Week 9: Explaining 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 and hard work.

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.

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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 seeking 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.

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

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 globalisation and the inequality of R>G leads to a greater concentration of wealth 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?

Week 9

 

Week 8: Wealth Inequality in Europe and the USA

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 $360 trillion.

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

Previously, 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 2019 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?

Week 8

Week 7: Explaining the Rise of Top Incomes

Introduction

Screen Shot 2018-10-22 at 15.48.43

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 a-political processes of economic change: education, skills and technology. This is usually captured under the term “skills based technological change”.

These certainly matter in the long run. Most research would suggest that 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%.

 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 favour redistribution. This, however, is not the case. People don’t just vote on the basis of 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, arguably, 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.

Week 7

Week 6: Income Inequality in Europe and the US

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?

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 generalised structural process of wage inequality compression has occurred.

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 more important.

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

A senior manager on an income of $5,000 per month might rent out an apartment at $1,000 per month, and/or hold shares in her firm. This is a monthly income of $6,000. 80% of 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, such as the 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 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, and off shored.

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.

The political effect this had on the labour market led to a significant compression of wage inequalities. Libertarians would argue it creates unemployment.

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

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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 when 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 international financial crisis in 2008-2010?

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 i.e debt.

This debt was repackaged and recycled into complex and increasingly uncertain financial markets, leading to increased risk and instability.

Larger share of the pie

From 1977-2007 (the eve of the crisis), the richest 10 percent appropriated almost 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 was for a company that doesn’t even make much profit.

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.

Week 6

 

Week 5: The Return of Neoliberal Capitalism

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.

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).

Piketty’s argument arguably applies in the very, very long, but it is not a very useful mechanisms to explains the dynamics of global financial capitalism in 21st century.

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 in a democracy.

For example, a country will not gain from a large wealth/income ratio if it is all tied in up in housing capital (i.e. rising house prices that make homes unaffordable are not necessarily a sign of a developed democracy).

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 that capitalism, in the long run, is a stable market economy, and not driven by boom-bust cycles (see Hyman Minsky).

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

Furthermore, it does not explain the short-term shocks to capital, and the short term fluctuations in wealth/prices (which are deeply political!).

Capital income

But how do we explain the amount of income that accrued from the ownership of capital/property, and how much of this is included in 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.

This is a standard liberal classical economic assumption.

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 economic resources, and who stakes a claim to national income and national wealth is conflictual, not harmonious.

Just think about the impact of central banks quantitative easing (QE) on the price of assets since 2008, and the impact this has had on wealth accumulaiton.

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.

Again, it was about politics.

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), and the liberalisation of capital accounts.

Remember our discussion about Germanylast week. There is no such thing as a natural market price. Private property is a human regulatory-legal construct.

Multinational corporations can be conceived as aggressive profit seeking business actors that actively shape the market in their own interest, or they can be conceived as functional utility maximisers, improving economic efficiency.

It all depends on your political and normative perspective.

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 ratios, 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

In popular discourse, the political and policy choices that liberalised the market, and enabled a return and rise of private capital is often referred to as “neoliberalism”.

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 ideas in explaining the politics of economic change?

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.

Slides: Week 5

Week 4: The Emergence of Democratic Capitalism

Revision  

Last week, we 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.

A highly unequal distribution of economic resources can undermine democracy.

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 entrepreneurial capitalism. But have things really changed that much?

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 of public 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 and Robinson’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 financial 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 capitalist development. 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 UCD). 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 50 billion (around 35 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 €8k 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).

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.

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 just discussed, 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.

The post-war shock to capital

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.

Slides: Week 4

Week 3: Perspectives on Political Economy

Introduction 

Last week we discussed the importance of economic and population growth in measuring the wealth of nations. We observed that there was a long period of stagnant economic growth from antiquity, and a limited improvement in aggregate living standards. The period from antiquity to 1700 is often referred to as the Malthusian era.

What we observed in the data was that it was only from the late 18th century, and the subsequent period of capitalist development from the 19th century onward, when economic growth really began to take off. What explains this divergence?

This was the fundamental question of ‘classical political economy‘.

Classical political economy is a term coined by Karl Marx in the first edition of Das Kapital, to describe those British economists that sought to explain the ‘internal framework [Zusammenhang]’ of the “bourgeoise mode of production”.

Classical political economy is a term usually associated with the normative defence of free markets (as opposed to state protectionism), and it’s origins are identified with the time period between 1750 and 1867.

Today, it is a term that primarily describes those group of political, moral and economic thinkers who drew upon and revised Adam Smith’s ‘An Inquiry Into the Nature and Causes of the Wealth of Nations‘. 

The objective of classical economic thinkers such as Thomas Malthus, David Ricardo, and John Stuart Mill was to analyze the production, distribution, and exchange of commodities in market societies.

But what really interested them was the impact of commerce on society; the role of the state in shaping the economy; and the emergence of industrial capitalism.

Put simply, they were interested in the politics of capitalist development, and the question why some countries are rich, and some countries poor?.

Adam Smith (and the division of labour):

Adam Smith’s Wealth of Nationspublished in 1776, opens with a discussion on the core concept that has shaped all theories of classical political economy: the division of labour.

For Smith, the division of labour explains the determinants of economic growth, as it is the key to productivity improvements in the process of capitalist development.

But what exactly does the division of labour mean?

  • It suggest that dividing the production process into different stages enables workers to focus on specialized tasks, which improves efficiency and enhances overall productivity. This, in turn, leads to technology improvements. In sociology, it is a concept that is used to describe the division of tasks in any given society.

One of Smith’s most popular examples to describe the division of labour is the manufacture of a pin. He describes each stage in the production process and shows that one person doing all 18 tasks can produce 20 pins a day, whereas if the 18 different tasks are divided among 18 different people they can produce over 300 pins a day.

For Smith, the most important outcome of the division of labour is skill specialisation.

The outcome of skill specialisation (which Smith describes as something that involves dexterity, tacit knowledge, skill and judgement) is a diversified economy, whereby each person is dependent upon the labour of another person.

In this context, everyone is compelled to co-operate freely in a process of exchange, as everyone is reciprocally dependent on everyone else.

This leads to his next observation:

The division of labour is wealth improving when the size of the market is bigger, and more diversified. Large markets increase the incentive to specialise.

Large markets, in turn, are made possible by “trust, reciprocity, good government, free trade and geography”.

It is often assumed that Adam Smith was a radical advocate of individual self-interest. But for Smith “man has constant occasion for the help of his brethren… he will most likely prevail if he can interest their self-love in his favour….it is by barter that we obtain from one another those mutual good office that we stand in need of“.

It is through individuals pursuing the satisfaction of human needs: food, clothing, hunger, which gives rise to commercial trade in a market society.

In summary: for Adam Smith, the wealth of a nations comes from the commercial expansion of markets, and productivity growth, which is dependent upon skill specialisation, and the division of labour.

Adam Smith (and the division of society):

Adam Smith’s labour theory of value led him to divide society into three different “classes” of person: landlords, wage-earners and capitalists.

Those who live by rent, those who live by wages and those who live by profits.

In Smith’s commercial society the hidden hand of the market acts a horizontal mechanism to ensure a diverse economy meets supply and demand. This horizontal market supplants a hierarchical model of society governed by elites.

Only productive labour, he argues, contributes to the wealth of nations. When citing unproductive labour he includes “politicians, poets, musicians, lawyers and economists”.

These are all necessary forms of labour but they are not wealth producing.

The hero of Smith’s tale of wealth accumulation (told in four historical stages) is the capitalist entrepreneur. Trade is considered more profitable than agriculture, even if the agricultural labourer is the most “virtuous of all persons” in craft and skill.

At the core of the human psyche for Smith, and classical political economy more generally, is need and desire (not rational optimal utility calculation associated with the marginal utility revolution of contemporary economics).

The desire to save and the desire to consume is what drives individual effort.

Free commercial trade, the division of labour and the expansion of markets is what enables this individual effort to come to fruition.

Contrary to popular conceptions of Adam Smith as the defender of vice and unfettered free markets he considers prudence the core virtue of capitalism.

For it is only through hard work and saving for the future that one can ensure the respect of their peers (sociability) and generate wealth (savings) for investment.

The role of the government, for Smith, is to get out of the way of commerce. But government in this context means protectionist, monarchic and authoritarian rule.

But Smith was also quite clear on what government (the sovereign) should do: provide security, infrastructure, administer justice and public education.

Adam Smith was under no illusion about the tradeoffs associated with commercial expansion, and capitalist development.

He states that commerce ultimately renders the merchant “deceitful”, whilst the idle landlord usually ends up “stupid”. If natural man is a “merchant”, then “the virtuous man is a farmer”.

Despite his romanticism for agriculture, he regularly points out that it cannot lead to aggregate wealth. A growth in national income depends on commercial expansion.

It is important to note that the Wealth of Nations is a historical and empirical text.

Smith examined both the historical predecessor to market society: feudal agrarianism, and the subsequent emergence of ‘mercantilism’.

Mercantilism was associated with state sponsored export-led growth and production (the promotion of exports over imports, and savings surpluses at expense of other nations).

Smith agreed with the French anti-mercantilist thinkers that mercantilism is consonant with absolutist rule, and a beggar thy neighbour strategy of commercial expansion.

Adam Smith (on self-love not selfishness):

For Smith, self-interest is the connecting force between ethical and economic conduct.

But self-interest is not to be confused with selfishness. It is better understood, in his words, as “self-love”, which is closely connected to reciprocity (exchange).

The term laissez-faire was never used by Smith. Further, he only ever used the term “hidden hand”, three times in his book.

For Smith, the expansion of commercial markets would ensure greater social and economic equality, which must be primarily understood as the dissolution of feudalism.

Finally, contrary to neoclassical economics, classical economic theory was built around the theory of labour value, and it’s impact on the material production of society (and the division of social classes: rentier, wage-earner and capitalist) that it gives rise to.

Remember Piketty’s core concern is that the rentier has replaced the capitalist in modern market economies. He’s arguing that the capitalist always becomes a rentier.

David Ricardo (on rent, profit and wages):

Building on the foundations laid by Smith, the classical political economists began to focus on the specialisation of the division of labor as the source of increasing wealth.

David Ricardo became interested in economic theory after readings Smith’s Wealth of Nations. In 1817, he published his famous Principles of Political Economy and Taxation.

The first line of the book states that the principal problem of political economy is that of sharing national income between rent, profit and wages (therefore he was interested in the distribution of income and not just it’s production or creation).

For Ricardo, the societal division between rent, wages and profit is the product of the commercial economic system; the volume of production within it, and the absolute income received by each person within the system.

In the late 18th century, national income was divided up between landlords, workers and capitalists. He takes this tripartite division of society directly from Adam Smith.

But unlike Smith he is deeply concerned with the rise and fall of real wages (what we would call purchasing power today) as a percentage share in national income.

He was concerned that too much of national income was being accrued in the form of rent to landowners.

As we will see Marx effectively borrowed, in total, Ricardo’s labour theory of value.

David Ricardo (and comparative advantage)

Ricardo is most famously known for his theory of comparative advantage.

This implies that a nation should specialise in the production of those industries in which it is most internationally competitive. It should then trade with other nations to import those products that it no longer specialises in at home. Swapping wine for bread.

Think about this today. What does Ireland specialise in? China? USA? France?

David Ricardo (on scarcity and rising rents)

But in his Principles (which is of most interest to us) he is primarily concerned with the long-term evolution of land prices and land rents.

His argument on scarcity and rising rents is as follows:

  • Once population and output grows, land becomes more scarce. The law of supply and demand suggests that the price of land will continuously increase (it will become scarce). This implies higher rents for landowners. Landowners will therefore claim a growing share of national income, at the expense of profit and wages.

In response to this, Ricardo called for a tax on land rents to control price increases.

His concern proved to be misplaced in the long term. Land prices increased but with the industrial revolution, the value of farm land declined relative to other forms of wealth in national income.

But his ‘scarcity principle’ is an important concept for understanding why certain prices might rise to very high levels over a given period of time (and the wealth accrued to those who benefit from rising asset prices).

Rising prices

To recognise the importance of prices, and how they are capable of destabilising entire societies and markets (and therefore benefiting certain economic interests over others), just replace the price of farmland in Ricardo’s model with the price of housing in Dublin, San Francisco or London today.

What is a reasonable price for a basic human need like housing?

Does this need to insure a reasonable price imply that the state should introduce price (rent) controls? Or is it something that should be left to the ‘market’? Should the state build houses, and therefore remove the profit motive for house building?

Adam Smith once wrote: “in times of necessity the people will break through all laws. In a famine they will break open the granaries and force the owners to sell at what they think is a reasonable price”.

In theory there should be a simple mechanism to avoid rent controls: the law of supply and demand. If the price of housing or rent in Dublin is too high, then demand should fall. People would rent property in those places where prices are lower. They would move to Donegal and commute. This is obviously not realistic.

As we will see in the coming weeks, one of Piketty’s core observations is that we should be concerned about the idle use of private wealth.

Hence, an obvious solution to the housing crisis might be a public investment project to build more houses. This means using taxpayers money, or borrowing on markets.

The general point is that Ricardo was trying to demonstrate that a long lasting divergence in the distribution of wealth is intimately linked to changes in certain relative prices, such as housing or land (the scarcity principle).

Thomas Malthus (and the diabolical trade off)

Thomas Malthus was also concerned about the scarcity of resources and how this might affect the distribution of wealth.

He published his famous essay on ‘Principles of Population‘ in 1798, and argued that the primary threat to society was overpopulation.

He based his observations on what was occurring in France, the most populous country in Europe at the time (20 million compared to 8 million in the UK).

The rapid population increases contributed to the stagnation of agricultural wages (more workers than jobs) and an increase in land rents (more people than land).

All of this fed into the growing unpopularity of the landed aristocracy, and fed the conditions that gave rise to the French revolution in 1789.

Malthus was concerned that the mass poverty, associated with rapid population increases, would ultimately lead to political revolution in England, where he favoured separate houses of parliament for aristocrats and commoners.

He was concerned it would end the rule of the elite.

For Malthus, as population increases, food per person decreases. He called this the law of diminishing returns. This meant that there is an inverse relation between wages and population growth. This is what some call the  ‘diabolical tradeoff’.

But there were natural adjustment mechanisms to deal with it: famine and war.

The Black death (1348-1350) was one of the largest determinants of population decline in history. In England, the Black Death wiped out 1.5 million people out of a population of 4 million.

In the absence of such natural adjustment mechanisms, Malthus called for an end to welfare assistance to the poor and proposed other mechanisms to reduce their reproduction habits.

Charles Dickens clearly disagreed with Mathus. His ‘Christmas Carol‘, published in 1843, can be read as an allegory against Malthusians.

If you remember, Scrooge repents in the end. There is no natural diabolical tradeoff between income and living standards/population increases.

But there might be a tradeoff about the rate of growth and the cost of public services i.e. people living longer cost the state more on pensions. Demographic changes put increased demand on public services, which raises the question: who pays?

This is a core fiscal problem that many European states are struggling to deal with today.

In fact, many argue that the crisis of contemporary capitalism is related to the crisis of fiscal democracy: public services require more investment, but everybody wants somebody else to pay.

Conclusion

Classical political economy is a term that is popularly used to describe a body of economic theory that advocates laissez faire, free market capitalism.

But it is more nuanced than this.

It is better understood as the beginning of a scholarly attempt to systematically analyze the emergence of commercial society, and the internal conflicts of capitalist development (particularly the determinant and destabilising effect of rising prices).

For the classical thinkers, the determinants of economic growth (and therefore increased living standards and the overall wealth of nations) is labour specialisation, human skill, productivity improvements, trade and the expansion of markets.

All of this was based on a particular political democratic theory of economic liberalism. Private property (against the state) was assumed to be the primary source of justice. Hence, it was what could be described as a normative political economy.

John Stuart Mill, for example, whom we have not discussed, favoured a different concept of private property. Markets provide an incentive mechanism to promote social utility.

Classical political economists assumed that greater social and economic equality would accompany the ever greater expansion of the market i.e. economic growth.

It was assumed more markets = more trade = more growth = rising tide lifts all boats. Whether this is true or not is what we will discuss on Weds.

The critical turn…..

The study of political economy, and political science, can be distinguished from the study of economics/econometrics because of it’s focus on:

  • Power
  • Institutions
  • Distribution

In terms of power: whereas economists tend to analyze the market in terms of Pareto-optimality, political economists tend to analyze markets in terms of whose interests are being served by a given set of economic arrangements.

In terms of institutions: political economists tend analyze the economy as a diverse set of institutions that vary across time (history), and space (country).

These institutions are the rules of the game that shape actor behaviour.

In terms of distribution: political economists study the market as a social construct whose conception is not based on natural laws but the primacy of politics.

They are primarily interested in the question: who gets what, when and how.

This tradition stems from Adam Smith but took a critical turn when Karl Marx published the first volume of Capital in 1867, fifty years after Ricardo published his Principles on Political Economy. 

  • Think about the year 1867. What was happening across Europe?

It was twenty years after the 1848 European revolutions, which swept across Italy, France, Germany, Netherlands, Poland, the Austrian Empire, and even Ireland.

What all of these nationalist revolutions shared was the attempt to overthrow feudalism and to replace it with more participatory forms of democratic government.

This gave birth to the nation-state as we understand it today.

The revolutionary fervour began in Milan when 70 people were killed whilst protesting against tax increases on tobacco, imposed by their Austrian rulers. These protests spread to Sicily, where local citizens demanded a liberal constitution to replace the autocratic rule of King Ferdinand II.

Before long people were rioting in Geneva, Paris and across several cities in what we now call Germany.

Historical context

It was against this background that Marx published Volume I of Capital.

Think about the context. England had the fastest growing economy in the world. Thousands had left the land to work in factories. All of these new labourers were living in urban slums. This is what inspired Charles Dickens to write his famous novel, Oliver Twist.

From 1840-1890 poverty was widespread, real wages were stagnant, whilst profits increased. It was not until the second half of the 19th century before real wages began to increase for the emergent industrial/working classes.

Keep in mind Adam Smith’s labour theory of value that we discussed last week.

National income (all earnings in a country) can be divided into wages, rent and profit. During this period of growth, the share of wages in national income did not rise.

The capital share of national income (industrial profits, land rents and building rents) increased massively in the first half of the 19th century.

As we will see from Piketty’s data, from 1870-1914 inequality stabilized at an extremely high level, marked by an increased concentration of wealth.

  • The industrial revolution gave birth to a period of rapid economic and productivity growth, stagnant wages and a growth in economic inequality.

This is the historical context that led Marx to write the ‘communist manifesto‘ in 1848.

The method

After this polemic, Marx spent the next twenty years writing Das Kapital, which he considered the first scientific attempt to systematically analyze the internal logical contradictions of the capitalist system (based on the Hegelian dialectic).

For Marx, the most important resource in a market economy is not land but capital.

He takes Adam Smith’s analysis and works through the logical outcome of commercial markets. He concludes that markets lead to centralisation not competition.

Keep in mind that Capital in 1868 was increasingly industrial (machines, factories) rather than landed property. Hence, contrary to Ricardo, for Marx there can be no limit to industrial capital. This led Marx to formulate his “principle of infinite accumulation“.

A free market for capital/money, when left to its own devices will keep accumulating and become more centralised. For Marx, this principle of infinite accumulation implies that capital is doomed to perpetual crises (in the Hegelian sense).

Why?

  • For Marx, either the rate of profit will steadily decline (leading to violence amongst capitalists) or capital’s share in national income would increase indefinitely (leading to workers revolution).
  • For Marx, there is no stable equilibrium in a capitalist society, it will “build it’s own gravediggers“.

The theory (M-C-M)

Let’s unpack this theory further.

First, it is crucial to note that Marx is in dialogue with Adam Smith. In chapter 2 of volume I he accepts the Smithean argument on exchange, reciprocity and private property and then proceeds to deconstruct it entirely.

He points out that contrary to the positive outcomes suggested by Adam Smith, competitive markets will lead to:

  • the centralization of capital (markets lead to corporations)
  • the concentration of capital (centralization leads to class power)

The entire book can then be read as a deconstruction of the system of free competitive markets, in order to show why they can never be ‘free’.

Marx, much like Smith, tell a story about capitalist development: the capitalist starts out with a certain amount of money. He then purchases two crucial commodities:

  • Labor power and
  • Means of production (raw materials, machines)

He then puts these two to work within a given technology to produce a fresh marketable commodity. This is then sold in the market place plus a surplus value to make a profit.

But it does not stop here. The capitalists does not consume all the profit as luxury. Rather he/she re-invests it to produce more commodities.

To do this, the capitalist must expand labour and apply new technologies to produce new and better commodities.

Why? For Marx the coercive laws of competition compels the entrepreneur to reinvest the surplus. If he/she does not he/she will be destroyed by his competitors.

The outcome is a simple formula for the circulation of capital: M-C-M. Money-commodity-Money.

The 5 crises tendencies 

For Marx the capitalist mode of production always leads to crises. It contains 5 major problems that lead to the following questions:

  • Money: Where does it come from?
    • Solution: Secure the legal-state
  • Labour: how to source supply and demand?
    • Solution: Weaken organised labour
  • Environment: How to deal with scarcity?
    • Solution: Invest in technology
  • Technology: The falling rate of profit?
    • Solution: Source new markets
  • Debt: How to keep the system liquid?
    • Solution: Ensure aggregate demand

Keynes would later suggest that the role of the state and fiscal policy can be used to stimulate the economy if the market is faced with a lack of effective demand.

What is important to note is that these blockage points within the capitalist mode of production need to be overcome.

For Marx capital is a flow, if you stop the flow, capital gets lost. This is why Marxian economists are critical of Piketty, who thinks of capital as a stock of wealth.

For Marx, capitalist politics is a perpetual class struggle over all of these factors that keep the system intact. If there is no resolution then stagnation occurs. Crises = Revolution.

Why Marx was wrong

Marx predictions on the inevitable demise of the capitalism turned out to be wrong. He assumed that capitalism would collapse. It didn’t.

This mistaken judgement is not so much related to his insightful historical analysis, but to his use of dialectical Hegelian method, which assumes, by definition, implosion.

At the end of the 19th and into the 20th century, wages gradually began to increase, and the purchasing power of workers spread everywhere.

In Western Europe, workers and citizens explored the alternative avenue of social democracy, rather than communism.

Marx did not anticipate the emergence of a propertied middle class, the social state, nor the emergence of new technologies, or a steady increase in productivity.

The balance of power among different classes associated with trade unionization complemented the emergence of a new power configuration, with a a relatively autonomous state apparatus with the capacity to tax and spend.

This gave birth to the social state as we understand it today. Or capitalist democracy.

What did he get right?

Marx’s principle of accumulation contains an important insight that contemporary economists have tended to ignore: competitive markets have a tendency toward the centralization of ownership and the concentration of wealth.

Just think about the influence of large corporations, such as Google.

The accumulation and concentration of wealth does lead to the concentration of power, which has destabilising effects in both politics and economics.

It would be naive to think that growing income and wealth inequality does not impact on equality of opportunity and democracy.

Why then have economists tended to ignore the distributional question?

Simon Kuznets 

The narrative during the 20th century shifted away from apocalyptic predictions to happy endings. It was now assumed that a rising tide lifts all boats.

Simon Kuznets predicted that income inequality would automatically decrease in advanced stages of capitalist development, regardless of the economic policy choices pursued by government.

This theory was based on US data from 1913-1948. It built upon Robert Solow’s (1956) theory of a “balanced growth path”.

Economists increasing assumed that all the core economic variables in society: output, incomes, profits, wages, capital, asset prices, would progress at the same pace.

In the end,  a market economy would benefit everyone, as it is the best way to achieve high levels of economic growth.

This was the opposite conclusion to Ricardo and Marx’s assumption of an inegalitarian spiral built into the process of capitalist development.

Kuznet’s was the first to analyze social inequality using sophisticated statistical and mathematical tools. His data (which Piketty has since developed) was based on federal income tax returns.

This allowed him to measure top incomes, particularly the income shares going to upper deciles and centiles, in the overall income distribution.

What he observed was a sharp decline in income inequality between 1913-1948.

In 1913, the upper decile (top 10 per cent of earners) claimed 45-50 percent of national income. By the late 1940’s this had declined to between 30-35 percent.

This decrease was equal to half the income of the poorest 50 percent of Americans.

This decline in income inequality shaped the debate on the politics of distribution in the USA, and various international organizations, throughout the Cold War.

Capitalism was clearly working for everyone whilst the Communist experiments were not. This was an important normative justification for market economies.

Kuznets curve 

Kuznets delivered a paper titled ‘Economic Growth and Income Inequality‘ to the American Economic Association, which gave birth to a new theory: the ‘Kuznets curve’.

This predicted that inequality would initially increase during industrialization and decrease at a later advanced stage of capitalist development.

The internal logic of capitalist development was now assumed to be one of equalization not wealth concentration Market competition leads to a balanced growth path.

As we will see in the coming weeks, it is true that wealth and income inequality decreased in the 20th century, particularly after the shocks of two world wars.

But it is also true that wealth and income inequality have since increased, everywhere, since the late 1970s. This is the opposite prediction of Kuznets theory.

The income of the wealthiest have reached extraordinary levels whilst the incomes of the vast majority have stagnated. This is now clearly observable in the data.

This table and graph illustrate the point.

The question we need to ask is why this has occurred?

Conclusion 

The important question we will now try to address is why there was a decline in inequality in the 20th century, and and a rapid rise during the 21st century.

There are two competing explanations: economists tend to focus on skills-based technological change. Political economists focus on politics and bargaining power.

What we will see over the coming weeks is that in the aftermath of WW2, various forms of progressive taxation, capital controls, collective bargaining, rents control, minimum wages and expanded social programs worked to redistribute capital across society.

These were the ‘happy days‘ of a growing middle class.

There is now growing skepticism about the assumption that growth is “naturally” balanced. There are clearly winners and losers. In the US, the top decile receives over 52 percent of national income (a new historical record).

What the data increasingly suggests is that the gains of “economic growth” are being distributed disproportionately to the top of the income ladder.

But to explain the U shaped curve of inequality from 1900-2013, we need to examine the structural origins of this inequality (1890-1913), which is what we will do next week.

The industrial revolution, in addition to the race to colonize the world, completely transformed the face of market society in Europe. Wealth was totally transformed.

slides: Week 3

Week 2: Measuring Income and Wealth

Introduction 

The field of political economy was born in the late 18th century when moral philosophers such as Adam Smith began to ask questions about how nations prosper? What kind of conditions ensure their wealth? and how should this wealth be distributed?

It is not a coincidence that the inception of ‘political economy’ coincides with the birth of the modern state and industrial capitalism in the 19th century. This was the beginning of what’s often called “capitalist development”.

Political economy studies the state-market relationship. In economics, the state is considered to “intervene” in the market to correct market failures, or to provide public goods. This is a rather restrictive definition. In political economy, the state is conceived as actively shaping the market, such that there is not such a clear dividing line between state and market, economy and society, economics and politics.

The contribution of the World Income Database to the study of political economy is to provide 200 years of data to track the history of ‘wealth and income distribution‘. The general conclusion that researchers have drawn from this data is that we are witnessing a level of within country inequality not experienced since the early 19th century.

But before we discuss the determinants of inequality, and the different theories of political economy that explain capitalist development (Lecture 4 and 5), it is important that we clarify some important political economy concepts, such as income and growth.

Part 1 of Capital in the 21st Century is titled Income and Capital. This is where the core definitions are laid out. These videos are a useful starting point:

National Income

The first concept to understand is national income.

  • This can be defined as the sum of all income available to the residents of a country in a given year. Or more precisely, it is the total amount of money earned in a country. In this course we will use “Gross National Income (GNI)” rather than “Gross Domestic Product (GDP). This is particularly important in the Irish case.

Try to think about national income in real concrete terms. All socio-economic activity, and socio-economic production (whether it is teaching students, driving a bus, serving coffee, providing customer support, designing websites, cleaning roads  or manufacturing iPhones) must eventually be distributed as earnings i.e. income.

There are two ways these earnings will be distributed: labour income and capital income.  It will be either distributed as labour income (in the form of wages, salaries, bonuses) or capital income (in the form of profit, dividends, and royalties).

National income = labour income + capital income in a given year.

The core critique of the 1% is that their wealth is increasingly accrued not through earnings or profit (entrepreneurs) but through unearned capital income.

Unearned income is the interest/rent accrued from owning property or financial assets.

The income/rent received by virtue of owning an asset (i.e. housing) tends to yield a higher return than income earned through work/employment. It is this observation that underpins Piketty’s theory of R>G, which I will explain later.

If the ownership and inherited power of wealth and capital matter much more than than hard work and human capital (skills), then the normative justification for liberal market economies becomes increasingly problematic.

We will come back to this later, as it’s a controversial argument.

Many economists argue that what matters today in shaping the trajectory of economic development is human capital skill (which is heavily influenced by talent/education/training). But what is corporate capital matters a lot more?

  • For now, the crucial point to remember is that national income = capital income + labour income (this is the same whether we are looking at the accounts of a multinational company, a small family firm, a government or the global economy). The definition of national income (all money available) is an accounting identity.

National wealth

But what exactly is wealth and why does Piketty used the term wealth and capital interchangeably? Capital is a stock, income is a flow. National wealth is the total amount of capital stock (buildings, real estate, land, stocks and bonds) in a country.

Think about it this way: capital/wealth is something you own, and which generates an income. For example, housing is capital (stock), and the rent accrued to a landlord is capital income (flow). The purpose of owning a house to rent is to earn an income.

When you go to work, you earn a monthly wage. This is a flow. When you put aside some of this money into a bank account, it becomes a stock. It’s small form of wealth.

This definition of capital as a stock of wealth is important because Piketty’s conceptualisation of capital has come in for a lot of criticism.

  • Capital is accumulated wealth. For definitional purposes, you can define it as the sum total of non-human assets that can be owned and exchanged on some market. It can be either publicly or privately owned. The value of capital is decided by the price someone is willing  to pay for it (the market).

Or more precisely:

  • Capital/wealth is the sum total of non-financial assets (land, buildings, real estate, industry, machinery) and financial assets (bank accounts, mutual funds, stocks, bonds, insurance and pension funds ) less debt.

Generally speaking, capital or wealth is something that is not immediately consumed. It is something that is owned, and therefore it is defined by property laws.

But not every country defines property in the same way (think about the ownership structure of German firms, and compare them to US firms). It’s a legal construct.

What capital is worth is ultimately determined by market value.

If the market collapses, so does the price of assets and the value of wealth. Think about the spectacular rise and fall (and rise again) of house prices in Ireland. The houses did not burn down. They remained in place. But their market value (price) fluctuated widely.

When the price of a house falls by thirty percent, the person owning that house is likely to feel less wealthy. When the price rises by 50 percent, they felt wealthier. This observation is important because it has a big impact on electoral preferences toward government redistribution policies. Nobody who owns a mortgages wants prices to fall.

Or to put it another way, nobody who owns any form of capital/wealth/property/asset wants the price value to fall, because they will, by definition, lose wealth. Hence, the policy response to the financial crisis was designed to stabilise market prices.

Other examples: think about recent events in Argentina and Turkey. Or think about the value of a Damien Hirst painting. What determines the price of the painting?

The market value might say 100 million, even if the aesthetic value is zilch.

Public/private wealth

Capital/wealth can be public or private. In theory, all capital/wealth could be owned by the state. In market economies, capital/wealth is almost entirely privately owned.

  • National wealth= public wealth + private wealth. Private wealth accounts for most national capital in all of the twenty countries mentioned or studied in the book.
  • Public wealth (such as UCD) constitutes a tiny portion of national wealth.

Figure 5.1 captures this disparity in private and public wealth.

Note something very important in this graph: the fluctuations in the value/price of national capital tends to correspond to fluctuations in private wealth.

Given that most wealth is privately owned, and most political economists are not communist, it is perhaps no surprise that scholars focus on fiscal policies to tax wealth, and unproductive assets, rather than calling for them to be nationalised.

Think about the current housing crisis in Dublin. In theory, the state can issue compulsory purchase orders (CPO’s) and take private property into public ownership (as was done in Mayo on behalf of Shell, when the state issues CPO’s on farming land). Alternatively, they can use the fiscal tools of the state, and tax derelict property, such that the owners are forced to sell the property into the market (rather than hoard it).

Wealth/income ratios

For Piketty, the best way to analyze the importance of capital/wealth in a society (i.e. capitalism) is to measure the amount of capital (stock) as it relates to income (flow).

Dividing the total capital stock (measured by the market) by national income gives us the wealth/income ratio (β). This is also called the capital/income ratio.

Imagine all the capital in Ireland (housing, land, financial assets). Now imagine the value of all that in terms of a price (billions). Now divide that price by national income. This gives you the ratio, which we tend to express in terms of percentages.

Wealth/income ratios provide us with a comparable quantitative measure to analyze capitalist development across time (history). It allows us to measure whether or not wealth has grown in importance when compared to wages and labour income.

It allows us to observe the structural importance of capital/wealth in society.

However, it tells us nothing about whether that capital/wealth is being put to productive use or not. Nor does it tell us anything about the ownership of capital. For example, housing-capital might be worth billions, but if these are empty, what use are they?

  • If a country’s total capital stock (wealth) is equivalent to 6 years of national income we write β = 600%. β is a shorthand to say the capital/income ratio. If it is equivalent to 4 years of national income, we write 400%.
  • This graph shows the evolution in the capital/income ratio for Germany, Britain and France.

Back to the case of Ireland, if income per capita is 33k, and wealth per capita is 200k we simply divide the two to find the capital/income ratio (i.e. 6, which we write as 600%).

On a macro-social level we find that, on average, wealth is 6 times average national income. We then say that the capital/income is 6 (or 600%). But remember this tells us nothing about the distribution of wealth. Most people don’t own any wealth at all!

Keep that in mind: 50% of the population are propertyless, or owe significant debt.

In theory, a high capital/income ratio (more wealth) is a good thing. What matters is how it is distributed, and how it’s used. This is the core critique of rising wealth inequality today. Societies are privately wealthy, but publicly poor.

Scholars are concerned that the rise in wealth-income ratios means that wealth is concentrated in fewer and fewer hands, and that it’s not being used productively.

R>G mechanism

In the book you are reading, Piketty proposes a theoretical mechanism to explain the rise and fall of the capital/income ratio. The theory is R>G.

He suggests the following:

  • When the rate of return on capital (r) is equal to economic/wage growth (g) then the capital/income ratio remains stable.
  • When the rate of return on capital (r) exceeds economic/wage growth (g) then the capital/income ratio rises. Wealth accumulates.

This is what we observe in the USA and Europe since 1980.

R>G leads to rising capital/income ratios. This suggests ‘private capital is back’. It’s is an implicit critique of the economic theory of skills-based technological change.

It suggests that those who own wealth and property may be entrepreneurs, but over time, they become rentiers. What this means is that over time, as wealth accumulates, inheritance matters more than hard work in the process of wealth accumulation.

Piketty has come in for a lot of criticism from those who argue that the rise in capital/income is mostly accounted for by rising house prices. It is the rise of a property-owning middle class that distinguishes the 21st century, and the type of wealth that most middle class people own is housing. As it’s price rises, so does national wealth.

For example, when we begin to analyse the structural transformation of the composition of wealth over time, from land (18-19th century) to industry (19th-20th century) to finance (21st century), what we will observe is that “financialisation” is intimately connected to the mortgage-debt market, and the buying/selling of houses.

House prices have been rising much faster than wages/income, leading to an increase in the capital/income ratio, and housing is the asset of the middle classes.

From a political science perspective, think about the following question:

What matters more in shaping electoral preferences: home ownership or labour income? Do people who own housing vote differently to those who do not own housing? Why might property owners vote differently to the propertyless?

Discussion 

Lets think about these definitions in real concrete terms. How much does the average person in Europe own in terms of capital/wealth?

  • In most western European countries, average private wealth is around €180,000.
  • This means that, on average, each person in Europe will own €180,000 worth of capital (think about your savings account/or your parents house).
  • This will be divided roughly into €90,000 from residential dwellings (housing) and €90,000 in stocks, bonds, savings and investments.

Remember, these are averages, and just give you a rough sense of what’s going on.

In reality, more than half the population own nothing at all. As we will see, in the US, the top 1% own 80% of all wealth. 50% of the population own nothing.

If the remaining 40% do own any wealth, it is usually nothing more than some savings in a local bank account, which they may have inherited, or received as a gift.

Most wealth/capital is highly concentrated at the very top of the income ladder.

As we will see, and which is completely intuitive, wealth is far more unequally distributed than labour income. Most people work. Most people don’t own capital.

In terms of income:

In France, Germany, Italy, Britain (reflecting an average for Europe) and the USA, national income per capita (per person) is around €30-35,000.

Again, this is an average and hides enormous disparities amongst the population.

Most people earn significantly less than €2,500 a month from their labour income.

Income and capital

  • Take the average Irish person.
  • If per capita national income is €30,000 per annum (it’s actually higher). According to Piketty this mean that €21,000 will come from labour income (70%) whilst €9,000 will come from capital income (30%).
  • If each citizen owns €180,000 in capital this figure of €9,000 equals a rate of return of 5%.

Most people obviously don’t earn €9,000 in capital income because they don’t own any wealth. These are averages.

Most people will pay their landlord rent, and/or pay interest to their creditors (banks) for borrowing i.e. to pay their mortgage debt.

Rate of return

But how exactly do we calculate the rate of return on capital (i.e. capital income)?

  • On the basis of historical analysis, Piketty finds that on average, in the long-run, economic growth averages 1-2%, whereas the rate of return on capital is 4-5%.

The book you are reading does not really explain why the average rate of return on capital is 5 percent, which is a major blindspot.

But one way to think about this is in terms of how much interest one can generate from owning a capital asset. Lets go back to the example of owning residential housing.

Owning real estate or property can generate a return of between 3-4 per cent interest. Owning stocks in a firm can generate between 7-8 per cent. Owning German issued government bonds can yield around 1-2 per cent interest. The yield varies.

In Dublin, housing can yield up to 12%! Hence, it should be no surprise that those with money (international investors) are investing in Dublin real estate.

Generally, the riskier the asset, the higher the yield (return). For example, investing in a start-up company. You could lose all your money, or if the firm becomes a success, earn a fortune. Just think about the value of a company such as Apple, or Alphabet.

Distribution

You should now have a clear sense of what it means to talk about national income, labour income, capital income, national wealth, wealth-income ratio’s, and the rate of return on capital assets.

But even if you know what national income is, this will not tell you about how national income is distributed. Similar, even if you know what national wealth is, it won’t tell you who owns the wealth.

In this course, when we discuss the distribution of national income, and national wealth, we will do so with reference to distributional tables.

In the study of inequality, researchers usually divide up the population into quintiles (bottom 15%, top 20% and so on), or deciles (top 10%, bottom 10%).

  • Quintile = 20% of the population
  • Decile = 10% of the population
  • Percentile = 1% of the population

We will mainly make reference to the bottom 50%, middle 40%, top 10%, and top 1%.

Discussing inequality with reference to distributional tables provides a much more visceral understanding of how income and wealth is distributed.

Summary

The most important concepts to remember for this course are:

  • Capital/income ratio, also called the wealth/income ratio
  • Public/private wealth
  • Capital income (income derived from owning assets)
  • Labour income (income derived from wages)
  • National income (the total income of a country, which flow from the factors of production)
  • The rate of return on capital (interest accrued from ownership of property)
  • Quintile
  • Decile
  • Percentile
  • Distribution tables (50/40/10-1).

Conclusion

To understand these concepts think about a 19th century Jane Austen novel, such as Pride and Prejudice.

The aristocratic characters in these stories revolve around the landed gentry of 19th century England. They constantly remark that the rate of return on land in their rural societies is around 4-5 per cent.

They are perfectly aware how much land/wealth they need to live well (or marry into). In this period, almost all wealth was bound up in land. Wealth was land.

How much does one need to live well today?

How would you generate that income: from work or from owning capital?

Next week will talk about the evolution of economic growth. This is crucial because the slow down in economic growth is often considered the most important determinant of the the re-emergence of a rentier society. Why?

  • Slow-growth economies are wealth-dominated societies. Think about Italy.

This is why many scholars argue that inherited wealth has become more important than hard work, much like the 19th century societies of patrimonial capitalism in Jane Austen.

In our democratic market societies this is difficult to justify, as it undermines a culture of meritocracy, which is the normative justification for capitalism.

Economic growth

In rich countries individuals are healthier, live longer, have better access to public services and better educated. Why are some countries rich and some countries poor?

Why does this matter? Is economic growth coming to an end? What do economists mean when they talk about secular stagnation? Is economic growth always a good thing?

To explain these contemporary dynamics, and to answer some of these questions, it is worth taking a longer term perspective.

The first thing to note is that measuring “growth” requires examining both population and economic growth. It is the latter (better referred to as productivity growth) that tends to improve aggregate standards of living.

This data shows global economic growth since the industrial revolution.

The law of cumulative growth 

Albert-Einstein-8th-wonder

It is important to note that a small percentage change compounded over a long period of time accumulates very quickly. A generation of economic growth can spur huge social change. Just think about what Ireland looked like in the 1950’s, then compare it to the 1980’s. Now compare it to 2017. They are literally “generations” apart.

For example, an annual growth rate of 1 per cent is equivalent to a generational growth rate (30 years) of 35 per cent. An annual growth rate of 2.5 per cent is equivalent to a generational growth rate (30 years) of 110 per cent. For purely conceptual purposes, you can think of the latter as a 100% change over a generation.

In contemporary political discourse, politicians and policymakers often assume that a growth rate of 2 per cent per annum is small, and insufficient. But when compounded over 30 years, it can lead to a huge amount of socio-economic change.

Economic change can spur both positive innovation and social dislocation. But it can also create huge societal problems (i.e. housing stock not keeping apace with demand). Relying on the market is not necessarily good public policymaking.

Measuring compound change is called the law of cumulative growth.

When thinking about it in terms of wealth accumulation (as opposed to economic or population growth), it basically means that the annual rate of return (capital income) compounded over several years automatically results in a very large increase.

Hence, if wealth grows faster than wages, we tend to see a divergence in who benefits from economic growth.

  • Table 2.2 captures what this means in concrete terms and can be applied to anything from the rate of return on capital, population growth, household income or economic growth.

This is crucial for understanding Piketty’s argument on the inequality R>G.

A small gap between the aggregate economic growth rate (which gives a sense of wage growth) and the rate of return on capital (which gives a sense of wealth accumulation) can accumulate over many years, creating a deep structural divergence in society.

Most economists in the 20th century assumed that there would be a perpetual decline in wealth inequality, and assumed that economic growth would lift all boats (often called trickle down economics). Economic growth was considered something that equalised standards of living, as ultimately, in the end, everyone would benefit.

This is the normative foundation of democratic capitalism: everyone benefits, everyone gains, and not just the elite. Piketty is suggesting this is no longer the case.

Population growth

Let’s look at population growth for the moment, from antiquity to the present, to get a sense of just how much has changed over time.

  • Figure 2.2 depicts the growth rate of the population from year 0 to 2100. The demographic growth rate from year 0 to 1700 was less than 0.1 per cent. But in the end, much of this growth in the population was wiped out by famine and disease.

Population growth increased significantly with improvements in medical technology and sanitary conditions. Demographic growth accelerated significantly from 1700 onwards.

But there was huge variation between countries.

The USA went from a population of less than 3 million in 1780 to 300 million in 2010, whereas during the same time period, in France, it only doubled from 30 to 60 million.

According to UN forecasts the annual population growth rate will fall to 0.4 per cent in 2030 and then 0.1 per cent in the 2070’s.

This is not a course in demography, and we are not interested in demographic growth for its own sake. We are interested in population growth because it has implications for the structure of economic growth, and wealth and income distribution. As Piketty states:

Strong population growth, as in the USA, tends to play an equalizing role in wealth distribution. It decreases the importance of inherited wealth in the sense that every society must reinvent itself.

What does he mean by this? Put simply: if you are one of fifteen children, it is probably not a good idea to rely on inheritance from your parents to generate income and wealth.  Conversely, if you are one child, then you’re likely to benefit from inheritance.

The same logic applies on a population wide aggregate basis.

Economic growth

This observation (the equalizing role played by the law of accumulated growth) makes more sense when we extend it to economic growth. Ireland is a good example here.

If you live in a country that is growing rapidly, such as 4 per cent per annum (with wages growing 3 percent), over a generation (30 years), you would be wise to get working, to take advantage. Hence, inward migration to countries with growing economies.

Conversely, in a country with stagnant population and slow economic growth, and with poor employment and wage prospects, inherited wealth and capital accumulated from the past (i.e. from the hard work of your grandparents) takes on much more importance in society. Think about Italy.

This is why people emigrate to fast growing economies.

This is the crucial point for Piketty. The data suggests that western economies are slowing down rapidly but remain rich in wealth. They are capital-asset rich societies, with slowing productivity growth. Hence, the past impacts on the present.

Low growth economies are societies dominated by inherited wealth, and accumulated assets from the past (think Italy or France). Private capital that is owned tends to be saved and hoarded, rather than put to productive use in the real economy (i.e. investing in infrastructure). Think about an empty building in the city centre.

  • See table 2.5 for a breakdown of per capita economic output by global regional blocs.

Distribution

For Piketty, declining economic/productivity growth at the macro-level is the main factor leading to rising wealth inequality over the long-term (the inequality R>G).

Slow growth defined the 18th and 19th century. The fast growth in the 20th century changed this. Piketty suggests it has re-emerged today in the 21st century.

It is crucial to note that it was only during the 20th century that economic growth became a tangible benefit for everyone. Why? Access to health and education were central to this shared growth. The birth of the social state re-distributed growth to the benefit of society.

It was the birth and complement of liberal markets, and democratic welfare states.

In particular, the strong economic growth that swept Europe from 1945-1975 enhanced the possibility of social mobility for those whose parents did not belong to the elite of a previous generation. It also funded the emergence of the ‘social state’ in Europe.

The social state primarily refers to the brith of social rights: universal provision of education, healthcare, eldercare, and in some countries, childcare and social security.

In the post-war period of strong growth, new business models were created. New skills and capabilities were developed. Capital and labour were put to work in different ways.

Economics, however, tells us very little about the distribution of growth. This is a question of politics. Trade unions, for example, played a significant role in making sure the growth was compensated with a strong wage-productivity push, as pointed out by Larry Summers.

If societies want to ensure that the gains of productivity growth and technological innovation are distributed fairly (i.e. not captured through rents by the elite) then this requires an inclusive set of political institutions.

Democracy enables market capitalism because it widens the opportunity space for innovation and inclusion. See the work by Acemoglu and Robinson.

Discussion

What institutions and public policies are likely to lead to inclusive economic growth? Is it better to live under a dictatorship with a home and a job, than to be unemployment in a democracy?

It is this emphasis on democratic institutions, public policy and electoral choice that defines large parts of contemporary political economy.

Markets are viewed as variegated, and subject to radical mutations and adaptations (not a deterministic techno-economic paradigm), and primarily shaped by politics.

Conversely, Marxist economists anticipate a never ending crises of capitalism (such as the great recession) that will lead to its collapse.

But what about recent events? Does Piketty’s data suggest that perhaps Marx was partially right? Yes and no. We will discuss this next week.

Labour market

The major impact of technological growth in the 20th century has been in the structure of employment. The structure of economic growth has a huge impact on jobs.

  • See table 2.4 on changes to the labour market.

Over 70 per cent of the population in the western world now work in services; even in countries as diverse as France and the USA. This is a broad category and includes high-skill and low-skill service jobs, traded and non-traded.

The defining characteristic in all advanced capitalist economies of the western world  is the decline in manufacturing (and low to medium skills more broadly).

What we are witnessing is a growing divide between high and low skilled jobs, with medium skilled jobs (bank clerk, manufacturer etc) in decline. For economists, this is largely driven by the impact of globalisation, and technological change.

Think about the impact of technology on the labour market. For example, consider the impact of the Uber on taxi-drivers, robots on car manufacturing, computers on office clerks, washing machines on cleaners etc.

Here comes the bad news, most research would suggest that the structural shift from ‘manufacturing to services’ has significantly slowed down productivity growth rates, and that these are unlikely to increase in the near future.

Secular stagnation 

Most forecasts suggest that the thirty post-war years of strong economic and productivity growth in Europe were the exception rather than the norm.

The implication is that liberal democracies cannot rely on economic growth to realize their democratic aspirations. This has major implications for electoral politics.

Further, as we will discuss in later lectures, some economists suggest that the determinants of economic growth (technology and productivity improvements) may be in perpetual decline. This is often referred to as ‘secular stagnation‘.

Capital/wealth is running out of places to invest. It’s being hoarded/saved.

Since the 1990’s the policy response to low growth has been to remove the political constraints that inhibit free markets: liberalization, tax cuts, capital mobility, hard currency and austerity.

This is what popular commentators, such as Paul Mason, among others, call the crisis of neoliberalism.

The golden age

  • Figures 2.3 shows the comparative evolution of economic growth rates in Europe and North America.

Per capita output surpassed 4 per cent every year in most European countries between 1950-1970. If we exclude Britain it was even higher.

Now think about this in terms of the law of cumulative growth. This was the golden age of capitalism, it’s your parent and grandparents generation.

Note the difference between Europe and the USA from 1940-1975. This difference might explain why Americans do not have the same nostalgia for the ‘golden age of democratic capitalism’, or socialist democracy, as many Europeans do (again, think France).

UN and OECD data now suggests that Europe and the USA look set to enter a new period of low-growth.

Inflation 

Any discussion on the history of growth must, however, include an analysis of inflation. If growth is 3% per annum and inflation is 2% then we say real growth is 1%.

Between 1913 and 1940 inflation in Germany was 17% per annum. Prices rose by a factor of 300. Inflation was widely used to reduce the public debts accumulated during the world wars.

In 1720 England the average income was 30 pounds. Fifty years later, it was barely 40 pounds. Think about the average income in France today compared to the 1950’s.

The crucial point to remember is: monetary markers are stable when economic growth is slow.

Inflation is largely a 20th century phenomenon. It can be explained by distributional politics rather than economic science. See figure 2.6.

We will have more to say about this later in the course.

Conclusion

  • Figures 2.4 and 2.5 show that global growth over the past three centuries can be pictured as a bell curve with a very high peak.

Western economic growth peaked from 1940-1975 and then declined. With the ‘neoliberal’ revolution in the 1980’s growth picked up again in the 1990’s, and has since declined again.

As we will see, the period of liberalisation (post 1990’s) was made possible by FIAT money; new credit formation and the financialisation of debt.

The question many scholars are asking today, in the aftermath of the international financial crisis, and the subsequent “great recession”, is whether we will see a new paradigm shift in the architecture of our political economies?

If so, what will define the period of growth over then next 30 years? Will we see the emergence of a new economic paradigm? What will be the structure of economic growth? How will this impact upon the politics of economic inequality?

We have now mapped the history and explained the core concepts.

In the next lecture, I will discuss political economy theories on the determinants of capitalist development, before trying to explain why inequality has increased so rapidly since 1970.

Week 2 slides: Week 2

Week 1: Capitalism and Democracy

Introduction

One core question permeates political economy scholarship: how is it possible to combine capitalism (free markets) with democracy (collective choice)? One produces stark inequalities in the distribution of income and wealth, whilst the other (the democratic state), in principle, is based on egalitarianism (one person, one vote).

So why don’t the poor soak the rich? There are a lot more poor people than rich people.

As we will see throughout this course, understanding the relationship between states and markets, under democratic rules, is anything but straightforward. A sizeable middle class can act as a buffer against radical demands for redistribution. Choices in the past create a path dependent effect, and the electorate often vote against their interests.

The puzzle

For the moment, all I want you to note is that the distribution of wealth and income is a big concern in the social sciences, and in particular, the study of political economy. For the next two weeks, I want you to think hard about the politics of inequality, and to ask yourself questions such as: what type of inequalities are justified? what are not?

The question as to who gets what, when and how (in terms of national income) is not just an academic concern. It has major public policy consequences.  As citizens, we want to know about wages, income, inflation, and cost of living. For example, you’ll certainly want to know how much you’ll be paid before you sign a contract to start a new job. You’ll also want to know how much tax you will pay on your income.

Whilst we all want to know about our personal income/savings and cost of living choices (i.e. at the micro household and individual level), social scientists also want to know about how these things evolve at the macro-level (i.e. across our societies).

There are two core concepts that permeate everything you’ll study for the next two weeks: income and wealth. Once you understand these concepts, you’ll then need to consider what they measure, and what type of indicators emerge from them.

We will define these systematically, next week. For the moment, use your intuition to try to understand these two basic concepts. National income is the flow of money in society (whether it is government spending, household spending, or wage earning).  National wealth is the stock of property as measured by market value in society (whether it is private housing, public roads, or shares in a multinational tech corporation).

Core questions

What do we know about the evolution of income and wealth distribution in the advanced capitalist societies of the western world?

Today, we know a lot more than we did 10 years ago, given revolutionary advances in technology. Three three basic questions that you should ask yourself are:

  • Do market economies inevitably lead to the greater concentration of income and wealth in fewer and fewer hands, as Marx thought in the 19th century?
  • Or, do the balancing forces of economic growth and market competition equalize the distribution of income and wealth, as Kuznets thought in the 20th century?
  • What is the role of the state, and other democratic institutions such as trade unions and collective bargaining, in shaping the distribution of market income?

In this course, we will use Thomas Piketty’s book, ‘Capital in the 21st Century‘, as a guide to answering these questions. His major contribution to the study of political economy, and social science, is to provide 200 years of data on the evolution of top incomes.

His core conclusion is that income and wealth inequality was exceptionally high in the 19th century (before democracy), then it declined in the 20th century (during the birth of the democratic state), but has since increased again in the 21st century.

Ask yourself why has inequality increased in the 21st century? Is it because of technological changes? Globalisation? Financialisation? Or politics?

Normatively, are these inequalities justified? If so, on what basis? If people get rich through inheritance, is it fair? If they get rich through hard work, is it fair?

Since the 1970’s, the income of the wealthiest (those who own large property portfolios), particularly in the USA/UK, has increased whilst the income of the majority has stagnated. But this was not the case during the 20th century. Why?

From a broader academic perspective, we are interested in the politics of who gets what, when and how. This is why it is called political economy.

Core theory: R>G

The data in the book covers three centuries and twenty countries.

This data has been carefully sourced from historical tax records, and is primarily concerned with measuring the incomes of the very top 1% of the population. These top incomes, usually involve wealth ownership, and are difficult to capture in survey data.

  • Piketty’s core theory to explain the rise of economic inequality is that when the rate of return on capital (think about the ownership of any property that yields an income, such as housing) exceeds economic growth, inequality grows (R>G).
    • Basically, what this means is that when those who own property earn more from the rents of that property ownership, than those who earn income from working (i.e. through earning a wage), inequalities grow.
  • The R>G inequality is not a market imperfection, rather it is built into the structure of capitalism and requires democratic intervention if it is to be avoided.
  • Basically, what this theory implies is that when left to it’s own devices, the free market will always end up being dominated by big corporate capital, unless the latter is restricted and regulated through democratic politics.

In the next 12 weeks, we will analyse the pattern of income and wealth, both historically within countries, and comparatively, between countries. What we will observe is that there is nothing inevitable about inequality. The changes that we observe reflect the changing relationship between the state and market, business and politics, property rights and social rights.  Or to put it another way, it reflects the ongoing tug of war between capitalism and democracy.

This is what I refer to as the history of democratic capitalism, or capitalist democracy.

Class discussion 

Most people are implicitly interested in the question of distributive fairness and usually have a preference toward how much tax they should pay, how much inflation is tolerable, how much the state should spend on education, healthcare and pensions.  the cost of housing, and the minimum wage, to name but a few public policy debates.

For example, just think about the following questions:

  • How much monthly income does a student need to live well in Dublin?
    • How much of your income do you try to save?
  • Do individuals have a social right o housing?
    • Should the state or the market provide this?

For the next week, I want you to do a mini-experiment. From the moment you leave this lecture hall, specify how much income you have to spend for the next week. Then keep note, and track precisely, how much of this income you spend.

Global

Now think about these questions from a global perspective. Average per capita monthly income in Europe is just over €2,000, whereas it is just €150 in sub-saharan Africa.

If all global income was equally distributed, how much would each person in the world get? How much does this vary by regional bloc (Africa, Asia, Europe and the USA)?

  • Take a guess. The answers are here.

Most people would not accept a world whereby 100 percent of all wealth and property (land, housing, finance, industry) was owned by 1 percent of the population. This would be not possible in a democratic society, with free and fair elections.

But what if 1 percent own 50 percent of wealth, or 60 percent, or 70 percent? Is there such thing as an optimal distribution of wealth and income? How much is tolerable?

If a country has extreme levels of income and wealth inequality, does it distort politics? Can we call a country with an extremely unequal distribution of economic resources a liberal democratic society?

We observe inequalities (good and bad) all around us, and these observations inevitably lead to political judgement. Normative interpretations cannot be avoided. There are no value free assumptions, regardless of what some of your econ textbooks might say.

Electoral preferences 

The bus driver who drove you to college this morning, and the Wall Street banker, experience the world in very different ways. Given their different socio-economic positions, they are likely to have very different political preferences toward taxation and government expenditure, trade unions and collective bargaining.

They will have different preferences toward economic redistribution. The question as to where political preferences comes from is a big theoretical debate. Are preferences a function of education, skill level, income, or occupation? Is this called social class?

However, one cannot assume that when voters go to the ballot box  that their economic preferences determine how they vote. They might vote on the basis of cultural grievances (i.e. because of their views of immigration or abortion).

Electoral preferences are heavily influenced by education, social class and income level. However, electoral theories that narrowly based on the “median voter” tend not to be very good at explaining aggregate distributional outcomes (and policy choices). Why?

Later in the course I will suggest that economic policymaking is less influenced by what the electorate want, and more influenced by the capacity of organised business interests to shape the agenda, and this varies significantly between countries.

Learning outcomes

The distribution of income and wealth inequality varies significantly across time (history) and space (country). A core objective of this course is to provide you with the tools, and critical thinking skills, to study the politics of inequality systematically.

Patiently looking for facts and historical patterns can inform democratic debate.

  • But perhaps more importantly, they enable us to ask the right questions.

The classical political economists of the 18th and 19th century (such as Adam Smith, David Ricardo, Thomas Malthus and Karl Marx) were deeply concerned with the question of income and wealth distribution, and the societal effects of capitalism.

They were experiencing the radical transformation within their societies brought about by increased demographic growth, the industrial revolution, rising poverty, and mass migration out of rural communities into emerging industrial towns.

To give a historical example of these debates, think about the abolition of the Corn Laws in England, in 1846. This was a dispute about the price of grain, and reflected a political struggle between aristocratic landlords and an emergent manufacturing class in Britain.

The repeal of the Corn laws reflected an ideological debate within Britain about how to manage the changing relationship between the interests of the state and private markets, and how this would affect the political equilibrium of European society.

  • It was against this political and ideological background that over 1 million people starved in the Irish famine. The British state chose not to intervene in the market.

The societal changes brought about by market technological change are all around us. Just think about the impact of automation on low and medium skilled jobs today.

Relevance

As we will see over the duration of the course, few doubt that wealth and income inequality has increased in rich countries from the 1970’s, particularly in the USA.

  • The empirical dispute is how to explain this change.

In the study of economics, the rise in inequality is usually explained by changes in globalisation and technology (and what’s often called, skills-based technological change).

In political economy it is usually attributed to the fiscal policies of government, the weakened power resources of left parties and trade unions, and rising corporate power.

However, before discussing the politics of inequality, and the politics of advanced capitalism, we first need an agreed quantifiable measure of things. A large part of the debate on inequality centres of different ways to measure similar phenomenon.

This is the part of the course you will probably find most difficult. Be patient.

Measuring capital and income

Piketty uses two sources of data in his book: the distribution of income (I) and the distribution of wealth/capital (w). Wealth and income are not the same.

He then analyses the relationship between these two (capital/income ratios).

It is important to note that he uses the terms wealth and capital interchangeably in the book: a problem we will discuss later.

At the most basic level, there are two ways to earn an income: selling your labour (earning a wage) or owning capital that yields an income (renting out a house).

The data on top incomes (the 1%) is gathered from historical tax records whereas the data on national/average incomes is taken from national government accounts.

The total stock of wealth (capital) in a country equals all the land, real estate, financial and industrial capital that can be traded on an open market.

The richest in society tend to earn their income from owning capital not from working.

All of this income data is then collated into the World Top Incomes Database (WTID).

Main findings:

  1. We should be wary of economic determinism. The historical distribution of wealth and income is a deeply political process.
  2. The shocks of WW1 and WW2 reduced the inequalities of the 19th century.
  3. The subsequent post-war period of strong economic growth and the emergence of the welfare state in Europe was a very temporary period in the history of capitalism.
  4. The long term dynamics of capitalist development reveal powerful mechanisms of convergence (a decline in inequality) and divergence (growth in inequality).
  5. The forces that lead to convergence are investment in education and training; the expansion of public goods; and tax regimes aimed at redistributing market income.
  6. The forces that lead to divergence in income inequality are associated with the capacity of top earners to increase their incomes through lobbying and tax cuts. This means that the growth in inequality is not associated with having better skills.
  7. The dominant force that leads to a divergence in wealth and capital inequalities is R>G (where the rate of return on capital exceeds economic growth).
  8. R>G means that when the economy is growing slowly, inheritance and wealth accumulated in the past becomes a powerful force of inequality.
  9. The implication is that inherited wealth grows in importance relative to merit.

Think about the following question: if inequality keeps rising, as Piketty suggests it will, what are the likely political consequences? Will democratic societies accept a level of inequality that undermines a culture of meritocracy? What will the electorate vote for?

Main findings of the book you will read

  • Figure 1.1 shows the rise in income inequality in the US. The top decile claimed 45-50 percent of national income in 1910 before dropping to 30-35 percent at the end of 1940. By 2014 it had risen to a historical high of 52 percent.
  • Figure 1.2 shows the rise in capital/income ratios in Europe. This is more difficult to understand and I will explain it in more detail next week.

Both graphs depict a U-shaped curve, which illustrates that income and wealth inequality decreased in the 20th century and then increased in the 21st century.

A core part of this course is to try and explain this change over time.

Let me explain two things about figure 1.2.

  • First, it shows the total market value of aggregate private capital/wealth (primarily real estate and financial assets) net of debt, expressed in years of national income from 1870-2010 (you’ll understand this language soon!!)
  • Second, capital income equals all the income generated from profits, dividends, interest, and rents. The growth of an economy (G) = growth in national income or output, which is often best considered in terms of productivity growth.

In a capitalist society, where R is greater than G, inherited wealth grows faster than income from labour. For Piketty, when this occurs, the entrepreneur becomes a rentier i.e. wealth is primarily accumulated through the ownership of assets rather than work.

  • The growth in capital/income ratios are important because they illustrate the structural influence of capital in society. Think about this in terms of housing

For Piketty the increase in the inequality associated with R>G has nothing to do with market imperfection. It is the logical outcome of a free market.

Conclusion

All of these technical terms will become familiar to you as the course unfolds. Don’t give up at first sight. Every discipline has its own language and it takes time to learn this.

  • Understanding statistics on income, wages, inflation, prices, expenditure, revenue and wealth is essential in a democratic society. Study hard and be patient.

The slides for this week can be viewed here:Week 1