The Two Pikettys

Thanks to Peter Berezin, Chief Strategist of The Bank Credit Analyst, for taking the time to provide us with a few timely comments on Thomas Piketty’s controversial new book, Capital in the Twenty-First Century. 

Thomas Piketty ReviewBy my count, there are already over a dozen reviews of Thomas Piketty’s book from a variety of big thinkers, so I won’t endeavor to write yet another one (Here’s Paul Krugman’s review, and from the right, here’s one from Clive Crook; also, do check out this hilarious piece from Carlos Lozada at the Washington Post).

Rather, let me make an analytical point that I think has been largely lost in the discussion. At the core of Piketty’s book is the idea that the difference between the rate of return on capital, r, and the economy’s growth rate, g, has a significant bearing on the economic and political landscape. Specifically, Piketty argues that a decline in g will cause wealth to increase more quickly than income (Y).

It is not hard to see why this might be the case. Imagine a situation where g is zero. In such a case, as long as there is more than enough savings to cover the depreciation of the capital stock, the capital-income ratio (K/Y) will rise. Piketty convincingly shows that capital income is less evenly distributed than labor income. Since there are reasons to think that g will fall in the future (lower labor force growth, fewer productivity gains, etc.), the implication is that inequality will continue to increase.

However, notice what Piketty is not arguing. He is not saying that r is going to fall in the future. In fact, if the capital-income ratio increases, then the law of diminishing returns implies that r will decline. All he is saying is that the decrease in r will not be enough to prevent the capital share of income from rising over time. But if you are a wealthy capital owner, what do you really care about: the return on your own wealth, or the ratio of wealth-to-GDP? Now, Piketty would argue that even if the wealthy care more about the rate of return that they themselves receive, this may not matter. As long as the share of overall income accruing to capital rises, political institutions will evolve in a way that protects the wealthy at the expense of the working class.

Maybe, but I have my doubts. Here’s a concrete example. Higher immigration would cause g to increase; by Piketty’s logic, this would dilute the influence that the wealthy have over decision-making. I suppose this explains why the U.S. Chamber of Commerce and the Wall Street Journal are so adamantly against easing immigration restrictions. Oh, wait, they’re not…

Next, consider the saving rate. Standard economic models, such as the one developed by Robert Solow in the 1950s that forms the bedrock of Piketty’s analysis, predict that an increase in the saving rate will drive up the capital-income ratio, reduce the rate of return on capital, and increase average real wages along with per capita output. However, as economists have long known, if an increase in the capital stock leads to a proportionately smaller change in the rate of return on capital (i.e., in technical language, if the elasticity of substitution between capital and labor is greater than one), then capital’s share of income will increase. But is that really such a bad thing? As Solow himself points out in an otherwise glowing review of Piketty’s book, “you eat your wage, not your share of national income”.

Admittedly, in the current environment of deficient aggregate demand, more savings would indeed be undesirable. But, this isn’t Piketty’s argument. After all, his book is all about structural, rather than cyclical, trends.  It’s also possible that an economy can save too much. However, in the simplest formulation of Solow’s model, …. where the production function is assumed to be Cobb-Douglas with constant returns to scale, the saving rate that maximizes the steady-state level of consumption – the so-called “Golden Rule” – is equal to the capital share of income. The gross saving rate for the U.S. is only half that level, suggesting that once the economy returns to full potential, a higher saving rate would be welcome. The point is that one can easily justify a higher saving rate if it leads to faster growth in average real wages, even if the income distribution worsens in the process.

This brings me to the title of this post: there are “two Pikettys” in full display in this wonderful, but ultimately, flawed book. On the one hand, there is Piketty the economist, who has done an exemplary job of gathering and analyzing the historic data on the distribution of wealth and income from days gone by, as well as creating an intellectual framework for thinking about how this distribution varies over time. On the other hand, there is Piketty the policy entrepreneur, who often seems to place greater importance on redistributing income away from the wealthy, rather than stressing the goal of creating an economic environment that would allow real incomes for everyone to grow more quickly. I like the first Piketty a lot more than the second one.