Capital for the Twenty-First Century

October 13, 2014

Capitalism and democracy have always had an uneasy history together, despite their seemingly complimentary natures. Democracy has always acted a bit like capitalism’s irritating little brother, and has picked countless fights over the years. Some of these it wins, but by and large, it hasn’t had a great track record in the face of the power of concentrated capital. After all, politicians tend to go where the money is; they don’t concern themselves overmuch with the plight of society’s least well-off. Inequality can have a profound effect as the numbers of those considered “least well-off” swell, and democratic institutions can’t help but fall increasingly out of touch with the needs of the majorities of their populations.

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Believe it or not, but much of what you see here is a reaction against growing inequalities and their consequences.

The tension that this creates is obvious to everyone regardless of political stripe. Progressives have made this clear, but the rise of the Tea Party and the insanity of America’s populist reactionary movement is a direct response to it. Even if these movements annunciate themselves poorly, they still illustrate a useful point: capitalism and democracy struggle to maintain a balance between one another. And inequality is an important measure of that conflict even though economists have often been torn as to what the problem means in practice.

Two competing theories have emerged concerned with this central question. The first, favored by libertarians, suggests that inequalities are the result of so-called government intervention. If only we were able to create a perfect and uninhibited capitalism, inequality would disappear. Those most marginal to the operations of economic life are assumed to deserve their fate. The other extreme is represented by the collectivist left. The belief here is that extreme inequality is an endemic problem to capitalism, and that it needs to be destroyed in order to alleviate the enormous suffering that it creates. The poor are exalted, and the entrepreneurial function is denied. The failure of the Communist experiments of the twentieth century have made it clear to everyone that such extreme solutions create more problems than they solve. But simply accepting a dogmatic program to end economic injustice neither explains nor resolves the basic problem. So where is the truth? Is inequality an artificially created problem within the system? A result of the nanny-state gone wild? Or is it an untamable beast that must be broken periodically by war and revolution?

Thomas Piketty, professor at the Paris School of Economics and author of Capital in the Twenty-First Century (translated by Arthur Goldhammer), has produced the single most important exploration of this topic, possibly ever. Though he doesn’t tell you what inequality means – not directly. Instead, he puts forward an interesting question: why is it that novelists like Jane Austin or Honore de Balzac wrote such similar things about money in the early nineteenth century? After all, no serious writer today would get into prices and the sizes of fortunes, so what changed? Professor Piketty compiled over three hundred years worth of economic data from as from a stunning variety of sources and has created the most comprehensive history of capitalism and the history of capital flows ever written. And the picture is stunning. And it turns out that, yes, inequality is in fact a structural feature of capitalism, and it is because of one simple rule, one that has been true since humans started acquiring and saving capital: r > g.

In this deceptively simple equation is the reason why inequality is guaranteed within any capitalist system. It states, very simply that the rate of return on capital (r) is greater than the overall growth rate of this economy (g). While the exact difference has varied over the years, the balance is always in favor of the rate of return. This means that if you have a significant stock of capital (cash, basically), you can invest it and make more of a return than you could simply by working; on average somewhere between 5-10 percent in returns. And yes, that percentage does seem to go up the larger your initial investment. Within the lifespan of an individual, this might sound great, but when applied to the whole capitalist world across time, it means that wealth has a real tendency to gravitate upwards, and loses all pretense of being distributed on a basis of merit. The lower classes are doomed to see most of their wealth gravitate towards the holders of real capital. However, this is not a conspiracy or an attempt made by capitalists to rig the system; it is a necessary function of growth. But it has enormous consequences over time.

Professor Piketty is not an evangelist for a strictly egalitarian society. He simply points out that, according to every piece of available data, capitalism has a natural tendency towards inequality, and that the economic system will tolerate rather a lot of it. Of course, capitalism requires inequality in order to incentivize actors. The very real question concerns the nature of those incentives. Because is greater that g, in our current systems of taxation and transfer payments, the longer term incentive is to acquire a mass of capital and to sit on it, not as much to work and innovate. Because democracy requires the vested interest of a broad population in order to work, Professor Piketty is genuinely concerned for the ability of modern democracies (unlike the more limited forms that were starting to appear in the 19th century) to maintain their openness and utility to the population at large in the face of large inequalities. Put another way, can democratic institutions serve the majority of their populations when wealth is highly concentrated, and merit is no guarantee of success?

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“Single women have a dreadful propensity for being poor. Which is one very strong argument in favor of matrimony.” Austen knew what was up…

Which brings us back to the novels of Austen and Balzac: they described a world in which growth was quite low, but nearly 90% of national wealth in England and France was controlled by a slender minority. It was a world in which the poor and the destitute were bound to remain in their place, and the best hope for a future was to marry into one of the existing fortunes. It was a static world: one in which writers could give specific numbers to the sizes of fortunes needed to live lives of dignity (often around 50X the normal income), and the wealthy paired off to protect their investments from social use. It was an aristocratic world, an oligarch’s paradise, and it proved incapable of dealing with the rising expectations of the vast majority of its people.

Americans don’t have much memory of this period. In America, the extreme inequality that characterized much of Europe was never as pronounced. After all, Americans inherited a country with plenty of space and a rapidly growing population. Both of these factors can serve to offset the worst extremes of inequality because such changes force a greater diffusion of capital (at least until growth slows). But if you know your history, this was also an age of deep corruption and incredible social instability, where strikes and open class warfare were common. When Americans think back to a better age, the 19th century isn’t the one they tend to get excited about.

Instead, Americans look back at the 50s and 60s. That magical time of diners and bebop, a car in every driveway, and an Elvis song in every heart. This was the great age of middle class growth, the moon landing, and the explosive rise of living standards that still makes even the most heartless conservative pundit get misty. Interestingly, the same period was broadly good in Europe and around the developed world. The middle decades of the twentieth century are the most studied period in economics because everyone agrees that something was going right, even if there isn’t much agreement on what that was. The question of how did we got from the grotesque inequalities of the 19th century to the incredible optimism of the 20th was never really examined in macro-economic terms. Until now.

Piketty’s data reveals a major fact, oft overlooked in other studies: the effects that two world wars and the depression had on inequality. The world before the wars and after are considered different places, but how the traumas of the twentieth century affected the global economy has never been examined over time – the data hadn’t been assembled before.

So what did they do? Simply put, these enormous disruptions wiped out existing capital stocks – effectively ruining the top 10% (after all, this class owned 90% of the buildings, infrastructure, trade goods, etc. that would have been, in many cases, actively destroyed – the depression did the same job in the US, until FDR’s government took control of the economy during the war). Following this, the 50s and 60s became the first time in history (really… ever) that the inequality function, r > g, was reversed. Suddenly, it made sense to work, because wages rose faster than returns. The only reason for this was that large fortunes had disappeared, and those that remained were no longer dominant. People participated in the economy with the full knowledge that their work would be rewarded and that tomorrow would be better than today.

But it didn’t last. By the time the first generation died off, the old fortunes started to return, and the traditional model reasserted itself. Today, we find ourselves in the throws of the greatest reconcentration of wealth in history. The great period of convergence through the middle of the century, it would seem, was a fluke. But a fluke upon which we have based most of our economic myths, and the most source of our most destructive economic policies. Piketty believes that we should acknowledge these realities, and work to make capitalism socially sustainable, presumably to prevent us returning to a static world of pure patrimonial capitalism.

Political economy is one of my favorite fields of study. And one that has been sorely neglected as economists have moved away from dispassionate studies of economic life and become the tools of hedge funds and bank managers. Professor Piketty has created a work that not only reorients the work of serious economists back to social questions, but painstakingly dissects the history and development of modern capitalism. His research is meticulous, and his findings are undeniable. He does offer several proposals to stabilize the situation, but most of these are geared towards Europe. America, while it’s problems with regard to inequality are considerably more pronounced than Europe’s, has a slightly different set of choices to make.

In sum, Capital in the Twenty-First Century should serve as a beacon to all who want to future to be a better place, and not just one dominated by the heirs and heiresses to the great fortunes of the information age. There is much work to be done, but this book is a serious challenge to the proponents of unregulated capitalism. They should sit up and take notice. Progressives should too though: This book doesn’t just offer a great chance to feel smug, it is also a signpost that can orient our approach to a better future.

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