Tuesday, June 03, 2014

Plots and Subplots in Piketty's Capital

Thomas Piketty's Capital in the Twenty-First Century is a hefty 700 pages long, but if one were to collect together all reviews of the book into a single volume it would doubtless be heftier still. These range from glowing to skeptical to largely dismissive; from cursory to deeply informed. Questions have been asked (and answered) about the book’s empirical claims, and some serious theoretical challenges are now on the table.

Most reviewers have focused on Piketty’s dramatic predictions of rising global wealth inequality, which he attributes to the logic of capital accumulation under conditions of low fertility and productivity growth. I have little to say about this main message, which I consider plausible but highly speculative (more on this below). Instead, I will focus here on the book’s many interesting digressions and subplots.

When an economist as talented as Piketty immerses himself in a sea of data from a broad range of sources for over a decade, a number of valuable insights are bound to emerge. Some are central to his main argument while others are tangential; either way, they are deserving of comment and scrutiny.

Let me begin with the issue of measurement, which Piketty discusses explicitly. He argues that "statistical indices such as the Gini coefficient give an abstract and sterile view of inequality, which makes it difficult for people to grasp their position in the contemporary hierarchy." Instead, his preference is for distribution tables, which display the share of total income or wealth that is held by members of various classes. In many cases he considers just three groups: those below the median, those above the median but outside the top decile, and those in the top decile. Sometimes he partitions the top group into those within the top centile and those outside it; and occasionally looks at even finer partitions of those at the summit.

Using this approach, Piketty is able to document one of the most significant social transformations of the twentieth century: the emergence of a European middle class with significant property holdings. Prior to the first World War, there was scarcely any difference between the per-capita wealth of those below the median and the forty percent of the population directly above them; each of these groups owned about 5% of aggregate wealth. The remaining 90% was in the hands of the top decile, with 50% held by the top centile. This was to change dramatically: the share of wealth held by the middle group has risen seven-fold and now stands at 35%, while the share of wealth held by those below the median remains negligible.

Piketty argues that this "emergence of a patrimonial middle class was an important, if fragile, historical innovation, and it would be serious mistake to underestimate it." In particular, one could make a case that the continued stability of the system depends on the consolidation of this transition. If there is a reversal, as Piketty suspects there could well be, it would have major social and political ramifications. I'll return to this point below.

In order to facilitate comparisons across time and space, Piketty measures the value of capital in units of years of national income. This is an interesting choice that yields certain immediate dividends. Consider the following chart, which displays the value of national capital for eight countries over four decades:

The dramatic increase during the 1980s in the value of Japanese capital, encompassing both real estate and stocks, is evident. So is the long, slow decline in the ratio of capital to national income after the peak in 1990. The Japanese series begins and ends close to the cluster of other countries, but takes a three decade long detour in the interim. Piketty argues that the use of such measures can be helpful for policy:
...the Japanese record of 1990 was recently beaten by Spain, where the total amount of net private capital reached eight years of national income on the eve of the crisis of 2007-2008... The Spanish bubble began to shrink quite rapidly in 2010-2011, just as the Japanese bubble did in the early 1990s... note how useful it is to represent the historical evolution of the capital/income ratio in this way, and thus to exploit stocks and flows in the national accounts. Doing so might make it possible to detect obvious overvaluations in time to apply prudential policies... 
Over short periods of time the value of aggregate capital can fluctuate sharply; over longer periods it is determined largely by the flow of savings. One of the most provocative claims in the book concerns the motives for private saving. The standard textbook theory, familiar to students of economics at all levels, is based on the life-cycle hypothesis formulated by Franco Modigliani. From this perspective, saving is motivated by the desire to smooth consumption over the course of a lifetime: one borrows when young, pays off this debt and accumulates assets during peak earning years, and spends down the accumulated savings during retirement. Geometrically, savings behavior is depicted as a "Modigliani triangle" with rising asset accumulation when working, a peak at retirement, and depletion of assets thereafter.

There is no doubt that saving for retirement is a key feature of contemporary financial planning, and individuals with the means to do so accumulate significant asset positions over their working lives. But one of Piketty's most startling claims is that there is little evidence for Modigliani triangles in the data. Instead, asset accumulation appears to rise monotonically over the life-cycle. That is, the capital income from accumulated assets is sufficient to finance retirement consumption without appreciable depletion of the asset base.

Now this could be explained by a desire to leave substantial bequests to one's children, except that the pattern seems to arise also for those without natural heirs. Piketty concludes that "Modigliani's life-cycle theory... which is perfectly plausible a priori, cannot explain the observed facts---to put it mildly." This is a challenging claim. If it stands up to scrutiny, it will require a significant change in the manner in which individual savings behavior is conceived in economic models.

Also interesting is the aggregate savings behavior of societies. Countries that run large and persistent trade surpluses (thus producing more than they consume) end up accumulating assets overseas. Other countries are in the opposite position; a portion of their capital is foreign-owned, and part of their current output accordingly flows to foreign residents in the form of capital income. Not surprisingly, countries with positive inflows of capital income from abroad tend to be more affluent in the first place; Japan and Germany are prime examples. As a result, "the global income distribution is more unequal than the output distribution."

While such imbalances can be large when comparing countries, Piketty observes that at the level of most continent blocs, the imbalance is negligible: “total income is almost exactly equal to total output” within Europe, Asia, and the Americas. That is, the rich and poor countries within these continents have roughly offsetting net asset positions relative to the rest of the world.

The one exception is Africa, where nearly twenty percent of total capital (and a much greater portion of manufacturing capital) is foreign-owned. As a result, income is less than output on the continent as a whole, with the difference accruing to foreign residents in the form of capital income. Put differently, investment on the continent has been financed in large part through savings elsewhere, not from flows from surplus to deficit countries within Africa.

Is this a cause for concern? Piketty notes that in theory, "the fact that rich countries own part of the capital of poor countries can have virtuous effects by promoting convergence." However, successful late industrializing nations such as Japan, South Korea, Taiwan, and China managed to mobilize domestic savings to a significant degree to finance investment in physical and human capital. They "benefitted far more from open markets for goods and services and advantageous terms of trade than from free capital flows... gains from free trade come mainly from the diffusion of knowledge and from the productivity gains made necessary by open borders."

Unless African nations can transition to something approaching self-sufficiency in savings, a significant share of the continent’s assets will continue to remain foreign-owned. Piketty sees dangers in this:
When a country is largely owned by foreigners, there is a recurrent and almost irrepressible demand for expropriation... The country is thus caught in an endless alternation between revolutionary governments (whose success in improving actual living conditions for their citizens is often limited) and governments dedicated to the protection of existing property owners, thereby laying the groundwork for the next revolution or coup. Inequality of capital ownership is already difficult to accept and peacefully maintain within a single national community. Internationally it is almost impossible to sustain without a colonial type of political domination.
Indeed, the colonial period was characterized by very large and positive net asset positions in Europe. On the eve of the first World War, the European powers "owned an estimated one-third to one-half of the domestic capital of Asia and Africa and more than three-quarters of their industrial capital." But these massive positions vanished in the wake of two World Wars and the Great Depression. These calamities, according to Piketty, resulted in a significant loss of asset values, dramatic shifts in attitudes towards taxation, and a reversal of trends in the evolution of global wealth inequality, trends that have now begun to reassert themselves.

There are many more interesting tangents and detours in the book, including discussions of the circumstances under with David Ricardo first developed the hypothesis that has come to be called Ricardian Equivalence, and the manner in which the "long and tumultuous history of the public debt... has indelibly marked collective memories and representations." But this post is too long already and I need to wrap it up.

For a lengthy book so filled with charts and tables, Capital in the Twenty-First Century is surprisingly readable. This is in no small part because the author cites philosophers and novelists freely and at length. This lightens the prose, and is also a very effective rhetorical device. As Piketty notes, authors such as Jane Austen and HonorĂ© de Balzac "depicted the effects of inequality with a verisimilitude and evocative power that no statistical analysis can match."

This is an important point. Numerical tables simply cannot capture the deep-seated sense of social standing and expectations of deference that permeate a hierarchical society. Those familiar with the culture of the Indian subcontinent will understand this well. There are many oppressive distinctions that remain salient in modern society but we at least pay lip service to the creed that we are all created equal and endowed with certain inalienable rights. The sustainability of significant wealth inequality in the face of this creed depends on the effectiveness of what Piketty calls "the apparatus of justification." But no matter how effective this apparatus, there is a limit to the extent of wealth inequality that is consistent with the survival of this creed.

This is how I interpret Piketty's main message: if the historically significant emergence of a propertied middle class were to be reversed, social and political tremors would follow. But how are we to evaluate his claim that such a reversal is inevitable in the absence of a global tax on capital? His argument depends on interactions between demographic change, productivity growth, and the distribution of income, and without a well-articulated theory that features all these components in a unified manner, I have no way of evaluating it with much confidence.

Piketty's attitude towards theory in economics is dismissive; he claims that it involves “immoderate use of mathematical models, which are frequently no more than an excuse for occupying the terrain and masking the vacuity of the content.” This criticism is not entirely undeserved. It is nevertheless my hope that the book will stimulate theorists to think through the interactions between fertility, technology, and distribution in a serious way. Without this, I don't see how Piketty's predictions can be properly evaluated, or even fully understood.