Book of the Week: Capital in the Twenty-First Century

02 Jan 2016

This week I read Capital in the Twenty-First Century by Thomas Piketty, because I wanted to find out the source of income inequality. Why are other people rich and I’m not and what we can do about it. Thomas uses decades of data to explore the how the relationships between income and capital changed over time. The book is really thick, but it only has a single point. There used to be a lot of income inequality, but then the great depression and the world wars messed that up. We are now returning to a world with a lot of income inequality and the only way to prevent that is a progressive tax on capital. The Economist has a four paragraph summary of the book. Convergence

In other words, the poor catch up with the rich to the extend that they achieve the same level of technological know-how, skill, and education, not by becoming the property of the wealthy.

There are rich and poor countries. Convergence is what happens when that gap decreases over time. Capital has better returns in poor countries since marginal increases in productivity are greater. This leads to rich countries investing in poor countries, which causes the problem of a rich country owning the poor country indefinitely, preventing the poor country from closing that gap. For poor countries to close the gap, they need to invest in themselves. This sometimes takes the form of explicit rules to prevent foreign investment like in China. Sometimes it just comes from savings by the country. But the biggest gains are not from getting capital investments, but from knowledge sharing. The First Fundamental Law of Capitalism $latex \alpha = r \times \beta$ where $latex \alpha $ is share of income from capital in national income, $latex \beta $ capital/income ratio and r is rate of return on capital. As the capital to income ratio increases, a larger percentage of the national income will be from capital instead of labor. The better the returns on capital, the larger share of national income will be from capital instead of labor. The Second Fundamental Law of Capitalism $latex \beta = s / g $ where $latex \beta $ is the capital/income ratio, s is the savings rate and g is the growth rate. The capital to income ratio is determined by the savings rate divided by the growth rate. Growth can come from increases in population or productivity gains. Historically, this growth rate is low, around 1%. As growth decrease, the capital / income rate increases. The capital to income ratio has remained relatively constant over time as the economies shifted from agriculture to manufacturing to service. People don’t farm, but work at Wal-Mart (WMT) now. Inequality

In the long run, the best way to reduce inequalities with respect to labor as well as to increase the average productivity of the labor force and the overall growth of the economy is surely to invest in education.

Inequality can be broken down into into 3 terms, inequality in income from labor, inequality in capital ownership, and the income to which gives it rise; and the interaction between these two terms. Income can only come from two places. In a hyperpatrimonial society, wealth is inherited. In a hypermeritocratic society, wealth comes from being paid more. Being paid more is a more recent Anglo-Saxon thing. The Japanese do not compensate their executives as much as Americans. Since executives can determine their own pay, you have the rise of supermanagers who get compensated enough to change the distribution in income earned from labor. There are a few people who are paid a boatload of money. Traditionally people inherited their wealth, but that changed during the great depression and world wars, when a lot of that wealth was lost. It looks like as time progresses, we will return to more inherited wealth. The Mechanism of Wealth Divergence

The primary reason for hyperconcentration of wealth in traditional agrarian societies and to a large extent in all societies prior to world war I (with the exception of the pioneer societies of the new world, which are for obvious reasons very special and not representative of the rest of the world or the long run) is that these were low-growth societies in which the rate of return on capital was markedly and durably higher than the rate of growth.

We looking at $latex \alpha$, the largest influences are r and g. The return on capital grows faster than the economy, so those with capital get a bigger and bigger slice of the pie. This starts to make inherited wealth more important. The Rich Get Richer The rich tend to have better access to better returns. This makes the rich even richer. Universities with bigger endowments get better returns on capital. The table below is the return on the capital endowments of US universities from 1980 to 2010. | Average real annual rate of return (%)
—|—
All universities (850) | 8.2
Harvard, Yale, Princeton | 10.2
Endowments higher than $1 billion (60) | 8.8
Endowments between $500 million and 1 billion (66) | 7.8
Endowments between $100 and $500 million (226) | 7.1
Endowments less than $100 million (498) | 6.2
Taxes The solution is to have a global progressive tax on capital to prevent the rich from getting richer. If you don’t you run into societal problems that will lead to revolutions and crap like that. It needs to be global to avoid people shopping around for tax havens. As things are going now, the rich are only going to get richer. Purchase Capital in the Twenty-First Century on Amazon.com or check it out from your local library.