why Thomas Piketty is wrong and what conservatives can do about it

In his seminal work, Meditations on First Philosophy, the French philosopher René Descartes tore down the philosophical foundation of human knowledge with a few simple arguments on the nature of sensation. He thus demolished centuries of thought on what is ultimately knowable. The rest of his book is dedicated to reestablishing a philosophical foundation for knowledge, with certainty as to the existence of God serving as the basic foundation. Needless to say, the questions he raised ultimately became much more important than the solutions he offered. Philosophers have been debating his principles ever since, culminating with modern philosophers such as Barry Stroud arguing that no knowledge can be truly beyond doubt.

Another French academic (in this case an economist) has come our way and raised a new question for our age: Dr. Thomas Piketty, author of Capital in the 21st Century. I’m sure that Piketty himself, self-deprecating man that he is, would be the first to admit that his intellectual achievements are dwarfed by those of Descartes. However, his new book is similar to Descartes’s in that it has started up an entirely new debate. In the centuries since Descartes wrote, his ideas have been studied, refuted, and rehashed by every philosopher with even a cursory interest in metaphysics. It will be so with Piketty, though on a smaller scale. He has asked the question; it will be the task of this generation of economists and lawmakers to attempt an answer.

Indeed, the task has already begun in earnest: luminaries such as Larry Summers, Paul Krugman, Kevin Hassett, and Deirdre Nansen McCloskey have already provided their critiques. While Piketty’s book has certainly garnered the most attention thus far, it is not the first book on the subject.

The book, nearly 600 pages in length, may suffer from an extremely low read-to-buy ratio. But this is more a statement about the general public’s ever shorter attention span than on the quality of the book itself. It was written with erudition and a brilliant ability to connect abstract economic theories with the general reader (though the author’s tone sometimes drips with leftist certitude, casting doubt on his claims of impartiality). Literary references scattered throughout the text humanize his argument and increase readability.

But the centerpiece of the book is Piketty’s use of his data. His monumental aggregation of previously unused data sets allow him to bring into the light of statistical scrutiny what had previously been a priori arguments based largely on intuition and insight. Although the way he uses his data has raised some serious concerns, there is little doubt that his voluminous work in this area is remarkable and worthy of the acclaim it has received.

Although it is impossible to compress his arguments into a few paragraphs (attempts to do so being the source of much misunderstanding), I will here attempt to recount his arguments, then point out some concerns that have arisen for me as I read the book. I will finish by providing some more liberty-centric alternatives to his policy prescriptions

Piketty’s essential point rests on his argument that as long as the rate of return on capital holdings grows faster than the growth rate of the income of the economy as a whole, wealth will accumulate in ever-growing proportions in the hands of an ever-shrinking share of the population. This is expressed in the equation r > g, where r = rate of return on capital and g = growth of national income.

He attempts to explain this using his data on the long-term evolution of capital vs. labor’s share in national income. He looks at data on a global scale and a national scale, focusing on France, Britain, Germany and the United States. The author addresses where he thinks growth is going in the medium- and long-term (next 100 years or so). He shows that r is probably going to remain the same (4–5%) and g (in terms of global growth) is probably going to decline to between 1 and 1.5% (from 3–4%). Thus, r > g is here to stay for the foreseeable future.

The result is that the amount of capital expressed as a percentage of national income will grow to ever higher numbers, possibly even surpassing its peak reached just prior to the outbreak of World War I. Today, it is around 5–600% of national income in most countries. The income from this capital as a share of national income can be expressed using Piketty’s “First Fundamental Law of Capitalism,” α = r x β, where α is the share of profit in income, β is the capital/output ratio, and r is the rate of return on capital. This share of capital in national income is discussed ad nauseam, but the point is that the “shocks of 1914–1945″ led to the rise of a “patrimonial middle class” which in turn led to a large decrease in the top 1%’s share in wealth. As a result, the rich countries saw unprecedented decreases in wage inequality in the 20th century.

How did this happen? One might be tempted to attribute it solely to the destruction of property the wars wrought. The answer is a bit more complex. While the destruction of property in Europe due to the war was a factor, it was primarily the result of a decrease in asset prices, low savings rates of the time, and the collapse of foreign portfolios held by the upper classes of the colonial powers. This is important: the author explains the drop in wealth inequality and wage inequalities as a direct result of the decline in the capital/income ratio. Thus the inequality problem is defined as a zero-sum game; a rising tide does not lift all boats in Dr. Piketty’s world.

A rising tide does not lift all boats?

Dr. Piketty next attempts to point out the role that inheritance plays, viz., that “inheritance predominates over saving” in wealth accumulation. Today’s entrepreneurs are tomorrow’s rentiers who will accumulate wealth and pass it on to their offspring. Declines in demographic growth compound the problem (the difference between passing on an estate to 1 or 2 children in the future, as opposed to 3 or 4 today).

Part IV focuses on how capital should be regulated by the state. While the government doesn’t necessarily engage in direct redistribution, the provision of certain services (e.g., health services and education), reduces inequality indirectly. The “social state” (made more efficient with a few updates) is Dr. Piketty’s engine for decreasing inequality.

But what fuel should the engine run on? Who is to pay for this “social state?” Piketty himself admits that:

“To be sure, good economic and social policy requires more than just a high marginal tax rate on extremely high incomes. By its very nature, such a tax brings almost nothing. A progressive tax on capital is a more suitable instrument for responding to the challenges of the 21st century…”

But, a few pages later, Piketty states:

“The evidence suggests that a rate on the order of 80 percent on incomes over $500,000 or $1 million a year not only would not reduce the growth of the U.S. economy but would in fact distribute the fruits of growth more widely while imposing reasonable limits on economically useless (or even harmful) behavior.”

Here Piketty argues that confiscatory marginal tax rates on high incomes will only solve the problem of “hypermeritocracy” and the rise of “very high salaries.” It will rid us of those pesky plutocrats that rake in multi-million dollar salaries with the help of their cronies on Washington, D.C. But if it won’t entirely fund the social state, how will it help in reducing inequality? Will corporations automatically decide that since they can’t pay the CEO nearly as much, they should give their other employees a raise? Would the raise be large enough to make a difference? A footnote would have been helpful here.

The other half of the equation is a global tax on capital. A tax of 1% on fortunes from 1 to 5 million euros and a 2% tax on fortunes above 5 million euros would lead to an income of about 2% of Europe’s GDP. Again, this is not nearly enough income from taxation to think about balancing budgets or paying down national debts in Europe or the U.S. The other side of this global tax is that taxing capital in this way will provide the data on wealth that economists and lawmakers need to make wise policy decisions. This would result in the end of tax havens as we know them, and usher in a new era of economic transparency, a welcome change.

The global element is important here, as international tax competition is a huge obstacle to more equitable distribution of wealth for Dr. Piketty. For example, if Europe implements this tax on capital, what is to keep the wealthy from simply moving all their accounts to another country that has lower tax rates?

Conservatives generally don’t enjoy reading Capital in the 21st Century

With the amount of attention Capital has garnered, it comes as no surprise that there has been a multitude of different reactions, particularly with respect to Dr. Piketty’s policy prescriptions. Some are chomping at the bit to get his ideas on the Democratic Party platform (think Paul Krugman). Others, though receptive of the message, are a little more sober in their reactions (think Larry Summers). Still others have grumpily tossed his book aside while shouting “socialism!” after reading the introduction.

While he describes himself as no communist revolutionary, his policy prescriptions would certainly mean a fundamental reordering of the way things are done in the United States. Politcally, it is highly unlikely that any of them will be adopted anytime soon, on the national or the global level. But the problems with the book are not just political. There are also many problems with his data and the way it is presented.

The first and most glaring error is his failure to include transfer income in his estimates of national income. It is a well-known fact that government assistance makes up a large part of the income of many Americans through the services provided by the “social state.” Add in employer-sponsored health care plans and as Scott Winship argues in his column over at Forbes online:

“When I incorporate these improvements using the Census Bureau data, I find that median post-tax and -transfer income rose by nearly $26,000 for a household of four ($13,000 for a household of one) between 1979 and 2012″

The numbers are clear: the definition of “income” is extremely important in how one defines inequality.

There are also some worries about Piketty’s assertions on the elasticity of substitution. Without getting too far into the weeds, elasticity of substitution begs the following question: all other things being equal, will introducing an additional 1% of capital into the economy result in more or less than a 1% decrease in labor production? If it declines by less than 1%, income from capital increases. If it declines by more than 1%, income from capital decreases. Piketty asserts that the decrease is less than 1%, and so capital’s income share will therefore increase with any increase in capital.

According to Harvard economist Larry Summers:

“I know of no study suggesting that measuring output in net terms, [decrease in labor is less than 1%, thus increasing capital’s share], and I know of quite a few suggesting the contrary.”

In other ways, too, Piketty contends that capital will continue to grow unabated, compounding year after year without regard to risk, economic conditions, or the fact that many investors do not simply reinvest all of their dividends back into their portfolio. There has been a substantial amount of research on the determinants of consumer spending. This research indicates that an extra dollar in income results in an extra $0.05 in spending, essentially eradicating the 4–5% returns on capital proclaimed by Piketty. Although this model has problems of its own, it is no secret that income certainly plays a role in determining how much an individual spends. Other critics have also raised questions about whether dimishing returns to capital will be an issue over the long run. At any rate, Piketty’s views on the growth rate of capital are not exactly in touch with reality.

There are also problems with Piketty’s theory of inheritance. Again, in the words of Mr. Summers:

“When Forbes compared its list of the wealthiest Americans in 1982 and 2012, it found that less than one tenth of the 1982 list was still on the list in 2012, despite the fact that a significant majority of members of the 1982 list would have qualified for the 2012 list if they had accumulated wealth at a real rate of even 4 percent a year. They did not, given pressures to spend, donate, or misinvest their wealth. In a similar vein, the data also indicate, contra Piketty, that the share of the Forbes 400 who inherited their wealth is in sharp decline.”

Thus, it may be doubtful whether today’s entrepreneur is tomorrow’s rentier after all.

Obviously these are only a few of the problems that one can discern from research. The debate will continue and more problems will certainly be noted. But his ideas about income inequality are worthy of some weighty consideration. It is his determination that capitalism by nature results in ever-increasing wealth in the hands of the few that I have here attempted to correct.

In the end, do the flaws in Capital’s overarching philosophy or the fantastic nature of his policy recommendations mean that the entire book should be tossed aside in toto? Certainly not.

Obviously his policy ideas are not the most efficacious way to help the poor and the middle class thrive. The solutions to the problems Piketty brings to our attention must place government in the position of maximizing incentives to get an education, start a businesses, start a family, save more for retirement, or just be more self-sufficient in general, rather than simply providing for all needs. It is government’s role to create the environment for Americans to thrive by the fruits of their own labor. What form could some of these incentives take?

Let’s start with education — improving education and making it more accessible for all would create value in the economy by producing more qualified workers. If we include the fact that many workers now own not only their labor, but also the knowledge it takes to do their job (the literacy of the average shop worker, the dental hygienist’s experience cleaning teeth, the IT technician’s understanding of computer systems), human capital becomes a very large share in a nation’s aggregate capital. Education can only increase this share, putting more power in the hands of those who are not fortunate enough to join the ranks of the 1%. Indeed, Piketty’s argument that advances in technology will not decrease inequality certainly has its critics. Some economists argue that working with new technologies has the capability to drastically reduce inequality by increasing human capital, as long as education is widely available.

Reducing the amount of big-government regulation will help in making it easier for entrepreneurs to start new businesses as well. Crony capitalist policies that enshrine “too-big-to-fail” banks and make it harder for smaller community banks to thrive are just one example. Job-killing EPA, labor, and healthcare regulations are deterring would-be entrepreneurs from starting new businesses. Although the frontier ideal of a self-sufficient middle class may be dead as Dr. Piketty proclaims, the new American dream must in some sense foster an entrepreneurial class to carry on the ideal. Small businesses are central to the American dream in the 21st century.

We have already discussed the (false) idea that capital accumulation will inexorably increase the top 1%’s share of national income. But it is hard to argue that responsible investments in stock, bonds and mutual funds is an essential part of any investment portfolio. What if we turned Piketty’s argument on its head by asking the following question: if investing in capital is such a great way grow your savings, why don’t we focus on getting a larger share of the general public invested in the capital markets?

The fact is that the social state that Mr. Piketty places at the center of his policy prescriptions disincentivizes the average American worker from saving on her own. More broadly speaking, the entire American economic system as it exists today provides disincentives to save. For example: easy credit allows Americans to purchase cars they can’t really afford; predatory lending practices allow people that probably should just rent to own homes; relentless social pressures drive people to “keep up with the Jones,” leaving them in a never ending cycle of working just so they can consume more. It’s no wonder that so many Americans are so far in debt that they have little left to save. In fact, as some personal finance gurus have written, the average American wastes a staggering amount of her income on things that she doesn’t really need. All of this comes at the expense of long-term financial security. The Federal Reserve is doing everything they can to keep savings rates low. And when they do talk about savings, it’s almost always to argue that home equity is the best way to build equity for middle- and low- income Americans. This also is highly debateable. Yale economist Bob Shiller has a few words to say on the subject. It comes as no surprise that the share of capital held by the rich is so high, and it has always been that way (also one of Piketty’s contentions).

The truth is, the cards are stacked against the average American simply because there are no incentives to save in solid investments such as index mutual funds. If capital income is going to inexorably rise over the next century, why can’t government help the average Joe get a slice of the pie? Just because it hasn’t happened in the past doesn’t mean it can’t happen. Let’s change that fact.

A good start could be partially privatizing Social Security in a phased and responsible way and allowing the public more control over their retirement finances. Broadening personal finance education (perhaps teaching the subject in elementary, middle and high school) would also help. Other ideas such as replacing the outdated Military retirement pension program with a more standard 401(k) plan could be another improvement. Alas, I cannot prescribe this without admitting, as Piketty does, that this may be politically impossible. Or maybe not. But anyone will admit that there is a lot more to be said on this subject.

There may be some problems with Dr. Piketty’s policy prescriptions.

As Americans we must always protect liberty first. The backbone of our nation must be a class of responsible adults who can make choices about what they can afford and how much they should save to ensure their future. We must embrace government policies that empower responsible adults, not policies that encourage irresponsibility for the masses at the expense of those who are successful.

But we must never confuse liberty with privilege. Labor income inequality is a real threat. It is on this point that I agree with Piketty. If a tax increase on the most wealthy members of our country is required to appease the left and allow other conservative goals like those discussed above (and elsewhere) to be placed on the bargaining table, so be it. Compromise leading to progress on other issues will pay innumerable dividends for the strength of our democracy, increase liberty for the vast majority of the people, and get our country on sounder fiscal footing.

So I propose, as do Auerbach and Hasset, that instead of a capital tax, a consumption tax will more accurately account for risk-taking in investment, while being more efficient in preventing wealth from reaching “economically useless” levels, as it were. Again, I only offer this principle as a bargaining chip which will allow conservative lawmakers to push for other changes that will put our country on more fiscally sound footing moving forward.

Apparently lengthy books make for lengthy book reviews, so I’ll end here. Capital in the 21st Century most certainly deserves a read. I learned a ton about economics, while being intellectually challenged in the process. There is much more here than just the ultimate conclusions. Every page is packed with interesting anecdotal information. Also, the multitudinous ways in which Dr. Piketty parses his data are like steroids for the intellect. Even if you don’t agree with most of his assumptions, in the end the book is still worth the trip. I suggest you don’t miss out on it.

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