Thursday, June 2, 2016

Capitalism and Inequality: What Does the Future Hold?

Thomas Piketty produced an enormously influential historical study of wealth during the capitalist era in Capital in the Twenty-First Century.  His work produced the conclusion that the return on investment in capital has historically been at the level of about 5%.  It dipped below that value during the period in the twentieth century marked by two world wars, the Great Depression and the post World War II recovery period.  Since that period, return on capital has returned to about the historical level.  Piketty’s study also concluded that the historical growth in income (on a per capita basis) was much lower except during that anomalous twentieth century period.  The high growth observed in the postwar years has since returned to the lower historical mean.

The obvious conclusion to be drawn from Piketty’s view is that capital (equivalent to wealth in Piketty’s reckoning) will continue to grow faster than the income earned from labor leading to ever greater inequality.  The lesson of the postwar years is that public policy, particularly with respect to taxation, led to diminished inequality and higher growth.  From Piketty:

“….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.”

The postwar European policies were much more aggressive than those in the US and led to greater growth of the middle class.  Tax policy was seen as the most effective way to alter inequality, provided taxes were used to provide services that were of value to all.  The middle class would be the ones who would benefit the most from the provided services.

“….modern redistribution does not consist in transferring income from the rich to the poor, at least not in so explicit a way.  It consists rather in financing public services and replacement incomes that are more or less equal for everyone, especially in the areas of health, education, and pensions.”

It should be noted that if the middle class benefits most from services provided by the government in the areas of health education, and pensions, it is the middle class that will suffer the most if those government services are scaled back or withdrawn.

Branko Milanovic has also tried his hand at providing understanding of inequality at the global level and predicting what the future might hold.  He has produced the very worthy and lucid book Global Inequality: A New Approach for the Age of Globalization.  Milanovic has collected a large amount of fascinating data on income levels around the world and tracked the evolution over recent decades.  This allows him to evaluate the effects globalization has had on incomes in both wealthy and non-wealthy countries, and to produce some interesting conclusions.

Milanovic also tries to produce an hypothesis to explain the dynamics that control economic evolution and predict how income inequality might change over time.  He believes that Picketty’s theory is inadequate to explain all the data, and suggests that a variation on and older idea presented by Simon Kuznets is more appropriate.  Kuznets was a very accomplished economist.  One of his deductions from perusal of the data available to him at the time was the existence of what came to be known as the Kuznets curve.  From Wikipedia:

“Among his several discoveries which sparked important theoretical research programs was the Kuznets curve, an inverted U-shaped relation between income inequality and economic growth (1955, 1963). In poor countries, economic growth increased the income disparity between rich and poor people. In wealthier countries, economic growth narrowed the difference. By noting patterns of income inequality in developed and underdeveloped countries, he proposed that as countries experienced economic growth, the income inequality first increases and then decreases. The reasoning was that in order to experience growth, countries had to shift from agricultural to industrial sectors. While there was little variation in the agricultural income, industrialization led to large differences in income. Additionally, as economies experienced growth, mass education provided greater opportunities which decreased the inequality and the lower income portion of the population gained political power to change governmental policies.”

Both Piketty and Kuznets would predict growing inequality in the nineteenth century, but without demonstrating it, Milanovic claims that the data on inequality in the UK and the US look to him like a Kuznets curve rather than anything Piketty could produce.  He then can claim, again without much in the way of justification, that, two world wars and the Great Depression notwithstanding, the postwar fall in inequality was merely following the economic evolution the Kuznets hypothesis predicted. 

Milanovic grants that Piketty correctly predicts the rise in inequality that occurred after the postwar period and continues to this day—which Kuznets could not.  In order to maintain his faith in the Kuznets curve he has to postulate that this rise must have been caused by a new industrial revolution that triggered a rise in inequality similar to that caused by the transition from an agricultural economy to a mechanized one.  Kuznets events can then come in waves.  Milanovic proposes that the rise of information technology has been responsible for this latest increase in inequality.  That conclusion is controversial.  Paul Krugman does a good job of trashing that notion in Challenging the Oligarchy.

It was not the intention to produce a detailed resolution of the differences between the views of Milanovic and Piketty.  The issue here relates to the quite different predictions for the future.  

Milanovic’s view suggests that there are economic mechanisms within the capitalist system itself by which inequality can be diminished.  He predicts that US inequality will begin to decline, although he describes the US as currently enduring a “perfect storm of inequality.” He seems to conclude that wars and revolutions are also “economic mechanisms,” consequently he may eventually be correct.

Piketty’s view suggests that the natural evolution of a capitalist society is to plutocracy unless inequality is explicitly constrained by society.  A Great Recession did little to convince our society of the need to rein in capitalism.  The only data we have suggests that a Great Depression and two world wars are necessary to do the trick.

Perhaps it is useful to remind ourselves what mindset emerged in Europe from the experience of a Great Depression and two world wars.  Tony Judt provides us with some insight from his book Postwar: A History of Europe Since 1945.

“The state, it was widely believed, would always do a better job than the unrestricted market: not just in dispensing justice and securing the realm, or distributing goods and services, but in designing and applying strategies for social cohesion, moral sustenance and cultural vitality.  The notion that such matters might better be left to enlightened self-interest and the workings of a free market in commodities and ideas was regarded in mainstream European political and academic circles as a quaint relic of pre-Keynesian times: at best a failure to learn the lessons of the Depression, at worst an invitation to conflict and a veiled appeal to the basest human instincts”

“The state, then, was a good thing; and there was a lot of it….The overwhelming bulk of the increase in spending went on insurance, pensions, health, education and housing.”

This attitude towards capitalism and economics generated an enormous growth in the middle class in Europe.  The subsequent rise in influence of market-based decisions has been gradually eliminating the middle class. 

There has to be an optimal middle ground between these extremes, but how do we get there?

The interested reader might find these articles informative:

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