Capital in the Twenty-First Century and Its Critique.

A nation’s income comes from two sources; capital – that is, rent, interest and dividends – and wages from labour. Through the 20th century it was believed that the split between these was constant, at around 70% going to labour. This split is determined by multiplying the stock of capital (relative to total income) by the average rate of return on capital. Therefore, the nature of the correlation between these two measures will determine how much income goes to each capital and labour.

The correlation is certainly negative – as capital accumulates its marginal productivity falls. The first acre of land will increase a farmers output greatly, however by the 100th acre he will struggle to cover all the land – any extra acres will provide less yield. This idea is transferable to most forms of capital, provided the quantity of labour is fixed.

This however does not give us enough information to discern how the capital-labour split will be. If the rate of return of capital decreases less than proportionally as the capital stock increases, capitals share of income will increase as it accumulates. Piketty uses data to suggest that this is the case. Over the last few hundred years, during period where the capital stock has been increasing (effectively the whole period excluding 1914-1945) capital’s share of income has increased slightly. This suggests that there is a substitutability of around 1.3-1.6 – the difference from proportionality in the relationship between the capital stock and the rate of return on capital.

It remains in question whether the stock of capital relative to total income (GDP) will increase. By comparing the rate at which each of these measures increase (rate of return on capital and the economy’s growth rate respectively) we can predict the future ratio. Piketty estimates the rate of return on capital to have remained constant at around 4% over the 20th century. Per capita economic growth averaged around 2% over the same period – this will be challenging to be maintain. The social and technological changes of the last 100 years (women entering the workforce and the rise of transnational corporations, alongside automobiles, planes and automated factory machines) are unlikely to be matched. Furthermore both slowing population growth and an aging population will inhibit future growth. While predicting the future is so often wrong, it is highly probable that the capital stock will continue to increase in the future.

So, provided there are no shocks of the same magnitude as the World Wars or Great Depression, as the capital stock continues to increase, as will capital’s share of income. But what impact will this have on total income inequality?

Inequality of wealth is far greater than inequality of labour income. This is due to the existence of economies of scale in investment. Those with greater initial wealth are able to spend a greater absolute amount (smaller proportion) of their wealth on financial advice and risk management, increasing their returns. For example, large US universities are able to generate returns of around 7-9%, an individual storing their money in an ISA will be lucky to receive 2%.

As capital’s share of income increases total income inequality, which is a weighted average of inequality of wealth and labour, will shift closer towards the less equitable distribution of wealth.

Common Critiques

  1. Piketty’s calculated substitutability of capital (1.3-1.6) lies far outside the mainstream, previous estimates predominantly lie between 0.2 and 0.7. This seems more intuitive, while much of the capital stock is versatile (industrial machines and computers), a far greater proportion of it is in the form of housing – which cannot easily replace labour in the production process. If this is the case, any increase in the stock of capital will not grant it a greater share of national income.
  2. There is also evidence to suggest that the wealthy do not earn higher incomes. Only 73 of those on the Forbes top 400 rich list in 1987 remained on the list in 2013, with average returns for the original 400 being between 0.2 and 2.4%. This refutes the notion that inequality of wealth will grow exponentially.
  3. Inequality in labour income has only increased over the last few decades because of an influx of new workers – primarily women, baby boomers, and the newly urbanised population in the developing world. The supply of labour will begin to contract in the near future because of; an aging population, a slowing rate of urbanisation, and less room for changing attitudes towards minorities in the workforce. This contraction will create labour shortages, leading to upward pressure on wages.

Perhaps the simple mechanism Piketty uses to describe inequality is not fully accurate, but Capital in the Twenty-First Century has been an important contribution to the discussion of inequality.

 

Contributed by Michael Tallent, Editor in Chief

One thought on “Capital in the Twenty-First Century and Its Critique.

  1. Regarding 3., do you think that Osborne’s plan re extending system of shared parental leave to cover grandparents will help?

    I recall from Geography AS (demographics unit) that the elderly provide informal care worth £11.4bn each year, given that a 1/3 work more than 50 hours/week.

    In this sense, the standard distinction between a youthful and ageing population in terms of economic contraction may be superficial?

    P.S., Check out the History page, won’t you? It’s more fun.

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