. It reflects the fact that “private property” is a legal construct.

Legal constructs are socio-political constructs.

We will examine this in more detail during the second half of the course, when we analyze the importance of ‘national models of capitalism’, a debate that has become more important in the aftermath of the great recession in Europe.

The PPT slides can be found here: Lecture 7