Monday, October 27, 2014

The History and Lessons of Economic Growth

There is much to learn from Thomas Piketty’s book Capital in the Twenty-First Century.  Perhaps the most fundamental lesson is that much of the last century was a unique period in social and economic history.  The experiences and conclusions garnered from living in and studying this recent era may not be appropriate for a future in which the world returns to more normal circumstances.

Two world wars and the intervening Great Depression created enormous social and economic damage.  The period of rebuilding after World War II generated a large amount of economic activity.  This was also the period in which a number of underdeveloped countries, particularly in Asia began to acquire modern economies.  For them, this was a period of rapid economic growth as well.  It is easy to conclude, after living through this period, that rapid growth is the norm for a healthy economy.  Piketty warns us that that may be a dangerous assumption.

The table below is from his book and is made available by Piketty here

Roughly half of growth in world GDP can be attributed to population growth.  What is desired is GDP growth as an indicator of whether or not the income of the average citizen is growing or not.  To acquire that knowledge the population growth must be factored out.  Piketty nearly always uses per capita GDP to capture that effect.  Below is a more detailed historical tally of per capita growth by continent.

Note that the only periods of sustained high per capita growth (3% or more) are found in Europe and Asia in the immediate postwar years, and in Asia with the emergence of China and India as rapidly growing economies.  Note also that the average rate of economic growth in the developed countries of Europe and America since the beginning of the industrial revolution has been a modest 1%. 

Piketty breaks out the growth rate history of Western Europe and North America in the figure below.

Note that Western Europe with its supposed burden of inefficient “welfare state” policies actually performs a bit better in recent years than the more economically unrestrained states of North America.

Piketty believes the developed world is returning to a long-term condition of low growth—on the order of 1.0-1.5%.  The data in the above figure supports that claim.  This is equivalent to the growth rate that persisted in the century before World War I, a period of great concentration of wealth and extreme inequality.  Piketty warns us that we may be reverting to similar conditions as we look to the future.

One of Piketty’s principle observations is the relationship between economic growth (g) and return on investment of capital (r).  He treats wealth and capital as interchangeable quantities, defining wealth as anything that possesses a market value.  If r is much greater than g then the possessors of wealth will continue to reap returns much greater than those who only possess their wages and wealth will grow inexorably.  Consider the following figure.

Throughout history the annual return on capital has been in the range of 4-5.5%.  Note that this figure does not include any deduction for taxes on wealth or on income from wealth.  For most of history such taxes were essentially nonexistent.  It wasn’t until the shocks of war and depression began early in the twentieth century that the extreme need for state income initiated income and estate taxes broadly across the developed world.  The results of that development are obvious in the chart below.

After taxes and capital losses are included in the return on capital, the rate of return actually falls below the rate of growth g for a time.  This means that during the postwar period the importance of labor-derived income became much greater and in the developed countries led to a broader distribution of wealth.  More people earned enough to purchase homes for example.  Home ownership in the United States is the hallmark of the middle class and represents much of its wealth.

Note, however, that the plutocrats fought back and have been gradually disassembling the tax structure and policies that allowed the middle class to grow.  Return on capital is returning to previous levels and the rate of growth is falling.  Piketty provides this explanation for the dynamic involved:

“….it is important to note that the effect of the tax on capital income is not to reduce the total accumulation of wealth but to modify the structure of the wealth distribution over the long run.  In terms of the theoretical model, as well as in the historical data, an increase in the tax on capital income from 0 to 30 percent (reducing the net return on capital from 5 to 3.5 percent) may well leave the total stock of capital unchanged over the long run for the simple reason that the decrease in the upper centile’s share of wealth is compensated by the rise of the middle class.  This is precisely what happened in the twentieth century—although the lesson is sometimes forgotten today.”

If the increase in taxation of capital income helped create the middle class, the decrease in such taxation could lead to the diminishment of the middle class—an effect that seems obvious today.

Piketty looked closely at data on inheritance flows of wealth in France to see if there was evidence that the extreme concentration of wealth that existed in Europe prior to World War I might be returning.  France is the country with the best recordkeeping of wealth transfers.  The results are discussed in Inheritance, thePropagation of Wealth, and Inequality.  In summary, Piketty found that that inheritance flows fell to a minimum and bottomed out around 1970.  Since that point they have been steadily climbing.  Extrapolations based on reasonable growth and return on investment scenarios indicate that inherited wealth will grow to near the levels of the prewar years in France. 

There is an importance difference between that earlier era and the current one.  The creation of a significant middle class has led to a de-concentration of wealth in the sense that instead of a few extremely wealthy families, there is a broader base of merely wealthy families.  However, this wealth is distributed in such a way that a significant fraction of the population is capable of propagating to their children assets that will allow them to continue to reside in this wealthy class.  Piketty suggests that of the people born in France in the 1970-1980 timeframe about 12% will receive an inheritance in the form of gifts and bequests equivalent to $1 million or more.  He expects that number to increase to 15% for those born in the 2010-2020 period.

The fear is that as the importance of inherited wealth grows it will produce a bifurcated society in which the majority gains little or nothing by inheritance, and 10-15% gains a sufficient amount to guarantee that they remain in the class of the wealthy.  This is a situation more reminiscent of an aristocracy than a meritocracy.  Piketty provides us this warning:

“This is….a fairly disturbing form of inequality, which is in the process of attaining historically unprecedented heights.  It is also more difficult to represent artistically or to correct politically, because it is a commonplace inequality opposing broad segments of the population rather than pitting a small elite against the rest of society.”

Piketty has provided us with a clear message: taxing wealth and wealth’s income can lead to a more fair distribution of wealth as well as healthy economic growth.  If you do not like the direction in which society is moving, you will have to intervene and change things—as you once did in the past.

Capitalism is the offspring of society; society is not the offspring of capitalism.
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