Lecture 4: The Law of Cumulative Growth

Introduction

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.

The shortened lecture slides can be viewed here: lecture-3-4

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Lecture 2/3: 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 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.

In political economy, we study 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 actively shapes the market, such that there is not such a clear dividing line between state/market.

Piketty’s contribution to the study of political economy is to provide 200 years of data to track the 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 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 Piketty’s 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:

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 either 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 called ‘The Return of Patrimonial Capitalism’. Piketty is arguing that wealth and capital matter much more than human capital (skills) in the politics of distribution.

We will come back to this later, as it’s a controversial argument. Many economists argue that what matters today is human capital: skill levels/education/training. Piketty is saying, corporate capital – hard money – 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.

Capital/wealth

But what exactly is capital and why does Piketty used the term wealth and capital interchangeably? Put simply: capital is the stock of wealth in society. Income is the flow of earnings in society. For example, housing is capital (stock), and the rent accrued to a landlord is capital-income (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 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 define 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 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 homeowners preferences toward government redistribution policies. Nobody who owns a mortgages wants prices to fall.

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?

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

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 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.

Wealth/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 (measured by the market) by national income gives us the capital/income ratio (β). This is also called the wealth/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 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, 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 in debt.

In theory, a high capital/income ratio (more wealth) is a not a bad thing. We all want to live in wealthy societies. What matters is how it is distributed, and how it’s used. This is Piketty’s critique. He’s saying we’re privately wealthy, but publicly poor.

Piketty is 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

Piketty proposes a theoretical mechanism to analyze the evolution of capitalist development, by tracking rise and transformation in capital/income ratios (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. For Piketty 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 are not quite the entrepreneurial class we think they are, rather it reflects the growth of a “rentier” class. It suggests that 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 the rise of housing capital (residential).

It is the rise of a property-owning middle class that distinguishes the 21st century.

For example, when we begin to analyse the structural transformation of wealth from land (18-19th century) to industry (19th-20th century) to finance (21st century), what we will see is that financial capital is intimately connected to housing capital.

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 this be the case?

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.

Summary

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

Rate of return

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, which is a major problem of the book.

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!!

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.

Conclusion

To understand these concepts Piketty suggests that we 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 also observe that owning government bonds yield around 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 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 3

Lectures 1/2: 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. Put simply, income is the flow of money in society (whether it is government spending, household spending, or wage earning). Wealth is the stock of property someone owns (whether it is private housing, public roads, or shares in a private legal firm).

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. But before looking at the data, ask yourself some basic questions, which are central to this course. 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.

We need to ask why has inequality increased so rapidly 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, Piketty’s core contribution is to put the politics of of distribution back into the study economics. This is what’s 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.

  • His 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 market economies and requires democratic intervention if it is to be avoided.
    • Hence, during the 20th century, governments liberalised global trade (buying and selling goods/services), but not financial capital.
  • Basically, what this theory implies is that when left to it’s own devices, the free market will always end up being dominated by 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.  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 distribution 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; rising rental costs and the minimum wage, to name but a few things.

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 such a country a democracy?

We observe inequalities (good and bad) all around us, and these observations inevitably lead to political judgement. Normative interpretations cannot be avoided.

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 situations, 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.

However, one cannot assume that when they go to the ballot box their “left/right” economic preferences determines how they vote. They might vote on the basis of cultural values (i.e. for conservative nationalism, or liberal internationalism).

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 policy choices shaping distributional politics is better analyzed as a form of organized combat between different interest groups.
    • That is, economic policy is often shaped by elite-quiet politics, whereby organised interest groups directly and indirectly influence government policy, and not electoral coalitions.

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, poverty, and mass migration out of rural communities into city-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 on how to manage the changing relationship between 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 technology (and what’s often called, skills-based technological change).

In political science it is usually attributed to institutional changes in the bargaining power among social classes; weaker trade unions and a rise in corporate power.

But 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

Piketty’s main findings on the politics of ‘divergence’ are represented in the two most important graphs of the book:

  • 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 PPT slides to the lecture can be viewed here: lecture-1-2