The 20th century was celebrated as the triumph of capitalism over both socialism and aristocracy. French economist Thomas Piketty argues that seeming was in fact merely a temporary historical anomaly. (More)

Capital, Part I: The History of Income and Capital

This week Morning Feature considers Thomas Piketty’s new book Capital in the Twenty-First Century. Today we begin with his definitions and history of the evolution of income and capital. Tomorrow we’ll explore his analysis of structure of inequality, both in income and capital. Saturday we’ll conclude with his proposals to limit inequality and maintain stable, democratic societies.

Thomas Piketty is Professor of Economics at the Paris School of Economics. He is the author of numerous articles and a dozen books. He has done major historical and theoretical work on the interplay between economic development and the distribution of income and wealth, and led in the compilation of the World Top Incomes Database.

The Myth of the Kuznets Curve

Much of neoclassical economics is grounded in the mid-20th century work of Simon Kuznets. He looked at the history of capitalism up through the 1950s, largely but not exclusively in the U.S., and concluded that inequality in industrial economies follows a predictable pattern, expressed in the Kuznets Curve.

In that happy story, agricultural societies begin with low inequality, as most families own at least small farms. As the society industrializes, wealth shifts from agriculture to factories and concentrates in cities. This produces higher levels of inequality, with wealth concentrating among urban factory owners and financiers, while unskilled urban workers and rural farmers are left behind. After that transition, Kuznets argued, democracy and the welfare state – especially public education – would combine with rapid growth to reduce inequality to low and stable levels.

As evidence, he offered the history of the United States, which began as a more egalitarian society than any in Europe, saw the Gilded Age as industry replaced agriculture, then blossomed into widespread and more equal wealth as the economy matured after World War II. This, he argued, was not merely one example of how an agricultural society might become an industrial capitalist society. Rather, all emerging capitalist societies would follow that pattern, with minor variations, as an inevitable consequence of market forces.

Piketty’s Spoon

Dr. Piketty acknowledges the attraction of Kuznets’ ideas. If the Kuznets Curve is correct, inequality is merely a temporary byproduct of industrialization. There is no need for economists to study it, and little need to governments to address it. Instead, they should focus solely on how to foster the economic growth that will, in time, resolve inequality on its own.

But Kuznets did his research in the 1950s and 60s, and largely in the U.S. And as Dr. Piketty documents, inequality has not followed the Kuznets Curve in the decades since then. Instead it has followed a spoon-shaped curve.

The long handle of the spoon, stretching back into antiquity, has high levels of inequality, with landowning aristocrats owning vast estates and the vast majority of people owning eking out a subsistence-level existence. The U.S. was an exception to this general pattern, at least in the northern states. The large southern plantations, Dr. Piketty notes, created income and wealth inequalities as great as or greater than those in Europe.

Then came the 20th century. Inequality dipped, both in the U.S. and Europe, but not due to the inevitable market forces that Kuznets proposed. Instead, Dr. Piketty argues, inequality dipped because two world wars sandwiched the Great Depression. Those devastating shocks, and governments’ responses, wiped out inherited fortunes and created the temporary drop in inequality that Kuznets observed.

But both wealth and income inequality have risen again – in every mature industrial economy – over the decades since. Based on that data, Piketty argues, persistently high inequality reflects the natural state of capitalism, absent the exceptional early- to mid-20th century combination of low capital return and rapid economic growth.

Income vs. Capital

Dr. Piketty spends the first part of the book distinguishing and defining income and capital. While some reviewers have disputed his definitions, I’ll summarize and use his:

  • Income – This is the annual flow of money to individuals, including both income from labor and paid returns on capital (interest, dividends, rents, profits, etc.). It does not include the market value growth of capital, unless that is paid out as income (capital gains).
  • Capital – This is (almost) anything you buy and can sell on an open market: real estate, commercial real estate, stocks, bonds, pension funds, contract rights, copyrights, etc. It does not include household durable goods (appliances, cars, furniture, etc.) but does include corporation’s durable goods (as assets).

Most notably, Dr. Piketty does not use the term human capital to refer to an individual’s education, training, or experience, because they cannot be sold on an open market, and in Piketty’s analysis their value reflects income from labor, not a return on capital.

He offers several simple formulas that relate income and capital, as well as income from labor to income from capital. One of the most important is the capital-income ratio: a country’s combined wealth, expressed as a multiple of the combined annual incomes of its citizens.

For example, if the people of Capitalia own a net $6 trillion in assets and combined annual incomes of $1 trillion, the capital-income ratio of Capitalia is 6:1 (or 6.0). Conversely, if the people of Incomia own a net $3 trillion in assets and combined annual incomes of $1 trillion, the capital-income ratio of Incomia is 3:1 (or 3.0).

Dr. Piketty shows that for France and Britain, and the other European countries for which he has reliable data, the capital-income ratio throughout the 19th century hovered around 6.0. In the U.S., the 19th century capital-income ratio was lower, typically around 4.0. Those ratios were relatively stable until the shocks of the early 20th century, when European capital-income ratios dipped to around 2.0 and the U.S. ratio to about 3.0. Since the 1980s, capital-income ratios in Europe have risen almost back to their 1900 levels (about 6.0), and the capital-income ratio in the U.S. has risen higher than ever (over 5.0).

Of course the specific substance of capital – what people own – has not returned to the 19th century. Specifically, agricultural land is a much smaller percentage of capital in modern economies. Instead, most modern capital consists of real estate, both domestic and commercial, and financial instruments (savings and retirement accounts, stocks, bonds, contract rights, copyrights, etc.). That is the defining characteristic of a mature industrial economy.

But as we’ll see tomorrow, that does not guarantee a steady reduction in inequality. Simply, Kuznets was wrong.

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Good morning! ::hugggggs::