Lecture 9: The Return of Capital in the 21st Century

Introduction 

In this lecture we will seek to answer three questions:

  • why the capital-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 western world?

The determinant of capital/income ratios

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

Piketty’s core claim is that the capital/income ratio is related to the savings rate and growth rate.  The relationship is so strong that he calls it the second ‘law’ of capitalism,  β = s / g .

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

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

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

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

For Piketty, low growth (especially slow demographic 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 0r 400% (12 divided by 4).

For Piketty, this is the long term driver of the capital/income ratio.

Note: I tend to disagree. Institutions and politics are arguably more important for explaining growth, whilst asset price fluctuations (price effect) are just as important as the volume effect (savings rate). But it all depends on the time period. Asset prices matter more in the short run (30 years), but maybe less so over the long run (100 years).

The case of Ireland

But what does all of this really mean for the political economy ?

Surely a high capital/income ratio 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.

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

From a political perspective, if wealth is concentrated in a few hands, then the economic resources of a society are not efficiently distributed. It is not likely to be put to productive/efficient use. It might be used 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 driven 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 €17n of the total capital stock.

Davy Stockbrokers conclude that the Irish private sector wasted the money. Today, the capital stock is rising, but it is almost entirely driven by the rise in house prices.

The two ‘laws’ of capital

β = s / g provides a logical historical account of the structural evolution of capital.

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

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

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

Piketty proposes another “law” to explain this.

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

A = 30 percent when r=5 and β=6

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

Capital since 1970

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

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

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

But the price of capital is not a ‘natural’ phenomena. It is a human construct.

Therefore the fluctuation in boom-bust cycles of wealth are consubstantial with the history of capitalism itself. Just think about the impact of quantitative easing (QE) on the price of assets since 2008.

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.

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

Some would suggest that the speculative boom and bust in prices are the norm in capital.

What the data clearly 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 capital-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 structural differences (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.

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 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 on another portion of the population. Instead of the wealthy paying taxes to fund the deficit they lent government money at interest – increasing their own private wealth.

At a global level the most extensive privatization’s 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  but was purely driven by privatization (and asset stripping), and close state-business ties.

The rebound of asset prices

The third complementary factor that explains the comeback of capital  is the historic rebound of asset prices.

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

The price of capital-assets is shaped by politics and institutions, such as rental control laws (real estate) and corporate governance laws (corporations). Remember our discussion about Germany last week. There is no such thing as a natural price. It’s a human construct.

Multinationals are political actors that actively shape the market.

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

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

Prices as a human construct 

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

The accounting value of a firm is equal to 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) 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 case the rapid rise was can be explained by the emergence of a property bubble. Ireland was similar.

Summary 

Hence, for Piketty the comeback of capital 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

The imbalance of capitalisms in Europe

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 is owned by another country to some extent.  Net international investment positions reflect this.

In the 1970s 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 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-strategies.

Conclusion

What Piketty does not discuss is that from 1970 to the present there has been a fundamental political change in public policy. This is often referred to as “neoliberalism”. How important are economic ideas in explaining this 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.

The lecture slides can be downloaded here. Lecture 9

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