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Trickle-up economics

Thomas Piketty's new book demonstrates why inequality is inevitable under current policies

March 23, 2014 8:45AM ET

Coming out of the Great Recession in 2009, inequality increased dramatically, the opposite of what happened when the Great Depression ended nearly eight decades earlier. Why?

The short answer: When investment returns exceed economic growth, the rich get richer, increasing inequality. So argues Thomas Piketty, a French economist renowned for analyzing incomes reported on tax returns over the last century, in his excellent new book “Capital in the Twenty-First Century.”

The future will be vastly more unequal, Piketty predicts, thanks to tax laws that allow virtually unlimited inheritances to pass from generation to generation. This sort of out-of-control inequality recalls similar class divides in 18th and 19th century France that were reversed only by sharp-edged popular responses.

The good news is that such increasing inequality is not inevitable. Piketty shows that the degree of inequality results not from natural forces or individual choices but from government policy. This is comforting to those of us who been making this argument for years, especially since even The Economist, that staid British magazine devoted to the interests of the investor class, has embraced Piketty’s theory.

Capital accumulation

Piketty’s fully developed argument is backed by careful analysis of official data and supplemented by his brilliant use of economic facts pulled from classics of 19th century literature. To his credit, he offers an easy-to-follow model to explain how, even when economic growth is weak, the rich can get richer while the rest of us find ourselves worse off.

When an economy grows at 1 percent annually but investment returns are 5 percent, the already wealthy need to reinvest only a fifth of their gains for their fortunes to grow at the same rate as the overall economy. The rest can be spent on a sumptuous lifestyle.

Since by definition the very rich do not need to consume 80 percent of their incomes — the portion by which investment returns exceed the growth of the economy in Piketty’s model — they can reinvest most of their annual gains in the market.  Over time this accumulating capital will snowball.

The official American income numbers, crunched by Piketty and his sometime colleague Emmanuel Saez, show that in the 21st century wealth and income increases are almost all taking place among the tiniest sliver of the wealthiest and highest-earning. This trend emerged in the mid-1970s, accelerated under Reaganism and took off like a rocket after the tax cuts and anti-regulatory policies of the George W. Bush administration.

The top 1 percent of Americans raked in 95 cents out of every dollar of increased income from 2009, when the Great Recession officially ended, through 2012. Almost a third of the entire national increase went to just 16,000 households, the top 1 percent of the top 1 percent, Piketty and Saez’s analysis of IRS data shows.

By contrast, in 1934, the year after the Great Depression officially ended, the 1 percent of the 1 percent saw their incomes slip by 3.4 percent.

The income changes for the vast majority are just as revealing. The bottom 90 percent saw their average incomes rise 8.8 percent in 1934 over the prior year, while in 2012 the same statistical group had to get by on 15.7 percent less than in 2009.

In showing the crucial role of government policy in the distribution of wealth and income, Piketty throws the proposals by many conservatives and billionaires to end all taxes on capital into proper perspective. The Steve Forbes flat tax, for example, would levy wages and business profits, but not capital gains, dividends or interest, meaning that the already rich could live tax-free while workers would bear the full burden of government.

Whenever the rate of return on capital is significantly and durably higher than the growth rate of the economy, it is all but inevitable that inheritance predominates over saving.

Thomas Piketty

Piketty shows that whether capital is taxed or not, inequality will grow under current policies because savings from current wages and salaries cannot grow as much as returns to existing riches.

The process of accumulating “becomes more rapid and inegalitarian as the return on capital rises and the [overall economic] growth rate falls,” Piketty writes.

“Whenever the rate of return on capital is significantly and durably higher than the growth rate of the economy,” he writes, “it is all but inevitable that inheritance (of fortunes accumulated in the past) predominates over saving (wealth accumulated in the present).”

The new dynasties

And that economic principle leads to what he sees as a serious long-run problem, the very one that ended the French monarchy but not extreme concentrations of wealth.

Dynastic wealth benefits those with rich parents while limiting economic opportunity for everyone else, he shows. This is true, Piketty says, whether inheritance laws are based on primogeniture, in which the first-born male child inherits all or nearly all, or whether siblings share equally in fortunes left by their parents.

“The dynamics of the accumulation and transmission of wealth automatically lead to a very highly concentrated distribution and egalitarian sharing among siblings does not make much of a difference,” he writes.

“The cumulative dynamics of wealth accumulation will automatically give rise to an extremely high concentration of wealth,” with half of the capital owned by the top 1 percent, while the bottom half end up with no savings, he says.

Because in the modern world the already rich need business and investment managers, and the CEOs he calls “supermanagers,” we may see a slightly broader distribution of wealth than in 18th century France or, a century later, in the Belle Époque, France’s gilded age.

One can be both a modest-sized wealth holder or rentier and a manager, Piketty writes, as we see today. But achieving this slightly wider distribution of assets, he says, is “probably to the detriment of low- and median-wage workers, especially those who own only a tiny amount of property, if any.” That is because the moderate wealth holders have an incentive to push down wages so they can reap greater rewards for themselves.

Return of the Belle Époque

Piketty’s genius lies in expanding beyond the numbers about how thick wallets are to show from literary classics how economic rules shape morality, especially for those with ambitions that are thwarted when society’s focus is on preserving the fortunes of the already rich.

Piketty shows that this is not just about numbers or the thickness of wallets. In one of the many examples he draws from literature, Piketty examines the economic logic and moral dilemmas confronting Eugène de Rastignac, an impoverished young noble hoping to regain his comforts by becoming a lawyer, as told in Balzac’s novel “Père Goriot.”

Wealth was so concentrated in 1835 France that “those who could somehow lay hands on inherited wealth were able to live far better than those obligated to make their way by study and work.”

Piketty writes that because “study and work cannot possibly lead to a comfortable and elegant life … the only realistic strategy is to marry Mademoiselle Victorine and her inheritance,” which forces Rastignac to consider a proposal to murder her brother, who would otherwise inherit.

Balzac, who famously wrote that “behind every fortune lies a great crime,” lived in a world the vast majority of us would not want to see recur, a world in which merit and hard work mattered little.

Piketty argues that we are headed back in that direction, however, through misguided government policies that encourage dynastic wealth and favor returns to capital over income from labor. His dark vision is one in which even the strivers will have a tougher time, and more modest fortunes, than those whose primary basis for their riches is ancestry.

We need not return to the much greater wealth disparities of the Belle Époque, or what in America we call the Gilded Age, when industrialization and mass production produced fortunes unimaginable to those who had lived only a few decades before.

To make smarter choices, however, requires understanding the financial dynamics of the modern world and the legal structures that make them possible. Piketty’s new book is an important contribution to understanding what we need to do to produce more growth, wider economic opportunity and greater social stability.

 

David Cay Johnston, an investigative reporter who won a Pulitzer Prize while at The New York Times, teaches business, tax and property law of the ancient world at the Syracuse University College of Law. He is the best-selling author of “Perfectly Legal,” “Free Lunch” and “The Fine Print” and editor of the new anthology “Divided: The Perils of Our Growing Inequality.”

The views expressed in this article are the author's own and do not necessarily reflect Al Jazeera America's editorial policy.

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