Saturday, March 22, 2014

Inequality and returns to capital

One of the strands of the story about widening inequality is that of increasing returns to capital at the expense of labor. This graphic of US wage and salary as share of GDP is striking.

One thing is very evident. In every recession, the share of income going to labor has declined. Further, not only has the share not rebounded during recoveries, but continued to decline as the benefits of economic growth have accrued disproportionately to the owners of capital.

In this context, Paul Krugman has a nice explanation, using the simple Solow model of economic growth, of Thomas Piketty's argument that the current decline in share of labor returns indicates a return to the historic trend where returns to capital has dominated the return to labor. The graphic highlights that, apart for a period in 20th century, the rate of return on capital has always exceeded the global economic growth.

In the long-run when a steady state of growth is achieved, economic growth converges to the sum of rate of population growth and rate of productivity growth. In the same horizon, the rate of capital accumulation converges to the savings rate. Taken together, in the long-run, the stock of capital as a percentage of national income should approach the ratio of the national savings rate to the economic growth rate. The same can also be derived from the simple Solow model as Krugman does here.

The importance of this comes from the fact that as the economic growth falls, the stock of capital as a share of national income would rise. In other words, as the rate of return from capital is more than the rate of economic growth, concentration of wealth follows. The current state of the world economy appears to provide the conditions required for this. Population growth, which has contributed roughly half of average global GDP growth in the 1700-2012 period (the other half coming from productivity growth, given that in the long-run the economy converges to the steady state rate of growth), is likely to decline in most parts of the world in the years ahead. Productivity growth, as people like Robert Gordon and Tyler Cowen have been arguing, too has been declining.
This just means that we are likely to see a long period where income from wealth would grow faster than wages.

As Piketty writes (from Free Exchange here and here),
Whenever the rate of return on capital is significantly and durably higher than the growth rate of the economy, it is all but inevitable that inheritance (of fortunes accumulated in the past) predominates over saving (wealth accumulated in the present)... wealth originating in the past automatically grows more rapidly, even without labor, than wealth stemming from work, which can be saved...
In a society where output per capita grows tenfold every generation, it is better to count on what one can earn and save from one's own labor; the income of previous generations is so small compared with current income that the wealth accumulated by one's parents and grandparents doesn't amount to much. Conversely, a stagnant, or worse, decreasing population increases the influence of capital accumulated in previous generations. The same is true of economic stagnation.
The debate generated by Piketty's book comes on the back of recent studies, which find that low-inequality countries did better at sustained economic growth and that redistribution appears generally benign in terms of its impact on growth. In the US, the top 1% own 35% of national wealth, more than all the bottom 90%, and the top 1% corner more than a quarter of the national income. For sure, inequality is back with a vengeance and looks likely to be the most dominant economic theme in the years ahead. The Economist, of all institutions, has already kicked off a fascinating debate with articles on how the rising inheritance wealth and financial market returns worsens inequality.

Update 1 (26/3/2014)

John Cassidy reviews Thomas Piketty here.

Update 2 (17/5/2014)

Lawrence Summers reviews Piketty here. He summarizes Piketty's central thesis,
Whether or not his idea ultimately proves out, Piketty makes a major contribution by putting forth a theory of natural economic evolution under capitalism. His argument is that capital or wealth grows at the rate of return to capital, a rate that normally exceeds the economic growth rate. Thus, economies will tend to have ever-increasing ratios of wealth to income, barring huge disturbances like wars and depressions. Since wealth is highly concentrated, it follows that inequality will tend to increase without bound until a policy change is introduced or some kind of catastrophe interferes with wealth accumulation...
So slow growth is especially conducive to rising levels of wealth inequality, as is a high rate of return on capital that accelerates wealth accumulation. Piketty argues that as long as the return to wealth exceeds an economy’s growth rate, wealth-to-income ratios will tend to rise, leading to increased inequality. According to Piketty, this is the normal state of capitalism. The middle of the twentieth century, a period of unprecedented equality, was also marked by wrenching changes associated with the Great Depression, World War II, and the rise of government, making the period from 1914 to 1970 highly atypical... It presumes, first, that the return to capital diminishes slowly, if at all, as wealth is accumulated and, second, that the returns to wealth are all reinvested. 
Summers' reservations about Piketty's thesis derives from his belief that the current American economy is characterized by diminishing returns to capital invested (average is over - the low hanging technology advances are past us and the returns from marginal investments in technology are far lower) and the reduced opportunities for reinvestment of the capital (Google and Apple, the touchstones of modern capitalism, sit on cash unable to identify opportunities for re-investment; though Sony and whatsapp have the same $18-19 bn valuation, the later has many times less capital invested than the latter). Taken together, Summers describes this as evidence of a secular stagnation - a new normal of low trend growth gets established.

He also attributes trends like the rising share of profits in national income (in developed economies) and the consequent widening inequality not so much to the process of inexorable capital accumulation but to the increased mechanization of work (which raises returns to capital than labor) and the abundance of cheap foreign labor. 


gaddeswarup said...

" the rate of return from capital is more than the rate of economic growth, concentration of wealth follows." This seems to be just a consequence of the definitions. Solow model is used to see the dynamics, I think. I have written a bit about this in my blog, you can perhaps tell me whether I misunderstood the definitions.

gaddeswarup said...

I had a few posts on Piketty in the last couple of months. This post has link to the pdf file of what I wrote