In recent posts I’ve discussed Capital in the Twenty-First Century, the undisputed Hottest Book of the Moment, which has turned its author, French economist Thomas Piketty, into an intellectual rock star. The book’s central argument is that, when the rate of return on capital consistently outpaces the rate of economic growth, capitalism produces dangerously high levels of inequality that erode the meritocratic foundations of democracy. Concerned that America, Britain, and other Western nations are trending toward such a plutocratic future, Piketty proposes tackling inequality through measures such as a global wealth tax and a top income-tax rate of around 80 percent.
Even critics have marveled at Piketty’s impressive collection of long-term data. Last week, however, some of those data came under fire from Chris Giles, economics editor of the Financial Times, who examined the numbers and concluded that “[Piketty’s] estimates of wealth inequality — the centrepiece of Capital in the 21st Century — are undercut by a series of problems and errors. Some issues concern sourcing and definitional problems. Some numbers appear simply to be constructed out of thin air.”
Piketty has responded to Giles, and analysts such as Ryan Avent of The Economist and Scott Winship of the Manhattan Institute have demonstrated that the charges are (at least somewhat) overblown. Here’s Avent: “Based on the information Mr. Giles has provided so far . . . the analysis does not seem to support many of the allegations made by the FT, or the conclusion that the book’s argument is wrong.” And here’s Winship: “The Financial Times blew the data issues it identified out of proportion.”
Regardless of how this particular controversy plays out, Piketty’s overall argument suffers from a number of significant flaws. I’ve already mentioned thoughtful critiques penned by Winship, George Mason University economist Tyler Cowen, Bloomberg View columnists Clive Crook and Megan McArdle, Hudson Institute scholar Chris DeMuth, American Enterprise Institute economist Kevin Hassett, Washington Post columnist Robert Samuelson, New York fund manager Daniel Shuchman, French economist Guy Sorman, and National Review correspondent Kevin Williamson. Today I want to focus on some of the issues raised by former Bank of England governor Mervyn King and by Harvard economists Larry Summers and Martin Feldstein.
King makes a simple but important point about comparing the rate of return on capital with the rate of economic growth: “The main reason for the average rate of return exceeding the growth rate by a good margin is that savers require a risk premium to compensate for the uncertain nature of the returns on investment. Adjusting for risk, average rates of return have historically been much closer to growth rates.”
For that matter, says King, “the present concern in capital markets is not that the rate of return is above the growth rate, but that the (risk-adjusted) rate of interest is below the growth rate” (emphasis added).
Summers — who served as Treasury secretary under President Clinton and as National Economic Council director under President Obama — hails Piketty for his scholarly achievement, writing that Capital in the Twenty-First Century “richly deserves all the attention it is receiving.” Yet he also highlights several problems with the book’s thesis. For example, Piketty assumes that the so-called elasticity of substitution between capital and labor — in other words, the interchangeability of capital and labor — is larger than one; indeed, that assumption is a crucial part of his broader argument about capitalism. But as Summers notes, there is a major difference between gross capital returns and net capital returns.
“It is plausible,” he writes, “that as the capital stock grows, the increment of output produced declines slowly, but there can be no question that depreciation increases proportionally. And it is the return net of depreciation that is relevant for capital accumulation. I know of no study suggesting that measuring output in net terms, the elasticity of substitution is greater than 1, and I know of quite a few suggesting the contrary.”
Summers also questions Piketty’s argument about the relative importance of inherited wealth, citing changes in the iconic Forbes 400 list:
When Forbes compared its list of the wealthiest Americans in 1982 and 2012, it found that less than one tenth of the 1982 list was still on the list in 2012, despite the fact that a significant majority of members of the 1982 list would have qualified for the 2012 list if they had accumulated wealth at a real rate of even 4 percent a year. They did not, given pressures to spend, donate, or misinvest their wealth. In a similar vein, the data also indicate, contra Piketty, that the share of the Forbes 400 who inherited their wealth is in sharp decline.
Meanwhile, Feldstein points out that Piketty (1) relies on IRS tax-return data but fails to account for post-1980 changes in tax rules that “create a false impression of rising inequality,” (2) uses income figures that exclude a host of government-provided benefits, and (3) measures wealth inequality with estate-tax data, even though “bequeathable assets are only a small part of the wealth that most individuals have for their retirement years.” As for Piketty’s assertion that capitalism has a tendency to generate spiraling inequality, Feldstein offers some much-needed perspective:
His conclusion about ever-increasing inequality could be correct if people lived forever. But they don’t. Individuals save during their working years and spend most of their accumulated assets during retirement. They pass on some of their wealth to the next generation. But the cumulative effect of such bequests is diluted by the combination of existing estate taxes and the number of children and grandchildren who share the bequests.
The result is that total wealth grows over time roughly in proportion to total income. Since 1960, the Federal Reserve flow-of-funds data report that real total household wealth in the U.S. has grown at 3.2% a year while the real total personal income calculated by the Department of Commerce grew at 3.3%.