Capital in the Twenty-First Century – a Book Review…

Title: Capital In the Twenty-First Century

Author: Thomas Piketty

Publisher: The Belknap Press of Harvard University Press (12-May-2014)

ISBN: 978-0674430006

Pages: 696, Price: Rs965

Reviewed by: Jainendra Shandilya, CFA, CAIA

‘Capital in the twenty first century’, originally published in 2013 in French, has been translated into English and published in 2014. It was after the English edition was released, the book caught the attentions of media, policy makers, political parties, economists etc. Parallels have been drawn between this book and the one with the same name published by Karl Marx.

There are two sources of income for any citizen, return on capital and income from wages. Looking through the annals of the history, return on capital has far exceeded the growth rate of the economy, for most of the nineteenth century. The same trend is likely to be seen in the twenty first century, the result: growing inequality among citizen and threat to capitalism. Ricardo was proven wrong by the technological revolution that led to falling value of the farm land in comparison to other forms of wealth. Marx failed to anticipate the balancing power of technologies in so far as its contribution to reducing economic inequalities were concerned. Simon Kuznets was the first modern economist to have prophesized the reduction in inequalities in the capitalist society, irrespective of the economic policies undertaken by countries. According to his theory, inequalities everywhere was expected to follow the bell curve. The reduction in income inequality, the one that Kuznets propounded, that was witnessed during early twenties century was the result of shocks caused by world wars and not due to any economic process as described by Kuznets. Joseph Schumpeter was hopeful that socialism would prevail over capital and even Paul Samuelson predicted that Russia would march ahead of USA in terms of GDP before the dawn of 2000!

The resurgence of inequalities in late twentieth century is due to political shifts in regards to taxation and finance, opines the author. The concentration of wealth in the very top centile is a major threat to equal distribution of wealth in a capitalist society. The total value of private wealth in developed society, expressed in years of national income, had reached around six to seven times in the late nineteenth century. It was during the post world war period this ratio reduced to between 2 to 3. Why is the private wealth of the magnitude witnessed in nineteenth century, and likely to be witnessed in the twenty first century too, a cause for concern? The reason lies in the high rates of return on capital compared to the growth of the economy. The forces of divergence becomes stronger when the difference between r (return of capital) and g (growth rate of the economy) is wide and positive. There are, of course, forces of convergence in terms of knowledge and skill, however, they are not very strong to bridge the gap between the income generated from capital and the one from labour.

The fundamental law of capitalism is the share of income from capital is equal to return on capital and the times the capital is to the national income. In other words, higher capital to income in case of a nation will lead to higher proportion of income coming from capital. The key to the long term growth of a nation is investment in physical capital and more on human capital, contrary to the classical economists’ belief that capital would flow from rich to poor countries and this would lead to convergence. Citing the cases of Japan, South Korea and Taiwan, the author contradicts the classical economists’ theories. The principal forces of convergence, therefore, is diffusion of knowledge. When inflation is low, as was the case during nineteenth century, lending to government can be very good business for wealthy people and this is what was seen in Belle Époque Europe – a period of optimism, peace at home and technological evolutions. Many countries, including Britain, resorted to printing money, hence creating inflation, in the twentieth century to reduce their debts to manageable level. Inflation as a tool to manage public debt, however, has its limitations. One, it erodes the incomes of the people dependent on Government Bond, and two, it cannot work indefinitely as after some time the retirees who are dependent on such income will raise their voices.

In case of Germany the agricultural land gave way to capitalist plants and the capital income ratio has been growing ever since the World War II and does not appear to be waning. The capital income ratio was around three years of national income in America compared to seven years of national income in case of Europe in the late eighteenth century and early nineteenth century. The United States, under President Roosevelt, showed more commitments towards reducing inequalities by introducing progressive taxation. Prior to World War I, Europe also owned capital in its colonies of Africa, Asia, and Latin America while the US not being a colonial power did not have foreign capital. Within the United States, the Southern Part witnessed extreme and cruel inequality, however, the northern part was relatively egalitarian. At the beginning of the 1970s, the capital income ratio stood between 2 to 3.5 in case of all rich countries, everywhere, whereas the same figure stands between 4 to 7 at present. Clearly, the private capital is going to dominate the modern world and since the capital easily passes from generation to generation, what we shall witness is patrimonial capitalism.

Public capital, on the other hand, is on decline in case of major countries of Europe, USA, Canada, Japan and Australia and net of debt most of these countries own almost nothing. Some countries such as China and Japan own considerable foreign capital.

As on 2010,  the United States has become the most inegalitarian based on distribution of income from labour, as the top decile receives 35 percent compared to 20 percent in case of Scandinavia and between 25-30 percent in case of many European countries. The inequality in terms of capital is more pronounced than the one due to labour. In France the bottom 50 percent owns only 4 percent of total wealth compared to 62 percent of total wealth owned by the top decile. The corresponding figures are even worse for the USA; the top decile owns 72 percent of the wealth compared to just 2 percent in case of the bottom half. The upper decile owns 60 percent in Europe and the bottom fifty percent owns just 5 percent of the total wealth in 2010. In essence, nothing has changed, the inequalities of ownership of capital are still extreme. If this level of inequalities persist, it will be hard for the bottom poor to accept without protest. Measures of inequality such as Gini index has its own limitations. It is impossible to infer about the status of various strata of a society just by referring to unidimensional number like Gini coefficients. Moreover, Gini coefficient is not very helpful in segregating inequalities due to labour and inequalities due to capital. The Gini coefficient was 0.19, during 1970-80, in Scandinavia; by this measure Scandinavia was very close to absolute equality. In the Belle Epoque Europe the Gini coefficient was 0.85 – a very unequal society.

Financial crises don’t alter the distribution of capital, the rate of growth of inequalities slows down.  The increase in inequality probably led to instability in the financial market in the USA. The increasing inequality decreases the purchasing power of the bottom fifty percent and the middle 40 percent of the population. Top managers in the US earn much more than athletes, actors, artists, etc and hence their evolution since 1970 is that of super managers. The increased wage inequality in the US is due to its failure to invest sufficiently in higher education, feels Goldin and Katz. According to them the US should invest heavily in education to make it more affordable for the masses. French experience also points towards the same direction. In case of Scandinavia, the result of their egalitarian education system is to be seen in terms of less income inequalities. The minimum wage announced by the Government helps in improving the lots of the poor in a society, however, it does not have significant effect in reducing the income of the top distribution. The inequality is more concentrated at the top centile and even more at the top thousandth of the population of the wealthy countries.

When it comes to inequalities in the emerging countries, the data points more or less the same pattern as that of the USA in so far as the share of the top centile’s income is concerned. The four countries included in the study are India, South Africa, Indonesia and Argentina. The top centile in India took around 15-18 percent of the income, during 1910-1950, and 22-25 percent in the three other countries. Then there was period of egalitarianism in these countries, especially during 1950-1980, the corresponding figures dropped to 5-6 percent in India for the top centile, 8-9 percent in Indonesia and Argentina, and 11-12 percent in South Africa. The situation turned towards the worse; the share of the top centile is around 15 percent, on an average in these four countries, with India the best at 12-13 percent compared to 16-18 percent for the rest. In case of India the difficulty of making further conclusion regarding evolution of top income is due to unavailability of data since 2000s, although the data had been published regularly since 1922.

When it comes to difference between the distribution of wealth and income, the former has always been more concentrated than the latter. In the case of the USA and Europe, in all societies and at all times, the least wealthy half of the population own virtually nothing, the top decile owning more than 60 percent and the middle 40 percent owning from 5 to 35 percent. Does mortality rate play any role in capital accumulation? Yes, a society having lower mortality rate will see less inheritance passing to future generations, ceteris paribus. The flow of inheritance and gift in the present times is likely to be high and hence the inequality is not likely to diminish if this trend continues. Both Balzac and Austen, in their novels, talked about possessing large fortunes in order to lead a comfortable life. Both the writers talked about amassing wealth equivalent to 30 times the average income of that period, to lead a comfortable life. However, there is a difference between that periods and now, inflation was not a problem during that period, and hence how much one would want was not very difficult. During the end of the nineteenth century, the same face of inegalitarianism is to be seen through the novel of Henry James in 1881 wherein the fiancé walks away on learning that the dowry would bring her partner much less than expected.

Can meritocracy lead to reduction in inequality? The United States has the same justification for paying very high salary to its super rich managers, on an average 50-100 times average income. The proponents argue that the system of rewarding talent will lead to social justice and without it only the heirs of great fortune would be able to amass wealth. Meritocratic extremism, as the other points out, will do no good to alleviate the sufferings of the rest who are neither wealthy nor supermanagers. The inherited wealth will mostly affect Europe and the United States, for some decades to come, though it will be in an important feature of the twenty first century everywhere.

Why is the accumulation of capital in the hands of few a bad thing? The return on capital is not the same for all owners of the capital. It is highly likely that the wealthier people obtain higher return than their less wealthy counterpart. The wealthy folks has far greater means to employ on their asset management; there is economy of scale due to size; high risk appetite is there in the wealthy people and they can wait for longer for the returns to materialize. Around the world, the largest fortunes have grown at higher rate compared to their peers. The case in point is that of the largest US Endowments. In 2010, Harvard with an endowment of $30 billion, Yale with $20 billion and Princeton and Stanford with more than $ 15 billion, have been able to achieve a real return of 10.2% on an average compared to 8.2% earned by the all 850 universities’ endowments.  What is more surprising is that the volatilities of these top endowments is no more than the rest of the endowments. Hence, there is clearly an element of knowledge and skill in the case of these larger endowments. Between 1990 and 2010, the fortunes of Bill Gates increased from $4 billion to $50 billion, the fortunes of Liliane Bettencourt – the heiress of L’Oreal, increased from $2 billion to $25 billion. The CAGR in both these cases was more than 13 percent, a real return on capital of more than 10 to 11 percent!

How can the world avoid this level of brutal inequality, everywhere?  A progressive tax on capital would serve much better purpose than the progressive income tax, which was suitable for the twentieth century. Together, both of these can be useful in the future. The US was the first country to impose tax of above 70 percent on income in 1919-22, and then on estates in 1937-1939. A tax of this kind is very effective in redistribution of income in the society. The author proposes tax of the order of 80 percent on incomes over $500,000 or $1 million so as to redistribute the fruits of growth and at the same time not affecting the economic growth. Why does the USA not tax its wealthier citizens? Is the problem due to its politicians being much wealthier than their European counterparts? Without a global tax on capital – that should include all financial and non-financial assets, the shares of the top centile would continue to increase. Another problem with the present taxation is that large, wealthy people are able to create ad-hoc legal entity that are not taxed in many jurisdictions. Hence, even taxing such individuals at the rate of 50 or 98 percent is not going to bring inequality down anytime soon.

China is in a better position to impose tax on capital and income that the author has talked about due to its control on capital. China has been able to spend a larger proportion of its income on education, health and infrastructure than many emerging countries such as India and this is the reason it has outpaced itself from India. Can immigration solve the problem of income inequality? At least the US example shows, it can. Movements of labour is much easier than the movement of capital. Some MNCs resort to paying less taxes as they are able to shift profit to low tax countries. Such instances should be discouraged and the tax should be based on the basis of sales in the region rather than on the basis of the head-quarters. Many countries of the world are grappling with huge public debt and because of that growth has slowed down. Debts must be reduced by way of one time progressive tax on private capital or by inflation. The US has been able to introduce FATCA to get information on income of its citizen. FATCA may not be enough, much more is required in this regard. Tax havens have flourished on the black money of oligarchs and they would always try to block any move towards transparency. The justifications given by the tax havens, for not disclosing wealth of other nationalities, are not proper; anyone who has benefitted and grown due to openness of economy should pay for it. Individuals cannot be allowed to steal money from others by hiding it elsewhere.

Society, if left at the mercy of market, will diverge away from its goals based on social justice, although the forces of convergence in terms of knowledge and skills are in operation yet not powerful enough to appropriate its due share. Assuming that the output and the wages continue to increase for quite a long time, they cannot outpace the growth in the wealth. A society of this kind ultimately becomes rentier – the one who survives on rent and income, and dominates over those who have nothing but their labour. This gives rise to widening inequalities, which then poses threat to capitalism. Taxing capital is the solution, however, there is a trade off. Taxing entrepreneurs indiscriminately and unfairly may discourage the very seed of capitalism on which the modern society of today is resting. A judicious, well thought out, progressive tax on capital seems to be the solution, however, it will require international co-operation and regional political integration. Those who have a lot of money will fight vigorously to defend their interest, the rest will have to really work hard.

– JS

About IAIP

India Association of Investment Professionals (IAIP), which is established April 2005 and located in Mumbai, is an association of local investment professionals. As one of the 136 CFA Institute member societies, IAIP connects members to a global network of investment professionals. Consisting of portfolio managers, security analysts, investment advisors, and other financial professionals, IAIP promotes ethical and professional standards within the investment industry, facilitates the exchange of information and opinions among people within the local investment community and beyond, and works to further the public’s understanding of the CFA designation and investment industry.
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