Capital in the Twenty-First Century (Thomas Piketty)

Six years after the publication of its English translation, Thomas Piketty's Capital In The 21st Century has shifted public and academic debate, sold over 2.5 million copies, and made an economics superstar of its author. The phrase 'the one percent' has entered the lexicon, and the research conducted by Piketty and his colleagues has underpinned the general critique of western capitalism prevalent in today's political discourse.

First a note on style. Capital is a 750 page book packed with tables and charts, covering data from over two and a half centuries and a dozen countries, concentrating on the largest western economies of Britain, France, USA and (to a lesser extent) Germany. One can quickly detect an author used to writing for academic journals, with a large proportion of the book dedicated to explaining, qualifying and critiquing its own methodology. It is clearly Piketty's stance that economists engage in either (often ideologically driven) frivolous story-telling or complex mathematical model-building without sufficient recourse to the real world, and he is critical of his intellectual predecessor Simon Kuznets and his followers on this point. Therefore he backs up any supposition with a mountain of data. Piketty uses the novels of Balzac and Jane Austin to illustrate his points throughout the book, perhaps in an attempt to mitigate the potential blandness of so much description and so little analysis. It is perhaps the book's success, or because I have come to it six years late, that the inequalities in society described are less shocking than they were at publication. Nonetheless Kindle data shows Capital to be the second least read-after-purchase book on record, with the average reader giving up on page 26.

This is a shame, because Piketty has a lot to offer. The headline takeaway from the book is that the top 1%, 0.1% and 0.01% of society are accumulating most of the wealth, and that this is likely to continue. That there is no self-correcting mechanism inherent in capitalism to stop the concentration of wealth is Piketty's primary assertion. To understand what is going on, Piketty constructs a model of capitalism with it's own logic, and shows the consistency of the model within the historical data - a set of data more comprehensive than ever previously assembled in this field. Economists have subsequently praised this thoroughness and critiqued its conclusions in equal measure.

First, the model. Piketty describes the capital-income ratio (β) as all wealth in a nation (including home ownership, financial assets, land, machinery, bonds etc) as a ratio of one year's national income, and shows the change in the concentration of capital across time in various countries. He describes the annual proportion of incomes from capital (as defined above) of total income (α) as being equal to the capital-income ratio multiplied by the rate of return on capital (r). This is simply an accounting truism, saying that the amount people earn in a given year from capital as opposed to labour is the proportion of capital in the economy multiplied by the return on that capital. Piketty takes this identity, and then states as his central thesis, that in the long run r>g, meaning that the rate of return on capital exceeds the rate of growth in an economy. So, if the economy is growing at 2% per annum, but return on capital is 5% per annum, the people with capital will earn more than wage-earners. Those with capital who reinvest a proportion of those earnings in more capital every year, will have an ever-bigger pot giving them 5%, which they can again reinvest. And so on. Of course, there are fewer people with capital than there are workers, and so wealth will concentrate.

Taken at face value this model shows an ever increasing level of wealth inequality, since an increase in β (more capital in the economy) leads to an increase in α (more earnings from capital as a proportion of the total), and vice versa. In fact says Piketty, things are actually more drastic than that. The more initial capital one has, the higher return one can get. If I have £10 million pounds I can afford to be more patient and take more risks than if I have £1 million; I can also afford more professional management of my capital. Piketty compares the dowries of U.S. universities to brilliantly illustrate this point - showing that the bigger the fund, the higher the annual returns. Thus the top will accelerate away from just below the top, earn more, can reinvest more, causing the massive concentration of income and wealth we see today. This effect means that, once past a certain point wealth becomes self perpetuating - not only did Liliane Bettencourt (the heiress to L'Oreal)'s wealth increase at the same speed as Bill Gates (despite her never having worked), Bill Gates' fortune grew at the same rate after he ceased working as it had before. This model and its implications are dependent on the truth of the inequality r>g however, something we will revisit.

If concentration increases over time (and through generations), why are we not at or on the way to absolute inequality? The aforementioned capital-income ratio, plotted over time shows a similar pattern for western economies, rising through the 19th century until World War 1, then decreasing until around 1980. When this pattern was detected by economist Simon Kuznets in the 1950's, he postulated the now-famous Kuznets Curve - the idea that as an economy industrialises it becomes more unequal, but then reaches a point where government can afford (and people demand) social services, unemployment benefits, better wages as a share of profits, and so on- reversing the effect. The narrative that capitalism becomes more egalitarian over time was a popular one, and despite warnings from Kuznets himself, people saw more of a law than a one-off statistical occurrence. This of course was in no small part a symptom of the Cold War desire to refute communism, and reassure those in capitalist countries who were dissatisfied with their lot.

Piketty shows that from 1980 to present day, inequality is rising again, approaching (but not yet reaching) the levels of 1910. Dismissing any Kuznets-type self correcting mechanism, it is Piketty's assertion that a series of shocks (most notably World War I & II, the Wall Street Crash & The Great Depression) wiped out much of capital. This happened via inflation, the destruction of assets, and confiscatory income and inheritance taxes introduced to fund wars or their consequences. After the Second World War taxes remained reasonably high, whilst capital took time to build, and so countries remained more egalitarian than in the 19th century up until around 1980.

The strong growth in France, Germany and Japan after World War 2 argues Piketty, was a catching up of these countries to the technological frontier at which Britain and USA were situated. It is worth noting that the g in r>g is not per capita growth - therefore population growth also reduces inequality. This is why the U.S. was less unequal prior to 1913 (as its population exploded in the prior century).

After this, wage inequality skyrocketed, particularly in the UK and U.S. The wage inequality stems from what Piketty calls 'supermanagers', top executives at large companies gaining massive pay increases. The author demonstrates that this wage differential cannot be explained by traditional economist's ideas of marginal productivity - one can roughly measure the impact of an extra person on a production line, but not a top executive - but that these pay rises are largely the result of lower income taxes at the top rate. It is easier to ask for an extra £1 million per year he argues, when 90% of it isn't going straight to the treasury. In fact Piketty argues in favour of 'confiscatory' top rate income taxes despite the acknowledgement that it would raise very little revenue - simply to stop them happening. So, ignoring for a moment the r>g discussion, which pertains to wealth, the driver of inequality from 1980 (especially in the U.S.) is explained by wage differentials. This itself can become self-perpetuating however, when access to top education is a function of wealth. Piketty shows that being in the top percentage of earners is an almost perfect predictor of access to top universities, and how in the U.S. (somewhat unsurprisingly) donations from alumni to said universities coincide with the college attending-age of their offspring.

So what of the central thesis of r>g, and its consequences? There are some qualifications to the doomsday scenario of near-total concentration of wealth. Firstly, consumption of some of the returns from wealth must be deducted. Secondly, wealth concentration over generations is diluted by the fact that it is divided amongst multiple heirs. Thirdly, most western countries carry an inheritance tax of some form.

More significant than the above (all of which are acknowledged by Piketty), is the idea that as capital increases, it's marginal utility decreases relative to labour. That is, it seems common sense (and economic orthodoxy) that the more abundant something is the lower return it will get; and many economists state that elasticity between capital and labour is lower than one. One economist Matt Rognlie argues that in addition to the above critique, once one properly takes account of depreciation, the increase in capital's share is entirely accounted for by house price rises. It is beyond the scope of this review (and the capabilities of this reviewer) to critique the data, merely to acknowledge that the key conclusions are disputed.

As expected of such a significant book, there is further commentary of Capital worth considering. Inequality economist Branco Milanovic argues that the political and historical causes of the shocks at the beginning of the 21st century were consequences of the levels of inequality - that these ought to be counted as corrective mechanisms in and of themselves. Going back 500 years he postulates 'Kuznets Waves' of rising and falling inequalities within nations, initially with Malthusian properties. The problem with this idea is that it means absolutely anything, including World Wars, fit the 'model', which is then always correct as long as levels of inequality change direction from time to time.

Nassim Taleb (in addition to criticising the technical methodology) argues that what matters is less the proportion of wealth owned by the top 50% or 10% or 1%, but the movement of people between these categories over time. When we say (for example) that "the top 1% went from 30% of the wealth to 35% of the wealth between 1990 and 1993", we can forget that the top 1% are often different people from one year to the next. Taleb argues that more important than the concentration level is the ability to move between these levels by members of society. He also argues that the manner in which one accumulates wealth is of central importance - a risk-taking entrepreneur drives the economy, while a rent seeking executive or politician is a parasite on society. Bill Gates argues that rather than target wealth which he (unsurprisingly) thinks can be put to 'good' or 'bad' use, we should concentrate consumption.

While most of the Capital In The 21st Century is an exercise in re-writing economic history using better data, Piketty ends the book with some policy recommendations - most notably the idea of a global wealth tax. Describing this idea as 'utopian', since all nations (including tax heavens) would have to cooperate, it is not out of the question he argues, at the continental level (especially for the European Union).

The idea of a wealth tax, cuts to the heart of the popularity of Capital In The 21st Century. The bottom 50% of households have seen no increase in real incomes in over 30 years. The economic crisis of 2008 was in many people's view, the fault of bankers, who were bailed out by tax payers. Subsequent cuts to public services were accompanied by record bonuses on Wall Street. Similarly, previously lionised tech entrepreneurs became the establishment, and lost public support after innumerable breaches of trust.

The true theme of Capital In The 21st Century then, is fairness. Piketty provided in 2014 evidence of an inherent unfairness in society, and an overarching tale of a rigged system. More accurately, Capital provided ammunition to those who wished to tell that tale, and a call to arms for those who suspected something was systemically wrong. Whether the figures were misinterpreted, the model flawed, or the prescriptions erroneous scarcely matters. Prior dismissive assertions that inequality is necessary for dynamic growth no longer stand unchallenged. Thomas Piketty has managed to shift the burden of proof from those in favour of redistribution to defenders of the status quo. From being ignored by the economics establishment, the concept of inequality is now ubiquitous in political discourse. This has surely been the greatest achievement of Capital In The 21st Century.