An Indictment of the Invisible Hand

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Thomas Piketty’s 700-page book, Capital in the Twenty-First Century, has stunned both the economic profession and most political observers. But the economic mainstream is not truly dealing with its most serious implications even as they widely praise his work.

Mainstream economics generally concedes the levels of inequality but for a very long time has said much the opposite of what Piketty has found.
Here in a nutshell is what he argues: Current rates of inequality are closer to historical norms than aberrations. Inequality is likely to stay high and perhaps increase. The normal workings of the free market won’t change this. The only way to rectify the imbalance is more aggressive taxes on property and high incomes to reduce inequality.

All this from an economist with strong mainstream credentials, and whose work in tandem with Emanuel Saez, Tony Atkinson and a few others has profoundly changed how we think about inequality. It was Piketty et al. who showed that a huge amount of income goes to the top 1 percent, and most of that to the top 0.1 percent. We don’t really have an inequality problem. We have stagnating incomes for the bottom 90 percent and a runaway of incomes at the very top.

Mainstream economics generally concedes the levels of inequality but for a very long time has said much the opposite of what Piketty has found. Current inequality is an aberration in the long march of capitalism, according to mainstreamers, due to educational inadequacies or globalization. Free-market competition should reduce excesses of capital accumulation and a balance will be struck with wages as productive investment creates more companies and more demands. Some higher taxes may be necessary, argues some mainstreamers, but excessive capital accumulation eventually has to fall as competition drives down the return.

Piketty’s book is an empirical tour de force. Close analysis of data in rich nations of several hundreds of years shows that the amount of capital compared to income in economies has always been high, even pretty constant. Capital includes stocks bonds, land, housing, business and on. It just keeps growing because it has generated persistently big returns, returns that make it grow faster than GDP or national income.

The only time capital as a percent of GDP came down was with the two World Wars of the twentieth century and some thirty “glorious” years of the Second World War’s aftermath. Capital stock itself was devastated by war, but GDP also grew rapidly in this period. The ratio of capital to GDP fell, and rich nations became more equal.

Piketty writes outright that the accumulation of capital is not the result of “economic mechanisms,” but of political ones. But he does not pursue this adequately and the mainstream can thus ignore the implications, which are that markets are not working well enough.
Now, that’s changed again. Capital is rising to its old levels, what Piketty calls the patrimonial state, epitomized by Britain in the first two thirds of the 19th century. As capital rises, the rich simply get richer, and inequality soars. They own the capital, after all, and reap its rewards. And in America, this has mostly been a function, Piketty calculates, of outsize remuneration for CEOs and other managers, who get huge stock options. Their compensation has risen with the stock market.

But the main flaw in the book is that it is not a tour de force of theory. (There are some more minor flaws, such as measuring labor income as if it is independent of capital accumulation, when US statistics include stock options as part of labor compensation.) Piketty writes outright that the accumulation of capital is not the result of “economic mechanisms,” but of political ones. But he does not pursue this adequately and the mainstream can thus ignore the implications, which are that markets are not working well enough.

Indeed, economist Robert Solow argued in one presentation that the persistence of high capital levels was not a “market failure” but the natural result of technological advance that continued to generate new opportunities set against diminishing returns to capital from older investments.

Had this been the case, however, the rate of growth of the economy due to technological advance would have improved, and the proportion of capital in GDP would have fallen.

[Piketty] believes higher taxes are the only solution. But regulation of monopolists and Wall Street manipulators would be part of such a solution. More vigorous anti-trust prosecution would be another.
What’s by and large been lost in the discussion as America’s most prominent economists try to contend with Piketty’s empirical findings is that they don’t seem constitutionally able to do so. In fact, the financial markets have failed to fully utilize capital, or worse, used it in perverse ways to make bankers rich while not dispersing capital effectively. Capital basically just sits there, enabling fat cats to get fatter. Not entirely, of course. Some of this capital has been put to good use, but as it grows so much faster than the economy, it seems more than obvious that it is the result of monopoly, rents that are not related to real returns of investment, manipulation of markets and regulations, political influence, and so on. Free market competition has not worked.

If Piketty had paid more attention to such market failures rather than gloss over them, he would have uncovered a treasure trove of policies that could reduce the hold on capital and distribute the benefits of the economy more widely.

Instead, he believes higher taxes are the only solution. But regulation of monopolists and Wall Street manipulators would be part of such a solution. More vigorous anti-trust prosecution would be another. Fairer and more strongly implemented labor laws would have given workers a fairer shake, as would more union-friendly regulations and a higher minimum wage. Keynesian stimulus policies have been stymied by the deficit hysteria of Republicans and not a few Democrats.

Piketty’s book is an indictment of laissez-faire market theory. One sign of how ineffectual the economics community has become is that it is unable to see the true fruits of the work, even as it praises Piketty’s extraordinary empirical contributions.

Jeff Madrick
Jeffrey Madrick is director of the Bernard L. Schwartz Rediscovering Government Initiative at The Century Foundation. His latest book, Seven Bad ideas: How Mainstream Economists Damaged America and the World, will be published by Knopf in September.
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  • Anonymous

    If only the situation and solution were not related to global geopolitics, perhaps some common sense could apply. But unless we can find a way to relieve governments of the need to wage blood and economic warfare against one-another in the battle over the last of the worlds dwindling economically recoverable energy resources, then perhaps the acorns of the banks could be judged by their performance at the Nation State level, but the banks are manipulated for competing globally, as instruments of political power and establishment of a social order based not he debt-money paradigm which confers ultimate control over governments and nation states to the bankers instead of their citizens. THAT is why the view of their acts and deeds in the context of it’s relationship to the US economy and politics will miss the point entirely. Anyone who pays attention knows that the FIRST order of business of State’s/Hillary’s/CIA’s rebels in Libya was to draw up papers regulating their banking and currency laws and joining the IMF and BIS. So even more important than the commodity that backs the petrodollar was the fact that their currency had to be backed by borrowing. Creating ones own currency is the very definition of a “sovereign”, but the BIS and IMF want it outlawed and only their system of debt based money to prevail. This beast, imagined on Jekyll Island in 1910 & unleashed by Wilson in 1913 to fund the USA’s entry into the First World War, it has now swallowed most of the sovereign nations on earth. This is a global conquest by bankers, any context short of recognizing that misses the point.

  • msbhavn

    Apparently whoever wrote the headline never read Adam Smith. Adam Smith was not talking about corporations, which are the main players in today’s markets, when he was talking about the “invisible hand.” He was talking about Individuals– people like sole proprietors. See Wealth of Nations, Book III, Chapter II.

    In fact, Smith was against the whole concept of corporations, then called “joint stock companies,” and said they were as dangerous to the public as “unaccountable sovereigns.” He believed that businesses should be regulated by governments to keep them from harming the public.

    Smith strongly warned against what he called the 3rd order of men– businessmen and bankers– those who live by profit. He said these people “have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.” And he also said, “The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state… It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.”

  • Denis

    You are right. Adam Smith’s “Invisible Hand” idea has been blown out of proportion by right-wing politicians since the 1980s. Smith uses the term only once in the Wealth of Nations, and it is not even a major idea in his work. Nowhere does it say that government should be done away with, or that corporate enterprises know what they are doing.

  • leah #lovemyplanet

    This kind of economic system does not work without adjusting for various factors. One is men greed and manipulation, use of favoritism, nepotism,secret info. cartel banks and high percentage of loaning on deposit. The banks use leverage not money to make money…and nothing to protect the people. Keep the cash and use it for its own investments and get bigger…greed will destroy this country.
    Free market is impossible in this environment…soon everyone does what is best for business not for economy in general. Unethical behavior, stealing and unfair businesses deals are consumed without protection for the vulnerable..Maddoff prime example of how easy it is to steal legally….for while. the larger the corp the more complex for small business to make it. Other political decision to allow companies to manufacture overseas and sell here has ruined the economy. Let them pay higher taxes then.
    We do not need terrorist to destroy America we have the banks.

  • Anonymous

    This is totally flawed analysis. If you look on a global level, inequality is being reduced at a very fast pace. 20 years ago the top 10% of Americans (25M people) had more wealth and income than 1,000,000,000 Chinese. In 20 years alone 300,000,000 Chinese escaped poverty and joined the middle class.

    Incomes for the 90% of the planet is, in fact, going up quite rapidly. This whole 10% vs 90% inequality discussion only holds water if you look at the US as a closed system.

    The only thing that has happened is that the bubble of union extorted high pay for unskilled workers in the US (and to some extent the EU) hard burst. So unskilled wages in the US are going back to the historic norms.

    That is the whole story.

  • Anonymous

    It seems to me that Piketty has blown away the myth believed by both the fresh and salt water schools of economics that the economy is inherently stable and will always return after a perturbation to “normal”. One exponential force swamping out another exponential force is not a recipe for stability.

    If we step back and ask what a robust, sustainable system would look like, we would want one where the worker’s share of GDP is constitutionally guaranteed and where the influence of capital on elections, elected officials and appointed officials is nil. These are the areas that will need to be addressed if our political/economic system is to survive.

  • Anonymous

    Median global income remains around $1000/yr. Care to try living on that?

  • Anonymous

    It’s easy to live on $1,000/year in Fantasy Land!

  • Anonymous

    My Uncle Zachary
    recently got a 9 month old Mercedes-Benz CL-Class CL63 AMG only from working
    off a home pc… go now F­i­s­c­a­l­P­o­s­t­.­ℂ­o­m

  • Anonymous

    That’s not true, median household income is something over USD10,000, isn’t it? I don’t have sources but it’s a very large, slow-moving thing that we should be able to see quite clearly. Perhaps they are trying to measure the FMV of food, shelter and whatever else people actually consume in rural areas and the global south.

  • JC

    Right you are sir. I would go a few steps further in that economic benchmarks in a company should be earmarked to the