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Risk & Inequality; A Reply to ‘Capital in the Twenty-First Century’

by | 16 July, 2018 | Article


Written by Brodie Fennell, Edited by James Penfold

The issue of economic inequality has become front and centre amongst the commentariat and the economics profession, not least due to the stir that Thomas Piketty’s book Capital in the Twenty-First Century has created. However, does the work of this French economist live up to all the hype? For Piketty, there is a ‘fundamental logical contradiction’ at capitalism’s heart with ‘terrifying’ consequences for the redistribution of wealth unless the developed world implements a set of radical taxation policies on the wealthy. Piketty has fuelled hope for those on the left that there exists an insoluble conundrum at the very core of capitalism. Regrettably, for those that harbour such views, the claims made by Piketty are overly exaggerated.

To his credit, Piketty draws upon an impressive array of historical data with reference to the overall share of the top incomes earned. The picture painted by Piketty is one which has been seen before; a widening gap between those in the top income brackets and those in the low income brackets over the past century. It comes as no surprise that income inequality has increased as a result of technological change and globalisation, which have substantially increased the demand for people with high skills and talent. In short, Schumpeter’s ‘creative destruction’ has always created winners and losers, but the economic stakes of the game have increased in recent times.

However, is this growing inequality of income causing a more unequal distribution of wealth? The answer is: Who knows? It will take many more decades to establish the result of such wealth distribution policies. However, that is not to say that we shouldn’t be concerned about high inequality, especially if wealth is a key element in providing opportunities (e.g. access to education), and can lead to class stratification. Hence, equality of opportunity remains an objective that past governments within Australia and abroad have wrestled with, and will hopefully continue to address.

It is evident that Piketty’s critique of capitalism is based far more on his personal views about the fundamental factors that determine the distribution of wealth rather than his concerns about genuine economic inequality. Measuring economic inequality is a far more difficult task then simply evaluating individual’s wealth statuses. It also needs to investigate the differences between talent, drive, education levels, savings and consumption behaviour, inheritances and luck. Whether the distribution of wealth converges or diverges, shrinks or persists, is dependent upon all these factors that determine social and economic mobility.

However, Piketty focuses far more narrowly on the so called ‘central contradiction of capitalism’, that is, that the average rate of return on capital investment (r), is normally greater than the rate of output growth (g) (r>g). For Piketty, ‘the entrepreneur inevitably tends to become a rentier, more and more dominant over those who own nothing but their labour. Once constituted, capital reproduces itself faster than output increases’. What I find surprising by Piketty’s analysis, is that there is no recognition that (r) being greater than (g) is actually a necessary condition for the efficient allocation of investment over time, regardless of whether the system is one based on capitalism or central planning. For instance, China is an example of a country that has over-invested, which has damaged their consumption possibilities. Moreover, this is entirely consistent with inequality, whether its rising or falling.

Wealth distribution is a far more nuanced area of research than Piketty has stated it to be, whereby he says that the owners of capital simply reinvest all their profits and the spendthrift workers spend all their wages. This proposition ignores the households that own their homes, have investment plans and have organised pension schemes. Where are the sovereign wealth funds that have become such a crucial form of collective ownership in certain countries? Sadly, there are many questions that Piketty’s analysis simply did not address. Perhaps the most important, is the questions of risk. This is a major factor in why the average rate of return is normally greater than the growth rate by a fairly wide margin, because economic actors who lend their savings to others, require a risk premium in order to compensate them for the uncertainty of the returns on investment. Thus, adjusting for risk, the average returns on investment in historical terms have been far closer to growth rates than Piketty would have you think.

Furthermore, Piketty’s premise falls flat on its face, when you consider that the concern in capital markets these days is not that the rate of return on investment is above the growth rate, but that the rate of interest (adjusting for risk) is well below the growth rate. For instance, in Australia, the official cash rate as set by the Reserve Bank of Australia is currently at 1.50% and the official growth rate for Australia as calculated by the World Bank sits at 2.80%. This so called “stagnation trap” is proving to be particularly difficult to escape from, and the danger facing asset markets is not that the values grow faster than national income, but that with rising interest rates they may start to decline.

Beyond this, the primary weakness of Piketty’s argument is that it simply does not live up to its own rhetoric. If one were to look at the changing shares of the total wealth owned by the wealthiest one percent of the population over the past 200 years, they have progressively owned less and less of the total wealth. This is partly due to technological change and globalisation, which have contributed to the growth of a middle class in developed countries and to the resultant reduction in power and wealth of the aristocratic classes within Europe. Piketty, wrongfully in my view, characterises the period between 1910 and 1970 as exceptional. He argues that this period tells us little about the evolution of wealth in regular capitalist societies. But as before, this is due to Piketty’s failure to consider the risk premium, which constitutes a large part of the rate of the return on capital, and reflects (partly) the uncertainty about the recurrence of major financial crisis’ that have occurred in the past and will occur in the future.

In 1867 Karl Marx’s Das Capital was published, whereby Marx predicted that under a capitalist system, real wages would reduce or remain stagnant indefinitely, and it was only a few decades later that this was proven to be demonstrably false. The question is, will Piketty’s predictions about inequality meet the same fate? Only time will tell. Economics, as distinguishable from the natural sciences, is not governed by indisputable laws of nature and hasty generalisations about the ‘laws of capitalism’ are far from being useful.

Inequality is an immensely important matter, and efforts to reduce it should be undertaken by policy makers. However, capitalism, as a system, has improved the livelihoods of billions of people, by raising living standards and promoting efficiency, a market economy has proven to be the best system we have discovered for allocating societies scarce resources. To argue, as Piketty has done in his book, that capitalism should be abandoned, due to ‘inevitably’ rising inequality, whilst ignoring its myriad benefits and achievements, is a dangerous position.



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