Lecture 3: How to Measure the Wealth of Nations

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?

As argued by Prof Peter Hall 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 capitalist development.

Piketty’s contribution to political economy is to provide us with a 200 year history of ‘wealth and income distribution‘. His conclusion is that we are witnessing a level of inequality not experienced since the early 19th century.

But before we discuss the determinants of economic growth and 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.

Part 1 of Piketty’s Capital in the 21st Century is titled Income and Capital. This is where the definitions are laid out.

This BBC video is a useful starting point:

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.

Try to think about national income in real concrete terms. All production (whether it is teaching, serving coffee, providing customer support, cleaning roads  or manufacturing iPhones) must eventually be distributed as earnings i.e. income.

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

As we will see, Piketty’s core critique of the 1% is that their wealth is primarily 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. (R>G). Think about that.

In light of this observation, the original title of the book was ‘The Return of Patrimonial Capitalism’. Piketty is trying to highlight that wealth and capital matter much more than human capital (skills) in the politics of distribution. We will come back to this.

  • 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.

Capital

But what exactly is capital and why does Piketty used the term wealth and capital interchangeably? Put very simply: capital is a stock. Income is a flow.

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 conceptualization of capital has come in for a lot of criticism.

  • Capital is accumulated wealth. It is 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 (the market).

Or more precisely:

  • Capital is the sum total of non-financial assets (land, buildings, real estate, 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.

What capital is worth is determined by market value.

If the market collapses, so does 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 fell by thirty percent, the person owning that house is likely to have felt less wealthy. When the price rose by 50 percent, they felt wealthier. This observation is important because it has a big impact on electoral-political preferences.

Other examples: think about recent events in China. Stock markets declined rapidly in response to a slowdown in Chinese growth (but have since recovered). Or think about the value of a Damien Hirst painting. What determines the price of the painting?

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

Figure 5.1 captures this disparity in private and public capital.

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 Piketty is not a communist, it is perhaps no surprise that he calls for wealth to be taxed rather than nationalised.

That is, he wants to tackle the problem of inequality using the fiscal tools of the state.

Capital/income ratios

For Piketty, the best way to analyze the importance of 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 by national income gives us the capital/income ratio (β). Imagine all the capital in Ireland (housing, land, financial assets). Imagine the value of all that in terms of a price (billions). Now divide all of that by the flow of national income.

Capital/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.

  • 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.
  • This graph shows the evolution in the capital/income ratio for Germany, Britain and France.

Back to the example 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.

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

In theory, a high capital/income ratio (wealth) is a not a bad thing. We all want to live in wealthy societies. What matters is how it is distributed!!

Piketty is concerned that the rise in wealth is concentrated in fewer and fewer hands.

R>G mechanism

Piketty proposes a theoretical mechanism to analyze the evolution of capitalist development and the rise in capital/income ratios (R>G).

He suggests the following:

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

This is precisely what we observe in the USA and Europe since 1980. R>G leads to rising capital/income ratios. For Piketty this suggests ‘private capital is back’. This is an implicit critique of the economic theory of skills-based technological change.

Piketty has come in for a lot of criticism from those who argue that the rise in capital/income is mostly accounted for by the rise of housing capital (residential).

It is a rising home-owning middle class that distinguishes the 21st century.

House prices have been rising much faster than 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?

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/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!

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.

On the contrary, most people will pay their landlord rent and/or pay interest to their creditors for borrowing i.e. to pay their mortgage debt.

Summary

To recap. The most important concepts for analysing capitalist development for Piketty are:

  • the capital/income ratio
  • capital income
  • national income
  • the rate of return on capital

How do we calculate the rate of return on capital?

  • On the basis of his 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%.

Piketty doesn’t really explain why the average rate of return on capital is 5 percent.

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!!

Conclusion

To understand these concepts Piketty suggests that we think about a 19th century Jane Austen novel, such as Pride and Prejudice. Who has seen the film with Keira Knightley?

The aristocratic characters in these stories, centered around the landed gentry in 19th century England, constantly remark that the rate of return on land in their rural societies is around 4-5 per cent. They also observe that owning government bonds yield around 5 per cent. They are perfectly aware how much land they need to live well (or marry into).

How much does one need to live well today?

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

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

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

This is why Piketty argues 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.

The lecture notes can be found here: lecture-2-3

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2 thoughts on “Lecture 3: How to Measure the Wealth of Nations

  1. I agree with Piketty’s definition of capital; capital by definition does not cease to be exchangeable just because the means of exchange (markets) may have stopped functioning. People will always need to exchange goods and assets of all sorts and new markets will arise should the former fail/collapse.

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    1. I think most of his critics would agree with this JP. What they tend to disagree with is the problem it creates when trying to analyze and measure the capital/income ratio. This is crucial to his analysis. Price changes and physical destruction are not the same thing as you outline. But Piketty seems to treat them as the same when analyzing fluctuations in capital/income ratios. The criticism is that he seems to shift between talking about physical volumes of capital and market values. But overall, I tend to agree, his definition is sufficient. Where it gets problematic is the extent to which this rise in capital/income ratios is purely driven by housing capital, and whether this should be included in total capital to assess they dynamics of inequality. See this article: http://www.voxeu.org/article/housing-capital-and-piketty-s-analysis

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