The Problems With Piketty

Everybody has had a go at the phenomenon of Thomas Piketty’s Capital in the 21st Century. Here’s a version of my Sunday Times piece of a few days ago.

Most people in Britain will never have heard of Thomas Piketty, a 42-year old professor from the Paris School of Economics, but that may be about to change.

If you believe the hype, Piketty is shaking capitalism to its foundations, and he is about to bring his message to Britain.

Piketty, an unassuming, softly-spoken Frenchman, has set the world of economics alight and taken America by storm. His book, a muscle-straining 685-page tome, Capital in the Twenty-First Century, published last month, is top of the Amazon bestseller charts in America, and has sold out its initial print run. His publisher, Harvard University Press, is busy getting the presses rolling again for what is likely to be easily its biggest seller in its 101-year history.

On his whistle-stop US tour a few days ago, Piketty wowed the chat shows, met the US treasury secretary Jack Lew and the White House’s Council of Economic Advisers and held forth at a seminar at the International Monetary Fund. New York magazine described him as the “rock-star economist”.

Though his book shows he is no admirer of America’s economics tradition, he appeared alongside two admiring US Nobel prize winners, Paul Krugman and Joseph Stiglitz. Krugman, one of America’s most influential economists, with a column in the New York Times, assessing Capital for the New York Review of Books, described it as a “magnificent, sweeping meditation on inequality”, which explained “why we’re in a new gilded age”.

“Capital in the Twenty First Century is an extremely important book on all fronts,” he concluded. “Piketty has transformed our economic discourse; we’ll never talk about wealth and inequality the same way we used to.” Robert Solow, another American Nobel winner, reviewed the book in New Republic under the headline “Thomas Piketty is Right”.

All this praise in the land of the free, the home of capitalism, is for a book that deliberately invokes Marx in its title and uses 300 years of data to claim that he has exposed the system’s fundamental flaw. Capitalism, according to Piketty, will always result in damaging and dangerous inequality that can only be corrected by taxes on wealth and sky-high income tax rates on the better-off of more than 80%.

Now he is about to bring his road show to Britain and word is starting to get out. The £29.95 book is seventh on Amazon’s UK list and the publishers, having expected to satisfy demand with copies imported from America, are now arranging a large print run in Britain.

On Wednesday Piketty will take the Eurostar from Paris, meeting senior journalists at The Guardian, hold a seminar at the London School of Economics, pre-record an interview with the BBC and give a sold out lecture on his book to an Institute for Public Policy Research event at King’s College. Prospect magazine has him at 27th in its list of 50 top world thinkers, with his long-time collaborator Emmanuel Saez.

He will be back again in June for more lectures and for a discussion in the House of Commons with Lord Stewart Wood, Ed Miliband’s senior adviser. Perhaps ominously for those worried about soak-the-rich policies under a Miliband-led Labour government, Wood says: “We must respond to Piketty’s challenge with ambition and imagination, not with pessimism.”

What is all the fuss about? Piketty’s appeal, certainly to US liberals, is that he has provided an intellectual framework for the challenge to capitalism that was expected in the wake of the banking meltdown and global financial crisis but never happened. The Occupy movement, which targeted the richest 1%, and claimed to speak on behalf of the remaining 99%, had a brief flurry, which in Britain included the occupation of St Paul’s churchyard. But it faded. Capitalism has picked itself up, dusted itself off and carried on more or less as before, though with the regulators keeping a closer eye on things, particularly in the banks.

Piketty, if he is right, has exposed a flaw in capitalism that existed before the crisis and will become increasingly evident as the 21st century progresses. The tendency towards greater inequality, to the rich becoming richer and the masses being left behind, may not bring about the collapse of capitalism – he insists he is not as “apocalyptic” as Marx – but it will put the system under increasing strain.

Measures to correct what he describes as “the fundamental force for divergence” and “the central contradiction of capitalism” will not only be needed on grounds of fairness but will also be required because they threaten democratic societies.

Part of the appeal of the book is that it is readable, despite its length, thanks to Piketty and his English translator Arthur Goldhammer. Frequent references to Jane Austen, Honore de Balzac and other classical novelists, show that this is one economist who has not spent all his life with his nose in economics texts. There is a grand sweep of history in his use of data stretching back 300 years, particularly French data on incomes and inheritances, but also statistics – carefully assembled by Piketty and his fellow researchers – for Britain and other countries.

He also has a nice self-deprecating touch, when he criticizes economists for being “all too often preoccupied with petty mathematical problems of interest only to themselves”. “There is one great advantage to being an academic economist in France,” he writes. “Here, economists are not widely respected in the academic and intellectual world or by financial and political elites. Hence they must set aside their contempt for other disciplines and their absurd claim to greater scientific legitimacy.”

There are two essential conclusions in Piketty’s book. Simon Kuznets, one of the giants of American economics in the 20th century – he lived from 1901 to 1985 – published a seminal paper in the 1950s to demonstrate what became known as the “Kuznets curve”. This was that, while societies had a tendency to become much more unequal during the early stages of industrialization, in which the rewards go to the magnates and landowners, there is a natural tendency towards greater equality in capitalist societies towards greater equality. The longer the process of growth goes on, in other words, the more that the masses will share the fruit of that growth. Capitalism survives by spreading its rewards.

For Piketty, however, Kuznets had identified what was a temporary and special case. Yes, there had been a tendency towards greater equality for much of the 20th century but that was “above all a consequence of war and of policies adopted to cope with the shocks of war”. Since 1980, capitalist economies have been reverting to their 18th and 19th century norms, faithfully recorded by novelists as well as the numbers, in which inequality widens. The rich get richer, the rest stagnate.

The reason why this is the second central claim of Piketty’s Capital, which could be summed up as money will always go to those who already have it. The wealthy will always grow wealthier – inequality will increase – because, according to Piketty, the rate of return on their capital or wealth, r, will always exceed the rate of growth of the economy, g. Most people are stuck in the slow lane, held back by the economy’s growth rate – which he thinks will be quite modest in the 21st century. The rich are in their own fast lane. Money begets money.

If he is right, we may only be seeing the opening skirmishes in the defining battle of the 21st century. When Vince Cable, the business secretary, writes to Britain’s FTSE 100 businesses telling them to curb executive pay, or when a sizeable minority of Barclays’ shareholders votes against higher pay and bonuses, these may just be the early rumblings of far bigger wars to come. If the future is one of ever greater inequality, the wealthy may need very large walls to keep out the dispossessed.

But is Piketty right? Before jumping onto the Piketty bandwagon, however, we should note that the recent history of economics bestsellers changing the world is decidedly mixed. In the 1990s, Will Hutton’s The State We’re In appeared to set the agenda but its theme of stakeholder capitalism was dropped by Tony Blair’s New Labour as quickly as it picked it up. Hutton, predictably, has been singing Piketty’s praises.

A few years ago another book The Spirit Level: Why Equality is Better for Everyone, by Richard Wilkinson and Kate Pickett, was widely attacked for its use of statistics, even prompting a book-sized riposte.

Though Piketty is basking in the warm glow of effusive praise, much of it unthinkingly effusive, the criticisms are starting to mount, even from some who might be expected to be sympathetic to Piketty. Tyler Cowen, the well-regarded professor of economics at George Mason University and co-author of the hugely popular Marginal Revolution website, finds serious flaws.

“Overall, the main argument is based on two false claims,” he wrote recently. “Firstly, that capital returns will be high and non-diminishing … Second, that this can happen without significant increases in real wages … I’m not convinced by the main arguments and the positive reviews I have read worsen rather than alleviate my anxieties.”

James K Galbraith, son of the legendary Keynesian economist J.K. Galbraith, and like Cowen an economist who has done a lot of work on wages and income distribution, has been even more critical. Writing in Dissent, a quarterly journal, Galbraith accuses Piketty of a “terrible confusion” between physical capital – the plant, machinery and buildings needed to make things – and financial wealth.

In straightforward terms, leaving aside academic niceties, Galbraith accuses Piketty of getting his understanding, and his facts, wrong. “In global comparison, there is a good deal of evidence, and (so far as I know) none of it supports Piketty’s claim that US income today is more unequal than in the major developing countries,” he writes. Branko Milanović identifies South Africa and Brazil as having the highest inequalities. New work from the Luxembourg Income Study (LIS) places Indian income inequality well above that in the United States.”

Piketty does not, he concludes, “provide a very sound guide to policy” and the book “is not the accomplished work of high theory that its title, length and reception (so far) suggest.”

Economists are meant to disagree and, though nobody would accuse Cowen and Galbraith of it, Piketty’s success is provoking more than a little professional jealousy. That said, there are three important flaws in the book. The first is that the idea that the rate of return will always exceed the economy’s growth rate is assertion, and most likely incorrect assertion, rather than fact. The period leading up the financial crisis of 2007-9, indeed the prime cause of the crisis, was the quest for a higher rate of return – the search for yield – in a world of low returns. That led to the taking of big and in the end highly destructive risks.

The second flaw is that Piketty is guessing. He is assuming, because it happened in the 18th and 19th centuries, and has been happening in the past three decades, that rising inequality is the new norm. Nobody knows whether that is the case or not. Inequality is diminishing between countries, thanks to the rise of economies like China and India, which is raising living standards in those countries. Inequality is rising in those countries, as happened in Britain, France and America after their industrial revolutions. But you would expect inequality to diminish in these countries, as Kuznets recorded in America, not least because mass production requires a mass of consumers.

The third flaw, as even Krugman concedes, is that Piketty’s model might explain why plutocrats are getting ever wealthier but does not explain the phenomenon of the past three decades, the rise of top salaries. Chief executives, in banks elsewhere, are paid sums relative to the average worker that their predecessors could only dream of. That reflects their bargaining power and persuading enough people – maybe in some cases wrongly – that their talent is in short supply and has to command premium international rates. You do not need three centuries of data, Austen and Balzac to explain it. And already there are signs of a self-generated backlash against some of these boardroom excesses.

Bigger than any of these problems, however, is when Piketty gets into policy recommendations. He would have been better advised to present his conclusions and left it to others to decide what to do with them. As it is, he proposes a global tax on capital – wealth – which he concedes is “a utopian idea” which “is hard to imagine the nations of the world agreeing on any such thing anytime soon”.

Worse, is when he gets on to income tax. In 2007 Piketty backed and worked with Segolene Royal, the French socialist and former partner of Francois Hollande, for the French presidency. She did not get it, but is now back in Hollande’s cabinet. Hollande went for a 75% top tax rate. Piketty thinks it should be 80%.

This is dangerous territory. Piketty refers with a hint of admiration to Britain in the 1970s, when the top rate of income tax – on earned and unearned income – reached a record-breaking 98%. Nobody, of course, paid it, and the effect was not just to kill the golden goose but to stuff it and cook it as well.

Perhaps he thinks 80% sounds modest in comparison with 98%. “The evidence suggests that a rate on the order of 80% on incomes over $500,000 or $1 million a year not only would not reduce the growth of the US economy but would in fact distribute the fruits of growth more widely while imposing reasonable limits on economically useless (or even harmful) behaviour,” he writes.

That does not just apply to America. “According to our estimates, the optimal top tax rate in the developed countries is probably over 80%, he adds. Such “confiscatory” rates are in his view the only way to stem the growth of high salaries.

This is bizarre. Have we learned nothing since the 1970s about the impact of very high tax rates on growth and incentives? Does anybody really think that the prospect of eye-wateringly high tax rates on success will not stop people striving for success, to take the necessary risks needed to stimulate innovation? The Levellers had nothing on Piketty when it comes to tax.

As it is, we have discovered in Britain that lower top tax rates both incentivised success and brought a bonanza for the taxman. The top 1% of income earners account for 30% of income tax revenues, compared with 11% in 1979. The main effect of high tax rates is to boost the tax avoidance industry.

Wealth is Piketty’s great concern. But it, according to Credit Suisse’s latest Global Wealth Report, is more evenly distributed in Britain than in Canada, Denmark, France, Germany, Ireland, Israel, Holland, New Zealand, Norway, Singapore, Sweden Switzerland and America. It is also more evenly spread in Britain than in most developing countries in Africa, Latin America and Asia, including China, India, Indonesia, Thailand and South Africa.

A glance at The Sunday Times Rich List, or lists of global wealth, shows moreover that the money begets money model does not fit. Yes we can envy the mega-rich. Or maybe not, but they are usually not the same mega-rich as 20 or 30 years ago. The main effect of sky-high tax rates would be to preserve differences in wealth, by killing entrepreneurialism and the rise of new wealth-creators at at birth, not eliminate them.

Piketty, the rock-star economist, has written a huge book, and sold more copies than he could have dreamt of. Mostly, it has been well-received, though it is flawed. But his conclusion, slap huge taxes on the rich, is as crude as it could be. And if politicians are tempted to take it up, they will find that it comes back and bites them. Piketty has been greeted as some kind of inequality messiah. The one way to guarantee the slow growth he fears is to take his advice and tax it out of existence.

This piece is cross-posted from EconomicsUK with permission.

6 Responses to "The Problems With Piketty"

  1. burkbraun   May 2, 2014 at 12:41 pm

    Let's see. You are not sure about the r>g thesis, but don't know why it might not be true. The most obvious point is perhaps that loans (inter-temporal shifting) will always be needed by those without money, which generates returns for those with money, in perpetuity, regardless of economic growth. The only question is how sustainable high rates of economic growth are, and the lesson from history is that they are not sustainable at all. The norm is zero growth, more or less. We are lucky to have any due to technological progress.

    Next, you grant that the problem of r>g and inequality is real, but hate the taxes that would solve it. This is particularly odd, since it may well the residual effect of Britain's high tax rates that put it in the moderate inequality camp, rather than the very high inequality camp of the US et al. At any rate, if the problem exists as stipulated, what is your solution, perpetual inequality, a la Ancien Regime? That is clearly where we and the UK are headed. And the thing we have learned about incentive and innovation is that money is a very poor motivator. It only works on the most base level of conduct, not on the creative levels that a modern economy needs. The people who work for money and compete for the millions and billions are the psychopaths among us. And they will compete no matter what the level of after-tax reward, because, after all, it is only a matter of keeping score at that point.

  2. El_Cap   May 3, 2014 at 3:28 am

    From my reading, he placed far more importance on the 1% wealth tax than on the 80% income tax. A 1% tax on all wealth would be far more generous than the wealth taxes the middle classes currently pay on their houses. Why should the wealthy be exempt from paying taxes on the holdings that make up their wealth, while the rest of the population pay on the order of 3% annually on the holdings that make up their wealth?

    Also, you say Piketty can't know the future. Well, of course that's true, but neither can anyone else. Do we just throw our hands in the air and appeal to our favourite notions of how we think the world might work, notions generally selected because they conform to our preferred choice of policies? Or should we gather the available data, identify the trends that happened in the past, and suggest that the most likely future trajectory is that the same processes previously observed, will continue to play out in the future. In other words, do the research. That attitude is one of the reasons this book is making waves – finally an economist has done the hard work of gathering the data, rather than the easy work of pontificating without grounding theory in observation.

    Consider your statement: "He is assuming, because it happened in the 18th and 19th centuries, and has been happening in the past three decades, that rising inequality is the new norm." I'm sorry, but something that happened throughout the 18th, 19th, and 20th centuries, except for a blip during the world wars period, is not a new norm. It is simply, the norm. You need to explain what it is about the world that has fundamentally changed if you want to argue that the new norm is, in fact, increasing equality.

  3. benleet   May 4, 2014 at 4:05 pm

    Such is the state of uncritical analysis of our economy. The "golden age" in the U.S., 1934 to 1976, was born on the premise that a greater equality of income, and the graphic display found in Piketty's colleague, professor E. Saez' reports Striking It Richer show how success coincided with a reduction in income share to the wealthiest. This was crucial to widespread prosperity and the systemic growth of production. Keynes said it, as did Marriner Eccles, Jesse Jones, Roosevelt, most New Dealers. They maintained that government was needed when the capitalist system died, as in 1934 when all the banks shut their doors — on holiday avoiding a complete run on their reserves. And a modern capitalist economy cannot survive without a banking system, and this happened again only 7 years ago. The Fed extended around $30 trillion in emergency loans, as is documented at the Levy Economics Institute. The high tax rate on incomes above say $400,000, today's threshold into the top-earning 1%, propelled the most fruitful expansion of prosperity in capitalism's history, and now this author would like to totally ignore and berate those tax rates as "killing" the goose and entrepreneurialism, Those rates obviously did not kill it then, and will serve to restore it. I recommend Jeff Madrick's book, Why Economies Grow — his thesis is it takes widespread prosperity to incentivize innovation and the advantages of mass production.

  4. jpd007   May 5, 2014 at 12:48 pm

    Pikitty should be happy, he leaves in a country which applies his recommandations, the French socialist Government has raised the property tax and slapped a marginal income tax of 70%, the result of it:
    •rate of growth in France <1% (below US, China, Britain, Germany, etc.)
    •Unemployment rate 10.4%, US, an unequal country according to Piketty, 6.7%, Britain another ugly capitalist country: 6.9%, Germany 6.7%. all these countries have a declining rate of unemployment and France with a socialist Government has an increasing rate of unemployment, find the error

  5. devasa   May 6, 2014 at 5:29 am

    “Firstly, that capital returns will be high and non-diminishing … Second, that this can happen without significant increases in real wages”

    “important flaws in the book. The first is that the idea that the rate of return will always exceed the economy’s growth rate is assertion, and most likely incorrect assertion, rather than fact.”

    Both can happen if there are less and less real wage earners and more people are underemployed like part time work in food outlets or go on dole.

    “The top 1% of income earners account for 30% of income tax revenues, compared with 11% in 1979. The main effect of high tax rates is to boost the tax avoidance industry.”

    It may that top 1% now earn so much more than in 1979.

  6. Erikwim   May 12, 2014 at 5:31 am

    "As it is, we have discovered in Britain that lower top tax rates both incentivised success and brought a bonanza for the taxman. The top 1% of income earners account for 30% of income tax revenues, compared with 11% in 1979."

    If you were trying to proof growing inequality you could hardly have come up with a better statistic. Of course the % of income tax provided by the 1% rises if the 1% gets a larger share of the income. Following your logic we would see a real bonanza if 100% of income tax is provided by the 1%. Well, actually why not 200%! I think the 1% would not complain if in return they also got 100% of all income. Or 200%, lending the 99% the money to do their purchasing?

    The rest of the flaws in logic i will leave for the readers to figure out, they are too many.