Capital in the Twenty First Century

Macroeconomics - Economic growth - Monetary Policy
Review by: 
George Gray Molina
Thomas Piketty
Belknap Press
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Growth will not save us

Thomas Piketty’s book title (Capital in the Twenty-First Century) is not really about Karl Marx’es magnum opus –nor about the 21st century– but about how the ownership of economic growth has evolved over the last century. In painstaking detail, Piketty shows that the return on capital has been growing faster than the rate of overall economic growth –thus pushing a longstanding labor-capital equilibrium into “divergence”. As inequality grows, he observes, the problem is not that the economic growth machine will stop working, but that it will continue to work to a small group’s disproportionate benefit –“super-managers”, whose exorbitant remunerations are “set by the executives themselves”.

Growth will not save us, argues Piketty, because capital’s rate of return is expanding faster than overall income growth. Is the world ready for a global tax on capital? As you may imagine, this line of reasoning sets things up for a very interesting conversation.

Given Piketty’s model, will the rate of return on capital ever decline?

There are already several valuable reviews of Piketty’s book, including those by Branko Milanovic and Paul Krugman. Given the back-and-forth, I’ll focus on a few questions that seem important for a Latin American reading of the book. This first part has to do with the central story: the return on capital (r) and the growth rate (g). Branko Milanovic makes an important observation on the dynamics of the return to capital. To the extent that r>g over a long period in the 20th century, the share of capital in income sky-rockets, and a feedback loop kicks in:

  …not only do capital owners become richer, but, unless they consume the entire return from their capital, more will remain for them to reinvest... The excess savings allows a further concentration of capital.1

In this dystopian world, asks Milanovic, will the rate of return on capital ever decline? After all, haven’t we just learnt from the Great Recession that there can be too much capital? With record levels of liquidity and “savings gluts” wouldn’t the rate of return on capital decline? Isn’t the zero-percent interest rate moment a sign of this? Piketty’s answer is complex and has to do with how he sees the Golden Age of capitalism –the period running from 1945 to 1975 in the industrialized world, and the present period for China and emerging economies.

For Piketty, the Golden Age was dominated by the equalizing forces of population growth, progressive income taxation and the threat of communism –all putting a check on massive concentrations of capital. These were one-off processes. Now, as the workings of capital markets settle back into a longer-term pattern, and as soon as China converges in income per capita, we will revert to a process of increasing capital concentration –unless something dramatic happens to taxation policy around the world.

How much of r>g is due to (not) taxing inherited wealth?

Enter Paul Krugman: how much of r>g is just due to the cyclical nature of economic growth, and how much is due to the absence of wealth taxes on inherited wealth?

  …because when the rate of return on capital greatly exceeds the rate of economic growth, “the past tends to devour the future”: society inexorably tends toward dominance by inherited wealth…2

While money managers may have not had incentives to give themselves massive pay raises in the 1970s at a time when the marginal rate of taxation on income was very high, changes in tax rules have opened the field since the 1980s. Will today’s super-managers become tomorrow’s Rockefellers? This is the gist of Piketty’s final chapters, which argue for the need to tax inherited wealth and apply a global tax on capital –thus leveling the playing field for the next generations.

Unlike most analyses of income inequality, which rely on household surveys, Piketty’s book is based on the dissection of tax returns. This has some advantages (long run temporal series, catches the top 1%) but also some disadvantages (income in tax data is under-reported in most places, although people must file taxes as individuals and also as companies). Piketty focuses on the evolution of the market income of a vast array of tax units which may or may not correlate with individual or household income. This mismatch means that the robustness of r>g depends on things other than the rate of return on capital –specifically, changes in the administration of taxes over various countries.

Inequality is not a race between education and technology

  Why is inequality of income from labor, and especially wage inequality, greater in some societies and periods than others? The most widely accepted theory is that of a race between education and technology. To be blunt, this theory does not explain everything…. This theory is in some respects limited and naïve.3

The prevailing conventional wisdom can explain the evolution of incomes for the 99%, but cannot explain the rise of the super-manager.4 This is important, because much of the current state-of-the-art on income inequality is undergirded by two assumptions: first, that a worker’s wage is equal to her marginal productivity, and, second, that a worker’s productivity depends on their skill level and the supply and demand on for that skill. These observations, while useful for the analysis of skills and their economic return, cannot explain why the top 1% receives compensation that have little or no relation to increases in productivity.

The conventional reply is that super-managers are a product of skill-biased technical change –they receive exorbitant compensation because they create exorbitant productivity. The missing link, argues Piketty is something working outside the educational, technological and skills market –unrelated to individual effort or talent: institutions and the power to bargain over labor share of income. The minimum wage is highly correlated to the labor share of income until we hit the 99th percentile. At this point, something other than skills or education or effort is driving income concentration.

If Piketty’s analysis holds, wouldn’t the next 30 years in emerging economies look like the last 30 years for the US/Europe?

One of the interesting effects of Piketty’s book is that it provides a field-day for counterfactual scenarios. If future growth in emerging economies “converged” along European/US lines, does this mean r>g as well? In the short run, probably not. The emerging economies are experiencing something similar to the Golden Age described for Europe in the postwar era. Massive access to education and explosive growth of the labor sector has been matched by one-off equalizing effects. However, as structural change accelerates, we might see a re-edition of the Piketty story for the emerging economies.

  Once China’s convergence ends, its growth rate will diminish. Its capital-output ratio (which Piketty does not show) may be low today, because China, like the United States in the 18th and 19th century, is a “wealth-young” country where wealth is still low compared to the annual flow of income. But it will soon rise.5

There is a “fallacy of composition” going on here. Returns on capital cannot everywhere climb at the same time, could they? It depends on where the source of economic growth is coming from and whether it is climbing faster than the rate of return on capital. John Cassidy makes a related point on the rise of Chine and India:

  [Piketty] doesn’t seriously consider the argument that globalization—and the rise of nations like China and India—is at once holding down wages and pushing up the profitability of capital, boosting inequality at both ends.6

While the so-called “middle income trap” might explain how growth dips in emerging economies, which price themselves out of cheap-labor markets, it cannot really explain how the returns on capital and labor evolve over time. At a global level, not everyone can converge (or diverge) at the same time.

Vautrin’s Lesson

Piketty concludes with a perceptive tale from Balzac’s Pere Goriot. In it, the protagonist, Rastignac, a penniless young noble, is lectured by the shady character Vautrin:

  By the age of thirty, you will be a judge making 1,200 francs per year…when you reach forty you will marry a miller’s daughter with an income of around 6,000 livres. Thank you very much….Would Baron de Rastignac like to be a lawyer? You will need to suffer ten years of misery, spend a thousand francs a month, frequent society, kiss the hem of a clerk to get cases, and lick the courthouse floor with your tongue… But can you name five lawyers in Paris who earn more than 50,000 francs a year at the age of fifty?7

By contrast, the strategy for social success suggested by Vautrin to Rastignac is “quite a bit more efficient”. By marrying Mademoiselle Victorine, a shy young woman who lives in the boardinghouse, he will “lay his hands on a fortune of a million francs”. This will allow him to draw at age twenty an annual income of 50,000 francs (5% of capital) and thus immediately achieve ten times the level of comfort he could hope to aspire years later…

As mentioned in other reviews of Piketty’s book, this is one economic treatise worth reading. The downside is that we may have to stow away the conventional wisdom on growth for a while –too focused on the sources of income convergence, and not focused enough on its effects. Divergence in wealth ownership is one problem not cured by “more growth”. In fact, as argued by the author, “the history of income and wealth is always deeply political, chaotic, and unpredictable.” So be it. Political analysis may have never had such a good econometric ally.

1. Branko Milanovic, 2013 “The return of “patrimonial capitalism”: review of Thomas Piketty’s Capital in the 21st century”, Forthcoming in: Journal of Economic Literature No. June 2014. Available at

2. Paul Krugman, 2014, “Why We’re in a New Gilded Age”, New York Review of Books, May 8, 2014. Available at:

3. Thomas Piketty, 2014 (p. 304).

4. Piketty takes aim at Claudia Goldin and Lawrence Katz’s, 2008, Race between Education and Technology (Cambridge: Harvard University Press).

5. Milanovic (2013).

6. John Cassidy, 2014, “Forces of Divergence”, The New Yorker, March 31, 2014.

7. Thomas Piketty, 2014 (p.239).