The best explanation for our growing economic inequality

On April 11, 2014, in Latest News, by The Somerville Times

shelton_webBy William C. Shelton

(The opinions and views expressed in the commentaries of The Somerville Times belong solely to the authors of those commentaries and do not reflect the views or opinions of The Somerville Times, its staff or publishers)

Economics has been called the “dismal science” ever since Thomas Carlyle turned that phrase in 1849. But a blazing discussion is illuminating the gloom. Its light source is the English publication of Capital in the Twenty-First Century by French economist Thomas Piketty.

His timely subject is economic inequality.  His exhaustive research and elegant analysis challenge economists, left, right, and center, obligating them to respond. Usually conservative in its views, The Economist writes that his work can change how we think about two centuries of economic history.

In 1993, at age 22 Piketty began teaching here at MIT, having already earned a PhD. But after three years he returned to France, bored with mainstream economics and with economists who were “too often preoccupied with petty mathematical problems of interest only to themselves.” He writes, “I was only too aware of the fact that I knew nothing at all about the world’s economic problems.”

He chose to focus on capital accumulation. By “capital” he means assets that generate income, such as factories, intellectual property, real estate, stocks, and bonds.

Dissatisfied with explanations offered by classical economists like Adam Smith, David Ricardo, John Stewart Mill, and Karl Marx, Piketty set aside theoretical assumptions and undertook comprehensive research. Of course he had access to data sources that they could never imagine.

With his colleagues, he spent ten years compiling historical data on wealth, income, and inequality in France, the U.S., Britain, China, India, Japan, and twenty other countries. His findings contradict conventional wisdom.

I was taught in college that inequality increases during the early stages of industrialization, but as an economy continues to develop, incomes converge. This assumption permeates much of academia, journalism, and popular culture. But taking the long view, Piketty found the opposite to be true.

The reason for this is elegant in its simplicity. Whenever the after-tax return on capital exceeds the growth of the economy, income produced by capital rises faster than wages and salaries. And as capital accumulates, it generates ever more capital for those who own it.

 

It makes intuitive sense that if those with a lot of capital are absorbing wealth at a greater rate than the economy is producing it, they will become ever more wealthy, while those with little or no capital will become less so. And this has been the case for most of capitalism’s history.

The six decades between 1914 and 1975 were an exception. For a variety of reasons, economic growth exceeded returns on capital:

 

  • Two world wars destroyed vast amounts of physical capital.
  • Stock market crashes, debt crises, and high inflation destroyed vast amounts of financial capital.
  • Nations imposed progressive taxes on wealth and income to finance their wars.
  • A global depression empowered labor movements, increasing wages and producing entitlement programs and other social benefits.
  • England, France and post-colonial countries nationalized industries and expropriated land.
  • Steep marginal taxes applied to vigorous postwar income growth financed infrastructure investment, further stimulating economies.

 

Maverick Republican Theodore Roosevelt had advocated steeply progressive income taxes, and under his cousin Franklin, the top marginal rate was over 90%, while large estates were taxed at 70%.

The Thatcher/Reagan “revolutions” changed all that by slashing taxes on the wealthiest, imposing anti-union regulations, deregulating the financial services industry, privatizing publically owned industries, abolishing or shrinking many social programs, and disinvesting from infrastructure and research. Today, average returns on capital are about 5-6%, while economic growth in the developed world is half that.

From 1976 to the financial meltdown of 2007, America’s wealthiest 1% absorbed 60% of its economic growth. Since the end of the Great Recession, they have absorbed 95% of income growth.

Today, the richest 10% of households owns 70% of the nation’s wealth. The richest 1% owns 35% of our wealth, while the poorer half owns just 5%.

Oxfam reports that the richest 85 people on the planet own as much as the 3.5 billion who comprise humanity’s poorer half.

Piketty has annoyed both conservatives and liberals. But his research is so rigorous and his analysis so tight that few quarrel with his central thesis, and fewer with his historical analysis. Instead, they contest his predictions, which are bleak, and his prescriptions, which are not practicable.

He forecasts “levels of inequality never before seen.” During the reviled Gilded Age, corporate chief executives were paid about 20 times what their average employee earned. Today, already that figure is 200 to 1.

Piketty, who like his countryman Alexis de Tocqueville admired America’s egalitarian values, writes, “The egalitarian pioneer ideal has faded into oblivion, and the New World may be on the verge of becoming the Old Europe of the twenty-first century’s globalized economy.”

Some of Piketty’s critics suggest a different future wherein accelerating economic growth exceeds returns on capital, perhaps driven by technological innovation. But in recent decades, those who derive their income from capital have appropriated productivity gains for themselves.

Others suggest a future wherein capital accumulation becomes so great relative to the entire economy that returns on capital decline. This would decelerate the pace at which the rich get richer, but I don’t see how it would make the poor less poor.

Meanwhile, the wealthiest buy the government they want, making policies that might reduce inequality increasingly unobtainable.

Piketty does not advocate abolishing capitalism. His solution is an annual wealth tax of 1% on those households with a net worth between $1 million and $5 million, and of 2% for those with a net worth more than $5 million. He proposes a graduated income tax with an 80% top bracket on incomes above $1 million. The tax regime would be global, to eliminate the possibility of tax havens.

These rates are lower than those imposed by the U.S. during its economic “golden age.” And reinvesting tax proceeds would boost world economic growth. But his proposal is as politically feasible as mandating the Easter Bunny to create a trust fund for unicorns.

Piketty acknowledges the improbability of implementing such a policy. But he offers it as an ideal or standard against which to evaluate policy alternatives.

What demonstrably has not worked is the Republican fantasy that shrinking government and further reducing taxes on the rich will stimulate economic growth, providing trickle-down benefits to all. Austerity policies have put European economies into a tailspin and produced a double-dip British recession.

I made a series of policy suggestions in the series that I wrote about inequality. But I don’t imagine that any of them will resolve what Piketty calls capitalism’s “central contradiction.”

You may ask, dear reader, why I choose to discuss this defining book about global economics in a publication focused on Somerville. The economic problems that confront our city—fiscal constraints, the worst jobs-to-workers ratio in the Commonwealth, inadequate commercial tax revenue, gentrification, and affordable housing—are all shaped, and their solutions constrained, by the dynamic that Piketty describes.

The old injunction remains:  Think globally. Act locally.

 

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