Inheritance, the Propagation of Wealth, and Inequality

We in the United States like to think of ourselves as a meritocratic society—one in which wealth is accumulated by a combination of hard work, talent, and creativity.  However, wealth need not be earned; it can be inherited as well—a mechanism that is definitely not meritocratic.  Societies dominated by transmitted wealth are associated with now-defunct aristocracies of an earlier century.  One assumes—particularly in the United States—that we now we live in a much different society.  But is that true?

Thomas Piketty set out to assemble data so that a historical record of such fundamental quantities as wealth, its distribution, and its mode of transmission could be obtained in order to determine just exactly how our economies and societies have operated in the past, and how they might operate in the future.  His results are summarized in his best-selling book Capital in the Twenty-First Century.  One hopes that everyone who buys the book actually reads it.

In Piketty’s usage, wealth and capital are essentially interchangeable terms.  Capital is anything that has a marketable value.

Piketty includes this comment on the state of knowledge concerning inheritance as an economic issue.

“….the unreliability of the US sources makes it very difficult to study the historical evolution of inheritance flows in the United States with any precision.  This partly explains the intensity of the controversy that erupted in the 1980s over two diametrically opposed economic theories: Modigliani’s life-cycle theory, and with it the idea that inherited wealth accounts for only 20-30 percent of total US capital, and the Kotlikoff-Summers, according to which inherited wealth accounts for 70-80 percent of total capital.

“I was a young student when I discovered this work in the 1990s, and the controversy stunned me: how could such a dramatic disagreement exist among serious economists?”

Here were two economists proposing theories based as much on philosophy, or bias if you prefer, as on fact.  One assumed that wealthy people spent down their resources after they retired and quit earning income, while the other assumed that wealth persisted.  The data to decide between these contrasting viewpoints did not exist.  Piketty ultimately estimates that Kotlikoff and Summers were closer to reality at the time with a value of at least 50-60% for the private wealth accounted for by inheritance.

When Piketty became a practicing economist he spent some time in the United States and encountered a continuing tendency to propose and argue economic concepts that were little more than hypotheses with no data with which to evaluate them.  Piketty became disillusioned with this process. 

It is always a pleasure observe professional economists receive a well-deserved slap in the face.  Piketty obliges.

“To put it bluntly, the discipline of economics has yet to get over its childish passion for mathematics and for purely theoretical and often highly ideological speculation, at the expense of historical research and collaboration with the other social sciences.  Economists are all too often preoccupied with petty mathematical problems of interest only to themselves.  This obsession with mathematics is an easy way of acquiring the appearance of scientificity without having to answer the far more complex questions posed by the world we live in.”

Piketty returned to his home country of France, partly because France had accumulated the best set of historical economic date, and partly because there was a better climate there for doing productive research.

“There is one great advantage to being an academic economist in France: here, economists are not highly respected in the academic and institutional world or by political and financial elites.  Hence they must set aside their contempt for other disciplines and their absurd claim to scientific legitimacy, despite the fact that they know almost nothing about anything.  This, in any case, is the charm of the discipline and of the social sciences in general: one starts from square one, so that there is some hope of making major progress.”

France has been keeping detailed records of property and property transactions since the eighteenth century.  That is what allows Piketty to determine with some confidence the degree to which wealth and its distribution was determined by inheritance over much of modern history.

The importance of inherited wealth in French society is illustrated in the following chart (Picketty makes his charts and data available here).

This shows the cumulative value of inherited wealth as a percentage of the total wealth of the living over time.  The long period before 1910 was a stable period of low growth.  Piketty has shown that is a condition that favors growth of capital over growth in income from wages.  That period, known in France as the Belle Époque, was characterized by large fortunes possessed by a relatively few individuals.  Piketty has also shown that wealth tends to breed more wealth, and the greater the wealth the faster it breeds.  The amount of wealth that is inherited wealth continues to grow until it reaches about 90% just before World War I.  The period from 1910 to about 1970 indicates a large decrease in inherited wealth, followed by a significant recovery after 1970.

Almost every chart Piketty produces indicates the period that spans World War I, the Great Depression, World War II, and the period of reconstruction that followed, roughly 1910 to 1970, is an anomalous period in economic history.  It is interesting—or perhaps alarming—to consider that this is also the period in which most of our economists, social scientists, and politicians formed their world views.  Piketty constantly reminds the reader that no developed society can maintain the levels of economic growth we have come to expect based on the experience of the postwar years.  One of his messages to us is that the most likely outcome for us is that per capita growth will return to its pre-catastrophe levels of 1.0-1.5% per year.  This is an environment that favors the accumulation of wealth from capital ownership.  If we are not alert, we might find ourselves returning to the levels of inequality that existed in the Belle Époque.

Piketty extrapolates the growth in inherited wealth out to the end of the century using two views of the future.  Assuming a relatively high economic growth and a relatively low return on capital, he arrives at an estimate of about 80% of wealth derived from inheritance.  Under the assumption that the future will look more like the historical norm, the fraction reaches 90%, back to the level of the Belle Époque.

Wealth seems to have its own particular dynamic, but the nature of wealth and how it is treated has changed.  Consider the following chart tracking the average wealth of individuals at death relative to the average wealth of living individuals.  Note the significant change in the amount of wealth distributed in the form of gifts prior to death. At present, the wealthy in France are distributing about half their wealth as gifts before they die.  This is a large effect and it must be taken into consideration for the effect it has on the propagation of wealth and wealth inequality.

Piketty points out that in the earlier periods much of the gift giving was in the form of dowries.  One might expect that in an era of large fortunes, gift giving in order to fund an entrepreneurial adventure by a comfortably wealthy child might be a low frequency event. 

One of the consequences of the extreme events of 1910-1970 was that wealth was diluted as large fortunes were reconstituted into a greater number of smaller fortunes.  In the postwar years of great economic growth many more people had the opportunity to acquire capital, such as real estate, either by saving or by investment.  That created a society dominated by what Piketty refers to as petits rentiers.  Whereas the Belle Époque society of rentiers sat back and harvested the returns from their capital, Piketty observes that the top 1% in France today gains about half of their income from inherited wealth and half from earned income.

Piketty does not claim to understand exactly what the strategy might be behind the dramatic increase in gift giving over recent decades, but it clearly must be aimed at optimizing the wealth opportunities of children or other peers.  If most people considered wealthy today require a mixture of earnings from inheritance and earnings from labor, then a wealthy parent would wish to provide financial assistance to a child at the time it is most useful to the child.  That time would come relatively early in the child’s adult life, rather than at the time of the parent’s death.  Piketty indicates that the gift giving is often in the form of real estate transactions.  In the United States, home ownership has long been the entry point to wealth accumulation.

The existence of a cadre of people sufficiently wealthy that they can contribute a large fraction of their wealth to their children, and still be able to support themselves through retirement until deceased, must be evaluated in terms of the effect on inequality within society.

“….whatever the exact role of each of the possible explanations, the fact is that the upsurge in gift giving, which we also find in other European countries, including Germany, is an essential ingredient in the revived importance of inherited wealth in contemporary society.”

In order to illustrate the significant role that inheritance plays in society, Piketty has derived the following chart. 

Piketty provides this explanation:

“It is the percentage of individuals in each cohort who inherit (as bequest or gift) amounts larger than the least well paid 50 percent of the population earn in a lifetime.  This amount changes over time: at present, the average annual wage of the bottom half of the income distribution is around 15,000 euros, or a total of 750,000 euros [about $945,000 today] over the course of a fifty-year career….According to my estimates, the proportion has already risen to about 12 percent for cohorts born in 1970-1980 and may reach or exceed 15 percent for cohorts born in 2010-2020.  In other words, nearly one-sixth of each cohort will receive an inheritance larger than the amount the bottom half of the population earns through labor in a lifetime. (And this group largely coincides with the half of the population that inherits next to nothing.)”

He also provides 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.”

What does this imply for inheritance and wealth in the United States where data is scarce and much of it is based on surveys?  Piketty provides this warning:

“In France, for example, we find that gifts and bequests declared in the surveys represent barely half the flow observed in the fiscal data….”

Piketty’s best estimate is that the share of inherited wealth in the United States was “somewhat” smaller at the beginning of the current century.  Recall that he estimated the share in the 1970-1980 period to be in the range of 50-60%, a value not too different from that in France at that time.

“….this difference between Europe and the United States has little to do a priori with eternal cultural differences: it seems to be explained mainly by differences in demographic structure and population growth.  If population growth in the United States someday decreases, as long-term forecasts suggest it will, then inherited wealth will probably rebound as strongly there as in Europe.”

The economic history of the United States differs considerably from that of France due to quite different demographic and social evolutions.  However, because the pasts differed it is not appropriate to assume the futures will differ.  Piketty’s data indicate current trends that seem to be quite similar among the developed countries.  If our wealth distributions and inheritance flows are not exactly equal to those of France today, they seem to be headed in the same direction.

Let us return to the original question.  Given what we learned from Piketty’s data, should France be considered a meritocracy?  Should the United States be considered one?

What social science tells us is that in the United States if you are born wealthy, you will most likely die wealthy.  Conversely, if you are born poor, you will most likely die poor.  It is easy to understand why being born poor might make it unlikely that one could rise to a much higher economic status.  It is less obvious why it seems to be difficult for the wealthy to lose that status—no matter how hard they might try.

What Piketty’s data on inheritance tells us is that there is a significant population of the wealthy with sufficient resources to not only maintain their status, but to also convey it their children.  It is not a question of the 1% versus the 99%.  The self-sustaining wealthy class is broader than 1%.

There is a class consisting of perhaps 10% or more who have access to more money—via gift or bequest—than many people earn in a lifetime.  These people also have access to the best education and the best social capital.  These are the self-sustaining wealthy, a class which seems to have little flow across its boundary in either direction.

It is difficult to think of this situation as being representative of a meritocracy.  The more important consideration is whether or not this is a desirable—or even viable—societal model.  Piketty and many others would argue that it is not.  Many would argue that it is the inevitable—and even desirable—outcome of a capitalist system.

We must thank Piketty for providing us this information.  We must also thank him for reminding us that economists rarely know what they are talking about. 

Many economists seem to believe their roll in life is to provide justification for the offenses of capitalism.  They even go so far as to try to convince us that our society should conform to the rules of capitalism rather than have capitalism conform to the rules of society.  This is a view that finds favor with those wealthy enough to purchase allegiances and have their views publicly promoted. 

The decision as to whether our society and our economy are headed in a proper direction is one that society must make.  Piketty seems to believe that this ever-growing concentration of wealth is dangerous and must be addressed; the proper way to address it is with small but progressive tax on wealth.  Perhaps it is time to consider such an option.  Capitalism would hardly notice.