A Review of Capital in the Twenty-First Century by Thomas Piketty: Analysis of Growth and Income Inequality Trends
Piketty, T. Translated by Arthur Goldhammer. Capital in the Twenty-First Century. Harvard University Press. April 15, 2014. 696 p. Approximate price: $17 (paperback), $26 (hardcover).
Introduction
Is pre-modern income inequality re-emerging? What policies can prevent developed countries from degrading into oligarchies? What policies can reduce the income gap between rich and poor countries?
This book describes the persisting income inequality in developed countries that existed before the two world wars, contrasts it with the egalitarian societies of the middle of the 20th century, and explains the inequality increase in the late 20th-21st century, arguing that it may undermine democratic institutions. According to Piketty, international cooperation in enforcing progressive taxation is the best tool to make societies more egalitarian.
This review is divided into two parts. In the first part, I summarize and assess the growth and income inequality trends that Piketty described. In the second part, I compare the current trends to those of the pre-modern times and describe and assess Piketty’s remedy proposals to increase tax revenues and resolve the European debt crisis.
Importance for Central Asia
Growing income inequality in western countries is a relevant issue for transition economies for several reasons. Many transition economies have been conducting reforms intended to make their societies resemble those of developed countries. Growing income inequality in the West can make these reforms less appealing. Though the distribution of power and privileges in the Soviet Union was inequitable, official income inequality was much lower than in the West, not to mention that of most transition economies now. Soviet nostalgia makes egalitarian policies popular in the former Soviet republics. If western countries implement Piketty’s proposals in the future, transition economies will be more likely to follow their course.
Geopolitical tensions between Russia, the United States, and, possibly, China, may affect Central Asia in the near future. Political parties that push for closer ties with these powers may clash in future elections or during protests. Kazakhstan and Kyrgyzstan are members of the Russia-led Eurasian Economic Union (EAEU) and the Collective Security Treaty Organization (CSTO), yet nationalism and economic difficulties decrease the popularity of Eurasian integration in the region. Though Kasym-Zhomart Tokayev, the candidate of the ruling “Nur Otan” party for the June 9 presidential election in Kazakhstan, is likely to continue Nazarbayev’s foreign policies, he is unlikely to assume as much power as his predecessor. When Nazarbayev came to power in 1989, people of the Kazakh Soviet Socialist Republic, like the people of other Soviet republics, were living under a one-party system. However, all of Kazakhstan’s neighbors in the CIS region have had more than one president by now and some have experienced color revolutions. In spite of his experience as the ex-Prime Minister, ex-Minister of Foreign Affairs, and ex-Chair of Senate, Tokayev never assumed power or authority in Kazakhstan, comparable to Nazarbayev. Furthermore, Article 42 of the Constitution of Kazakhstan prohibits presidents after the first one from serving for more than two terms. Even if Tokayev stays in power for that whole period, he will have to take the views of the largely pro-western opposition leaders into consideration. The better the West handles income inequality, the more appealing their arguments will be.
In Kyrgyzstan, the power of the President is much weaker than that of the President of Kazakhstan. Almazbek Atambayev, former President of Kyrgyzstan, was the first president in Central Asia to leave office voluntarily. Prior to leaving, Atambayev had signed a constitutional amendment that extended the power of parliament. Kyrgyzstan is the only country in Central Asia that Freedom House classifies as “Partly Free”, having a score of 37, as of 2018 (0=least free, 100=most free). For Kazakhstan, the Freedom House score was 22. A weak president, a strong parliament and relatively lax restrictions on political freedom increase the chance of pro-western parties coming to power in the future. For both countries, the better the West handles income inequality, the more convincing the pro-western political parties will be.
The remaining three Central Asian countries have looser ties with Russia and are freer in their foreign policies. Turkmenistan and Uzbekistan belong to neither the EAEU nor the CSTO, and Tajikistan only belongs to the CSTO. Uzbekistan has embarked on a policy of financial and trade liberalization. Nevertheless, all three countries have highly authoritarian regimes. As of 2018, Freedom House ranked Turkmenistan, Uzbekistan and Tajikistan with scores of 4, 7, and 11, correspondingly, making their regimes among the most repressive in the world. If inequality continues to increase in the West, their governments will find it even easier to use it in their propaganda.
The key ratios
Piketty argues that the ratio of capital income to national income determines whether inequality approaches unacceptably high levels. The share of capital income to national income, α, is equal to the average return on capital, r, times the capital/income ratio, β. The accounting identity α=r*β is always true.
In the long run, the capital/income ratio, β, is related to the savings rate s (national or global) and income growth rate (national or global) g, according to the formula β=s/g. Wealth accumulation takes time. It may take decades for the second formula to come true. That formula is valid only if one focuses on forms of capital that can be accumulated. Asset prices must evolve on average in the same pattern as consumer prices.
High saving rates, combined with low growth rates, increase the capital-income ratio. The higher the capital-income ratio, the less equitable the wealth distribution.
Historical trends in growth and income inequality
Piketty decomposes output growth into two components: population growth and per capita output growth. Population growth is slowing down, yet not enough to neglect it in public debate. It must be taken into consideration when analyzing historical output growth trends.
Before the two World Wars, global population growth rates tended to be low. Between antiquity and the Industrial Revolution, annual global population growth could not have exceeded 0.1-0.2%. Otherwise, the world population would have to have been extremely small in the ancient times (fewer than 10,000 people), given the estimated population of about 600,000 people in 1700, or the standard of living must have been below minimum subsistence levels. The average population growth rate between 1700 and 2012 was barely 0.8%. Annual growth rates over 1-1.5% would produce enormous population increases.
Until 1913, output grew slowly. Average annual output increased 0.5% in 1700-1820 and 1.5% in 1820-1913. Between 1913 and 2012, annual output grew 3%.
After World War II, global output experienced unprecedented high growth rates of about 3.5-4% per year. During the period between 1950 and 1970, birth rates were high, the state sector expanded, and income inequality decreased.
Piketty argues that the decrease is due to decline in the return on capital, net of taxes and losses. After 1913, it fell to 1-1.5%, and for the first time in history, economic growth exceeded it. Nevertheless, this trend is gradually reversing.
The 1970s stagnation led to new laissez-faire theories, such as monetarism, and to the implementation of neoliberal economic policies by Ronald Reagan in the U.S. and Margaret Thatcher in the U.K. in the 1980s. Other western countries also embarked on tax cuts and privatization. Piketty argues that it was not the relative share of the state versus the private sector but the need to rebuild capital stock that increased European economic growth rates in 1950-1970. He also argues that since continental Europe was catching up with the U.S. and the U.K., voters in the latter countries wanted policies that would boost economic growth.
Since population growth is slowing down globally, world income growth in the 21st century will be low. The global population increase that averaged 0.8% over the past three centuries is likely to decrease sharply during this century. Piketty expects global income to grow 1.5% annually on average between 2050 and 2100. This is about the same rate as in the nineteenth century.
Inflation trends
The gold standard preceding the two world wars made inflation negligible, compared to today. The overall price level changed during discoveries or shortages of gold but generally remained stable. The value of a given amount of money would remain about equal across generations.
The world wars and the Great Depression led central banks to expand the money supply, abandoning the gold standard. Unprecedented inflation occurred. Many countries returned to the gold standard by 1927, but the Great Depression induced them to re-abandon it.
The Bretton Woods Agreements established a system under which many countries pegged their currencies to the U.S. dollar and could exchange dollar holdings for gold (the so-called gold exchange standard). This system existed until the 1976, when the peg was removed. By that time, the dollar was already floating against other currencies.
Nowadays, all market economies are inflationary to some extent, with lower rates in developed countries. Inflation can reduce private and public debt. It affects the rich and the poor differently. Low and medium wages are usually better indexed to inflation, especially during wartime, since employers make efforts to prevent the purchasing power of the least well-off from decreasing too far. Asset prices tend to rise at about the same rate as consumer prices, but this assumption does not always hold in practice. The distribution of the average return among individual citizens is likely to change with inflation. Piketty characterizes the redistributional effects of inflation as “complex, multidimensional, and largely unpredictable and uncontrollable.” Nevertheless, he admits that inflation enhances the financial position of the wealthy, since they can afford to hire financial advisers to mitigate its effects.
Measuring inequality
Piketty criticizes generalized inequality indices such as the Gini coefficient. These indices fail to distinguish between income from labor and income from capital or to account for justifications of inequality. Data from different countries or periods are not always comparable.
Piketty also cautions against interdecile ratios, such as the ratio between the shares of the 90th percentile of income and the 10th percentile. These ratios are generally more useful than indices, but do not show the actual shares. Also, they give no information about percentiles of income, falling beyond the range of the numerator and the denominator, such as income beyond the 90th percentile in the example above.
Piketty argues that distribution tables comparing the shares of income from capital versus labor, owned by deciles, such as the top 10% of the population or centiles of the population, should be used to analyze inequality. These tables are more transparent and comparable.
General inequality trends
Piketty distinguishes between two components of inequality: income inequality from capital and income inequality from labor. Income from labor usually amounts to between two-thirds and three-quarters of national income. In the Scandinavian countries of the 1970s and the 1980s, the top 10% of earners received 20% of total wages and the bottom 50% received 35%. In the United States of the 2010s, the top 10% received 35% of the total and the bottom 50% received 25%. Yet the inequality of income from capital substantially exceeds that of income from labor. Even in the Scandinavian countries of the 1970s and the 1980s, the wealthiest 10% owned about 50% of national wealth, and the corresponding figure for most European countries in 2010 is 60%. The poorest 50% owned 10% in Scandinavia of the 1970s and the 1980s and 5% in Europe and the United States in 2010.
Piketty illustrates that the poorest 50% of the population earn a small share of income from capital but does not mention how much they save by receiving free welfare services (cash and in-kind benefits). It may be inevitable that the poor are too risk-averse to invest, and that welfare should mitigate their low incomes. Since welfare benefits decreased between 1970 and 2010, the difference in the well-being of the poorest 50% is more substantial than income distribution tables alone suggest.
The author does not mention the role of technological and political rivalry with the Communist countries during the Cold War in increasing government spending. Governments of western countries had incentives to spend on areas such as education, science and technology. Technological advances would give the West a military advantage and make their political and economic systems more popular. For example, federal research spending in the United States as a share of total R&D spending increased from 53.83% in 1953 to 60.69% in 1968, reports the National Science Foundation. After the landing on the moon showed that the United States was winning the race, and during the stagflation of the 1970s, federal spending on R&D decreased. In 1980, industry R&D spending surpassed federal R&D spending. Between 1968 and 1981, the share of R&D in total budget outlays decreased from 9.1% to 5%, reports the American Association for the Advancement of Science. Increased private spending was consistent with Reagan’s laissez-faire policies. The slowing down of the Soviet economy may have also weakened incentives of the federal government to spend. Nevertheless, federal spending continued to increase due to new projects, such as the space shuttle program. The graph below illustrates changes in R&D spending by source of funding between 1953 and 2016.
Government R&D spending generated positive externalities. For example, Global Positioning Systems) GPS were initially developed to track space shuttle missions, satellite television would not be possible without space exploration, and defense spending during the Cold War led to the development of the Internet. Today, the private sector in many countries continues to benefit from government spending on research and development during the Cold War, since many companies provide or make use of these products and services. For example, the GPS market size alone was estimated at 37.9 billion U.S. dollars in 2017 and expected to grow at a compound annual growth rate of 18.4% until 2025, reports Grand View Research, Inc., an India and U.S.-based research and consulting firm.
Piketty argues that the resulting income inequality may undermine the existing democratic institutions and calls for more international cooperation in tax collection. The next post will detail and assess his claims and proposals.
References
American Association for the Advancement of Science. Historical trends in federal R & D. https://www.aaas.org/programs/r-d-budget-and-policy/historical-trends-federal-rd. 2018.
Freedom House. Freedom in the world 2018. Table of country scores.
Grand View Research, Inc. Global positioning systems market, GPS industry report, 2018-2025. https://www.grandviewresearch.com/industry-analysis/gps-market. 2019.
National Science Foundation. National Patterns of R&D Resources. http://www.nsf.gov/statistics/natlpatterns/. 2019.
Official Site of the President of the Republic of Kazakhstan. Constitution of the Republic of Kazakhstan. http://www.akorda.kz/ru/official_documents/constitution. 2018.
