Why Piketty is Wrong and Western Workers Have a Bright Future

I'm sorry.  I'm supposed to be angry and dismal, because angry and dismal is smart, or at least that's the current received wisdom, and not wanting to look smart is practically a cardinal sin these days, and it would be a wilful sin to boot given that I could just keep my mouth shut, or at least write something angry.  But I can't help it -- I'm just too happy and optimistic, though somewhat overworked, which I suppose goes a long way towards explaining many things, including my rather poor writing record of late.  It seems kind of easy to write angry things (especially when you've gotten into the habit!), but harder to write other kinds of things, especially with pressing matters to attend to.

But I do think I have something happy to say about Piketty's new book which also might happen to be smart.  I confess to not having read the actual book (which is something of an economic tome at 700 pages, and a bestseller on Amazon, no less, an unusual juxtaposition, to say the least).  But I have read reviews!  And I will try to be fair, and trust that the reviews have been more or less accurate.  I also don't intend to go into great detail, but just to stick with the basic idea, which I also confess to be a really interesting one, but, alas, as I said, wrong on a very central point.

But first, I'd like to talk about what I think he got right.

There are a few things to know -- Picketty, first and foremost, appears to be a marxist.  I use a little 'm' because he seems to be a methodological marxist, and not necessarily an ideological Marxist calling for a international revolution of the proletariat, or what have you.  But the marxism is fairly well displayed in 1) his approach, which is more or less neo-classical (it sounds strange, but Marx is old enough that he pretty well had to be a classical economist, as there weren't any other schools around yet) 2) he sees the vying for income as a struggle between 'capitalists' and labor, and 3) calling for heavy government intervention and progressive taxation to diminish inequality.

Leaving #3 aside for the moment, his basic claim is that when the economy (g)rows slowly, while (r)eturns to capital are high (which seems to have garnered the rather catchy shorthand r > g), that 'capitalists' are able to bid for an overwhelming share of the fruits of the economy and effectively shut labor out of the gains.  More and more income accrues to holders of capital over time, and this becomes a sort of 'steady-state disequilibrium' that undermines the ability of labor to participate in economic gains.  (I call it a 'disequlibrium' because one would expect that as capital accrued, the return to capital would fall and the share of income that goes to labor would naturally rise.  Some dreaded 'something' is keeping things in a state of disquilibrium to prop up the return to capital that would otherwise naturally fall.  Brad DeLong had some interesting things to say about that.)

Piketty thinks that this state of affairs is currently in play, and that if nothing is done, the entire world is looking at a very protracted period of mounting inequality going forward.  It is with respect to this last statement that I will disagree, and, somehow, find myself rather lonely in this regard; even many vehemently anti-Pikettians seem to agree with him on this point.  Anyway, I don't.

Piketty says that this has happened twice in recent history, and both times for roughly the same reason -- overly-free markets, more or less.  The first time was the great Gilded Age, when capitalism combined with the recently unleashed forces of industrialization to produce woeful inequality as labor found itself at the mercy of a tidal wave of labor saving machinery sans substantial government regulation thereof.  This was later 'ameliorated' by world wars which broke up a regimen of rampaging globalism and installed more social-welfare oriented governments that were amenable to interventionism.

The second time was the great wave of deregulation under such personalities as Ronald Reagan and Margaret Thatcher.  According to Piketty (again, more or less) the deregulation and flattening of the tax burden allowed the 'capitalists' to surge ahead in the income race and undermine the ability of labor to compete in the bid for income.

Many people have objected to these ideas (and others Piketty presents) for many different reasons.  A lot have to do with the neo-classical approach -- how can you just lump 'capital' and 'labor' into groups and call this meaningful economic analysis?  All capital is different -- over time, the fate (and the return) of each asset is different.  Tell the buggy-whip manufacturers that they have been earning an above market return, see how that goes over.  And much -- if not most -- labor owns at least some share of capital.  How can you separate the two, or not differentiate one sort of labor from another, for that matter?  I particularly liked one of Arnold Kling's criticisms (sorry, can't find the link at the moment) -- there isn't much of any meaningful labor aspect to income any more.  Most 'labor' compensation is really compensation for education, training, and skills -- a form of capital, in other words.  So this is really a story of different sorts of capital vying for income, not capital and labor.

Such retorts are interesting, but I don't think this will really satisfy the people likely to be sympathetic to Piketty, who are worried about the fates of people 'working for a living' (mostly) versus those (mostly) living off investment income.  I suppose that whether you find meaning in the question of labor income vs capital income, or whether you reject it as some sort of conjured-up 'philosophical construct,' is up to you, but most people do find meaning in it, which is to say, they find some truth in the distinction between capital and labor.  And if you find meaning in this question, I can't see how the basic neo-classical approach is stupid or invalid, if taken merely for what it's worth, with the appropriate caveats that these sorts of critics are tossing Piketty's way. 

And, conservative opinion to the contrary, I can't find a bone to pick with Piketty's basic assertion that 'labor' (I'll get to those scare quotes in a minute) has gotten the short end of the stick in recent decades.  The numbers seem to bear this out.  I haven't got the statistics he's got at my fingertips, but I do have those that the FED has made public.  Again, disclaimer -- yes, I'm fully aware that 'economic statistics' can't and don't tell the whole story about the economy.  But at least as best as we're able to 'measure' the situation, they are the best we have to go on.  And this is what they say --

 

This is a graph of wages (of non-supervisory employees, basically, 'labor' as close as one can approximate) corrected for inflation over the period 1960 to 2014, and the story it tells is unequivocal -- wages peaked in about 1973 and then fell until the mid-to-late 1990's when they began rising again, but still have not fully recovered.

There are, of course, objections to be made, the main one being that the CPI measure is bogus.  But most who would make this objection would say that CPI is generally understated, which would only make the graph look worse if it were corrected (i.e., if price-inflation were higher over that time period, the graph would get lower and lower as one moved to the right).  And as I pointed out before, there is Kling's objection that labor in modern economies is really just another kind of capital, but if you go that route the you've left the argument altogether by defining it into oblivion.  It is an interesting insight, though.

This graph is supported by a second, which to my mind is the most direct measure of what Piketty wants to talk about (and it surprises me that I haven't seen it anywhere...)

This is a graph of the percentage of income going to labor out of total GDP.  Notice that it also peaks in the 1971-1973 period, and falls over time (though not as dramatically as in the first graph).  It, however, does not recover, but keeps falling through 2014 with something of a spike in the latter 1990's. Of course, the scale is to be taken into consideration -- overall, from peak to trough is about a 10-12% drop ([~68% - 62%]  /~60%), which is not enormous.  Taken together with the first graph -- a much larger drop of about 20% -- tends to suggest that the return to capital in the US also fell over this time period, though not as much (an important clue, as we'll see...)

The 'non-recovery' of labor's share of income mentioned above vs. the recovery of wages is easily explained, I think, with a third graph --

Real wages increased ~1995-2014, but the labor share of income fell anyway because fewer people were working, which seems to be the economic story of the new millennium.

So, if all this seems sound, what if any objections are there to make to Dr. Piketty -- especially very happy, optimistic objections?  (Hopefully, at least one is obvious at this point...)

The first -- and obvious, at least to me -- is that, while I am game to entertain interesting and even far-fetched ideas, I do have some minimum requirements when it comes to speculations of cause and effect, and one is that the cause needs to come before the effect, or at least at about the same time.  All of these things started in the early 1970's -- almost ten years before anything Reagan could have done would possibly have had any affect at all because he wasn't even president yet!  (I think that deserves at least bold and italic, don't you?  I'm not trying to be mean, but how does this slip anyone's mind -- Piketty or the nay-sayers?)

So... what was really going on about this time?  Let's see -- Nixon was president, the Vietnam War was ending... oh yes!  Wage and price controls, high marginal tax rates, that barbarous relic (gold) finally taken off life-support and put into the grave, banking regulations still in place, basically not all that much Piketty would object to in terms of policy, I should think, and probably most importantly -- Deng Xiaoping was in the ascendant half a world away.  Nixon visited about this time, if I recall, something about China 'opening up' -- maybe the single most important economic event of the latter half of the 20th century?

Which brings me to the second major problem with the Piketty narrative -- it tends to purport to be global in scope (in terms of global growth rates and returns to capital) but is decidedly Western in perspective (I seriously doubt, for instance, the Chinese experience of the 'Belle Epoque' (Gilded Age) or the 1980's was much like yours or mine...assuming you're reading this in English.)  At least, that is how I understand it being described.  It may make sense to 'average' capital with other capital and labor with other labor in getting a grasp of what is going on within an economy, or to lump the Canadian economy with America's (and even Europe's, Japan's, and Australia's in the post-WWII period).  But it makes no sense at all to lump the undeveloped world with the developed world and average things out and call it a meaningful statistic as far as anyone's experience of either type of economy is concerned.  Sorry, I draw the line with that one.

And here, I think one can get a better grasp of what is going on, and start to write a better narrative than Piketty's.  So, I will do a little quasi-marxist economics of my own, and describe another neo-classical narrative that makes more sense, and comes to pretty well the opposite long-term conclusion.

The Gilded Age and the 1970s-2000's really did experience much the same thing in terms of a temporary falling ability of labor to bid for a share of total income, though the second experience was very much a dim echo of the first.  The Gilded Age produced fantastic and unprecedented -- and unequalled since that time --  inequality in the West for one main reason -- extremely highly productive capital suddenly entered a market which contained very little in the same productivity league with the new technology, and suddenly access to this capital was extremely valuable versus labor (or, really, almost anything else).  So, the owners and developers of that capital were able to bid for enormous shares of total wealth and income, which itself was increasing very rapidly (contra what Piketty would have reported, since he averaged things.  This was a time of very high 'g' and very high 'r' for the people actually involved, not high 'r' and mediocre 'g'.)

The 1970's-2000's period became like this because a titanic sea-change occurred overseas -- China opened up.  Later, Russia, India and other places also entered the game.  This seriously upset the bidding war between 'labor' and 'capital' by opening up an entire venue full of labor with almost no capital.  So, capital accumulation in the US stagnated, and labor in particular was put at a disadvantage.  Some argue that capital 'fled' overseas, but I think this exaggerates -- how, pray tell, does one move the Hoover Dam?  The Interstate Highway System?  Los Angeles, California?  Much capital of necessity stayed put, and supporting capital also would have stayed put, inasmuch as, for example, to strip a commercial building of its wiring and computer system would also render the building worthless.  It is generally more economical to build new capital overseas than move it there, especially when the production of physical capital has become as efficient as in modern times.

(Note -- This is not to mention that the West was also coming to the end of a business cycle, and trying to grapple with rising inflation, which necessarily would have impacted policy in a relevant way -- a drive to open the labor market to other bidders to try to keep wages down and tamp the effects of inflation without actually tightening monetary policy, which would have induced recession.)

But note here that all labor and all capital is not the same -- 'American' capital would have seen falling returns, as would American labor, the latter falling a bit further.  The place to own capital would have been China, just as in 1870 it was America, and access to this market would have been available mostly to fairly financially sophisticated Westerners.  So new capital tended to accumulate in the area with higher returns, which wasn't the West, and didn't improve Western worker's productivity/wages, and the returns went to a select few with better access.  The Western experience, then, was one of rising inequality, but in the main not at all as a result of Reaganism and deregulation.  And note that rising marginal tax rates since Clinton and increasing regulations have not helped solve the 'problem' -- which would be obvious to anyone who thought that the problem had nothing to do with tax rates and regulation, but really was a marxist and was looking at the competition between labor and capital for income.

You could also, I suppose, tell this story from a 'Klingian' perspective, that the rise of Deng and the fall of communism ushered in an explosion of 'social capital' overseas that went into competition with Western social capital, and began attracting away complementary physical capital to extend production to these areas as rapidly as possible, taking advantage of freed-up labor and resources.  In the process, Western social capital, physical capital, and labor was relatively devalued, to varying degrees.  That also has the ring of truth to it, but is kind of an awkward way to state it for most people, I think.

And the conclusion of this story is very, very different.  You can't, after all, open up China again.  (And you really, really can't open up the USSR again.)  At the time -- the early 1970's -- I guestimate that approximately 1 billion people were living in relatively open, developed economies (the West plus Japan and a few other places). About 5 billion resided elsewhere, waiting to open up and develop.  That is a very big differential -- 5 to 1.  Today, you have at least 3.5-4 billion people in roughly open economies or economies in the process of opening and industrializing (Greater West, plus China, India, and Russia).  Not all that many are left to 'open up' significantly (roughly, Latin America, central Asia, and Africa, maybe 2-3 billion, some of which are already significantly developed anyway).  Even if they all experienced a similar sea-change in social capital, it would be a drop in the bucket compared to the last experience.

Further, if it did happen, the brunt of the impact would most likely be felt by those nations which have only recently industrialized -- again, China, Russia and India & Co.  Why?  Because they would be most directly in competition, and jobs and capital can't leave twice, either.  Most of the manufacturing industries currently active in the West are either a) intrinsically more suited to highly-developed economies, or b) would have already left.  Probably, some effect would still be felt, as Chinese and Russian firms felt the pressure and began competing for even more developed Western industries, but this 'wave' would have gone through a fairly large dilution in the process.  So the echo of the Gilded Age felt in the 'second industrialization' of the 1970's-2000's would dwarf the changes felt in the 'third industrialization,' just as the second was dwarfed by the first.

But as there become fewer and fewer new places to industrialize, and capital accumulates at a faster and faster rate in a more evenly-spread fashion, I think we can expect once again for labor to get the upper hand in bidding for income, as we saw in the interim between the Gilded Age and its recent echo.  Inequality will fall, or at least moderate, especially if well enough is left alone.  I don't think progressive taxes and such will help the situation, or really have much of an impact one way or another, just as it didn't have much of an effect between the world wars and the 1980's, in my opinion.  That seems to be the story of the last couple of centuries, in broad brushstrokes, at least.

All around, I think we've had the brunt of the changes, contra it seems almost everyone's forecast.  Sorry, maybe that sounds out of tune for me or almost anyone writing today, but that's what I think.  The financial crisis will have yet to play itself out, yes, and of course that isn't going to be all that pleasant.  But accounting is (at least supposed to be) a reflection of reality, not reality itself.  Real new technology is being developed, real new capital is being produced.  The bad accounting may divert things to inefficient arrangements, yes, but it doesn't stop the train from rolling forward.  Accounts may get settled badly, but they will get settled, and we will move on, bad accounting or no.

Further down the road, some people worry about things like robots and 3D printers ruining labor markets, in a Pikettyesque sort of fashion (upsetting the competition of labor and capital for income, in the favor of capital).  But this idea operates on the principle of labor substitution, and while certainly, to a degree capital of this sort can substitute for labor, no one seems to take note that it substitutes even better for other capital -- especially of it's own kind.  How much is a robot or printer worth if you can use robots to make other robots, and printers to print out other printers? What does ownership of capital mean in such an environment, in terms of claims to income?  Certainly, there will be more goods produced in such an economy, and therefore, more income to bid for, but it is not entirely clear to me who will win in such a competition (unless, of course, one side manages to successfully collude against the other, at which point all bets are off.  But that is always a threat.)  At least, it is not at all clear to me that labor loses this fight as others seem to contend.  It would even seem to have something of an advantage.

So, I am optimistic and happy, at least on this front.  And I think you should be, too.