An Indictment of the Invisible Hand

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.

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.

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 19^th 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.

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.