The Piketty cheat-sheet: Six must-reads on Thomas Piketty

Months after its English translation was first published, the French economist Thomas Piketty’s book on inequality, Capital in the Twenty-First Century, continues to make news, and to win rave reviews from other economists. Here, we bring together the best writings on Piketty by six foremost economists of the world, which give a broad overview of Piketty’s work, and the debate it has ignited.

The latest prominent economist to lavish praise on Piketty’s magnum opus is the University of California emeritus professor of economics, Pranab Bardhan. In a recent review for the Economic and Political Weekly, Bardhan points out that the main contribution of this book is “the massive amount of historical data that Piketty and his associates have collected on inequality for several countries, and the broad patterns that they have deciphered in terms of historical changes”.

“In particular, the Kuznets presumption that has prevailed in Economics for many decades that inequality goes up in the initial stages of development and then mercifully starts declining is found by Piketty to be limited by the short range of data Kuznets looked into, and highly misleading about historical trends when seen in the larger perspective that is provided in the Piketty book,” writes Bardhan. “Instead it shows that the wealth-income ratio and the associated inequality was high in industrially advanced countries until about the World War I, then declined and stabilized in the period 1910-70 (possibly on account of the disruptions of wars, depression, high taxes and postwar growth), and has been rising remarkably since then (definitively in terms of inequality of income, and probably of wealth as well, but the data are a bit more spotty for the latter).”

As Mint’s executive editor, Niranjan Rajadhyaksha pointed out in an earlier Economics Express post, Piketty has empirically challenged two hoary truths in economics that took root more than five decades ago. The first is the observation by the US economist Simon Kuznets that income inequality initially increases and then falls in the course of a country’s economic development. The second is one of the stylized facts on economic growth proposed by the British economist Nicholas Kaldor about the shares of national incomes going to labour and capital remaining stable over time. Data collated and presented by Piketty shows that inequality has been rising in the developed world over the past few decades once again even as the share of national income going to capital has spiked.

In his review of Piketty’s book, the Nobel laureate Robert Solow argues that pre-Piketty explanations of the widening chasm between the rich and poor within economies—erosion of the real minimum wage, the decay of labour unions and collective bargaining, globalization and intensified competition from low-wage workers in poor countries, technological changes and shifts in demand that eliminate mid-level jobs and leave the labour market polarized—do not offer a convincing explanation even when all these effects are taken together.

“…they seem a little adventitious, accidental; whereas a 40-year trend common to the advanced economies of the US, Europe, and Japan would be more likely to rest on some deeper forces within modern industrial capitalism,” wrote Solow. “Now along comes Thomas Piketty, a 42-year-old French economist, to fill those gaps and then some.”

Solow summarizes Piketty’s central argument about the rich getting richer because returns to capital have been, and are likely to be, higher than economic growth as follows:

“Suppose it (an economy has reached a “steady state” when the capital-income ratio has stabilized. Those whose income comes entirely from work can expect their wages and incomes to be rising about as fast as productivity is increasing through technological progress. That is a little less than the overall growth rate, which also includes the rate of population increase. Now imagine someone whose income comes entirely from accumulated wealth. He or she earns r percent a year. (I am ignoring taxes, but not for long.) If she is very wealthy, she is likely to consume only a small fraction of her income. The rest is saved and accumulated, and her wealth will increase by almost r percent each year, and so will her income. If you leave $100 in a bank account paying 3 percent interest, your balance will increase by 3 percent each year.

This is Piketty’s main point, and his new and powerful contribution to an old topic: as long as the rate of return exceeds the rate of growth, the income and wealth of the rich will grow faster than the typical income from work. (There seems to be no offsetting tendency for the aggregate share of capital to shrink; the tendency may be slightly in the opposite direction.) This interpretation of the observed trend toward increasing inequality, and especially the phenomenon of the 1%, is not rooted in any failure of economic institutions; it rests primarily on the ability of the economy to absorb increasing amounts of capital without a substantial fall in the rate of return. This may be good news for the economy as a whole, but it is not good news for equity within the economy.”

Not all economists have been convinced by Piketty’s explanation though. The most prominent sceptic is the New York University economist, Debraj Ray. Ray agrees with Solow on the fact that Piketty has come up with a fairly robust description of historical trends in inequality in the developed world but finds Piketty’s explanation based on the divergence between the rate of return to capital (r) and the rate of economic growth (g) unconvincing. In a blog post, Ray points out that such an explanation (r>g causing widening inequality) is problematic because we are then trying to explain one endogenous variable with other endogenous variables. Also, what is driving inequality is not the mere fact that the rate of return on capital is greater than the rate of growth but the implicit assumption in Piketty’s argument that owners of capital save more than others. It is this assumption that is driving Piketty’s main result, Ray argues. If the propensity of the rich to save were lower, or they choose not to save in the form of dividend-paying capital assets, Piketty’s thesis would not hold true, Ray argues.

In a sharp rebuttal of Ray’s critique, one of the world’s foremost experts on global inequality, Branko Milanovic finds Ray’s critique abstract and ahistorical. Milanovic argues that Ray’s criticism would hold if indeed capitalists saved lesser than others and spent most of their wealth on consumption.

“If we had a capitalism where capitalists were poor or a capitalism where capitalists would spend all of their capital incomes on booze and trinkets, yes, Debraj’s critique of Piketty would be right,” writes Milanovic. “But it just so happens that these are not the features of contemporary, nor of any other known, capitalism at least over the past 200 years.”

The problem of endogeneity that Ray raises is germane to the discussion on Piketty’s work but even the neo-classical economic models that Ray cites approvingly suffer from a variant of the same problem. As the American economist James Galbraith points out in his sharply worded critique of Piketty, the problem of adding up different kinds of ‘capital’ has not been successfully resolved in economics yet.

The problem in adding up different kinds of capital using financial values based upon a rate of return that is itself determined by the stock of capital remains a fundamental contradiction within economics, and one that Piketty’s analysis too suffers from, Galbraith argues.

Both Piketty’s tome, and standard economic theory have tried to pretend that problem does not exist, writes Galbraith:

“The basic neoclassical theory holds that the rate of return on capital depends on its (marginal) productivity. In that case, we must be thinking of physical capital—and this (again) appears to be Piketty’s view. But the effort to build a theory of physical capital with a technological rate-of-return collapsed long ago, under a withering challenge from critics based in Cambridge, England in the 1950s and 1960s, notably Joan Robinson, Piero Sraffa, and Luigi Pasinetti.

Piketty devotes just three pages to the “Cambridge-Cambridge” controversies, but they are important because they are wildly misleading. He writes:

“Controversy continued . . . between economists based primarily in Cambridge, Massachusetts (including [Robert] Solow and [Paul] Samuelson) . . . and economists working in Cambridge, England . . . who (not without a certain confusion at times) saw in Solow’s model a claim that growth is always perfectly balanced, thus negating the importance Keynes had attributed to short-term fluctuations. It was not until the 1970s that Solow’s so-called neoclassical growth model definitively carried the day.”

But the argument of the critics was not about Keynes, or fluctuations. It was about the concept of physical capital and whether profit can be derived from a production function. In desperate summary, the case was three-fold. First: one cannot add up the values of capital objects to get a common quantity without a prior rate of interest, which (since it is prior) must come from the financial and not the physical world. Second, if the actual interest rate is a financial variable, varying for financial reasons, the physical interpretation of a dollar-valued capital stock is meaningless. Third, a more subtle point: as the rate of interest falls, there is no systematic tendency to adopt a more “capital-intensive” technology, as the neoclassical model supposed.”

“In short, the Cambridge critique made meaningless the claim that richer countries got that way by using “more” capital…. And Solow’s model did not carry the day. In 1966 Samuelson conceded the Cambridge argument!”

“Notwithstanding its flaws, Piketty has succeeded in making everyone ponder on the right questions,” writes Lawrence Summers, the former US treasury secretary and Harvard University president in his review of Piketty’s work.

“Piketty provides an elegant framework for making sense of a complex reality”, writes Summers. “His theorizing is bold and simple and hugely important if correct. In every area of thought, progress comes from simple abstract paradigms that guide later thinking, such as Darwin’s idea of evolution, Ricardo’s notion of comparative advantage, or Keynes’s conception of aggregate demand. Whether or not his idea ultimately proves out, Piketty makes a major contribution by putting forth a theory of natural economic evolution under capitalism.”

“Does not the rising share of profits in national income in most industrial countries over the last several decades prove out Piketty’s argument?, writes Summers. “Only if one assumes that the only factors at work are the ones he emphasizes. Rather than attributing the rising share of profits to the inexorable process of wealth accumulation, most economists would attribute both it and rising inequality to the working out of various forces associated with globalization and technological change. For example, mechanization of what was previously manual work quite obviously will raise the share of income that comes in the form of profits. So does the greater ability to draw on low-cost foreign labour.”

Even if the deep forces underlying economic inequality are not so clear yet, there can never again be a question about the phenomenon or its pervasiveness after Piketty’s seminal contribution to the subject, Summers writes.

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