How does capitalism work? Does the principle of free markets necessarily mean equality for all? In “Capital in the Twenty-First Century,” Thomas Piketty attempts to draw up a history of the distribution of wealth, to show how an inequality of wealth came into existence and what the future of capitalism could look like. Will inequalities between the rich and poor continue to grow?
You do not need any prior knowledge of economics to enjoy “Capital in the Twenty-First Century,” so, get ready to learn how capital can be used to create a fairer world in the future!
The distribution of wealth has been widely discussed, but Piketty says most of these discussions have taken place without any actual knowledge of the facts. Very often, opinions on this have been based on prejudice, so the theories on the impact of capital have alternately focused on two extremes: either apocalypse (as in the case of Karl Marx) or fairy tale (as in the case of Simon Kuznet).
To gather the facts on the distribution of wealth and income, Piketty looked at data covering more than three centuries and more than 20 countries. His primary database was the WTID (World Top Income Database). He mainly studied the historical experiences of Britain, France, Germany, US, and Japan.
Of those, he chose to focus primarily on France and Britain since the two countries provided the greatest amount of historical information. France in particular is instructive thanks to the impacts of the French Revolution. Even though the French Revolution did not create a just or equal society, France was the first country to go through the demographic transition and can therefore provide a useful place of reference for possible future developments around the world.
The French Revolution also established “an ideal of legal equality in relation to the market” and therefore made France the ideal starting point to see how this affected wealth distribution. The case of France quite clearly shows that equality in the marketplace does not guarantee overall equality in society. In fact, the income inequality in rich countries has significantly increased since the 1970s.
In the second decade of the 21st century, inequalities of wealth are regaining or even surpassing historical highs - thanks to a global economy. Since we are faced with rapidly changing economies around the world, we should ask ourselves: how is this going to affect wealth distribution?
In order to understand the working and applications of economics, only a small theoretical framework is necessary. In basic terms, income and output are the interplaying forces of economies, whether on a personal or national level.
National income means the sum of all income available to residents of a country in a given year. National income includes income both from within the country and from abroad. The fact that countries can own assets abroad as well as at home is already one of the factors that can enhance inequality: think of the possible implications of rich countries “owning” poor countries, for example.
The national income includes both capital and labor income. Capital basically means the “sum total of nonhuman assets that can be owned and exchanged on some market.” It can be owned by private individuals or public bodies, such as government agencies, hence there is a distinction between private and public wealth.
Labor, on the other hand, is sometimes referred to as “human capital.” It is essentially a country’s workforce. Most conflicts around wealth distribution center around the capital-labor distribution: how much of the output should go into wages, and how much should be retained as profit?
Historically speaking, the share capital had in income was quite high prior to 1914-1945, when it experienced a historic low as a result of the two World Wars and the Great Depression. In the 1980s, capital began growing rapidly again as a direct result of the conservative revolution and the fall of the communist Soviet Bloc. Even the economic crisis that began in 2008 could not slow the rise of capital.
So, in relation to labor, capital has always played a more prominent role. Even though an evolution in technology from the Industrial Revolution onwards gave rise to a greater demand for skilled human labor, it increased the share of capital at the same time, as it also produced a need for more buildings and equipment.
Owning large amounts of capital isn’t necessarily a bad thing. After all, it can be spent on training and skills, or be used to diffuse knowledge, which are all forces of convergence when it comes to the distribution of wealth. However, the dynamics of wealth distribution also include mechanisms of divergence, as the next few chapters will show.
Another central concept to wealth distribution is that of growth. The growth of output can be divided up into population (demographic) growth and per capita (economic) growth. Economic growth entails an increase in purchasing power, meaning that you can buy more for your money. In the example of the Industrial Revolution, the growth resulted in improved living standards for society.
Piketty points out that the law of cumulative growth applies to both population and economic growth and means that, “A low annual growth rate over a very long period of time gives rise to considerable progress.” For example, a growth rate of 1% per year translates, over the 30-year span of one generation, into a cumulative growth of more than 35%, which would necessarily require “major changes in lifestyle and employment.”
This, in itself, is not a bad thing. In fact, a strong upsurge in population actually serves as an equalizing factor because the role that savings play decreases. Each generation has to make their own luck. This also means, however, that if a population grows slower than its economy, wealth is accumulated by only a few, since the importance of savings increases.
Similar to the law of cumulative growth is the law of cumulative return: even when the annual return rate is low, it eventually leads to greatly increased capital. The capital/income ratio (β) of any given country is closely connected to its growth. It is calculated through the following formula: “β = s/g,” whereby s is the savings rate of a country, and g is the growth. So, if a country saves 12% of its income every year and the growth rate is 2% a year, the capital/income ratio would be 600% in the long run - meaning that the country would have amassed capital equal to six years of income.
And even with a decreased or small growth rate, capital will still grow. Especially in stagnant economies therefore, savings “acquire disproportionate importance.” Even with a growth rate of 1.5% a year, the capital/income ratio would rise to eight years of national income.
Generally speaking, this is not a bad thing – owning capital can be potentially positive for the entire population, but it depends on how the capital is spent. It also means, however, that those already owning large amounts of capital will grow richer.
Even more defining for wealth distribution in the long run is the relationship between return on capital (such as “profits, dividends, interest, rents, and other income from capital”) and the growth rate of the economy (“annual increase in income and output”). This is expressed in the following formula: r > g, with r representing the average annual return rate of capital, and g representing the growth of the economy.
The ideal economic market has a return rate that is higher than the growth rate, which is why this presents the central contradiction of capitalism. Combine this with the fact that even a low growth rate favors those who are already rich, and you have the perfect formula for inequality.
This means that often, a private return on capital outstrips the general economic growth for long periods of time. Accumulated wealth grows faster than output and wages. The rich will only get richer, and this is aggravated by the fact that those with high incomes usually manage to get larger returns on their wealth as well.
World War I and World War II interrupted this development as they brought down the return on capital. But in the near future, economic and demographic growth are likely to decrease, meaning that the divergence in the distribution of wealth will increase. So, if you have savings, you will be in a better position than someone who works their entire life to earn money.
It seems therefore that the fundamental frameworks of capitalism are defined by powerful forces pushing towards a divergence of the distribution of wealth – in other words, capitalism enforces inequality through its basic principles.
So, if the natural forces of our market economy only exacerbate inequalities, what can be done about it? As the past has shown, it takes an “unnatural” intervention - that is, an intervention from without the system - to interrupt the potentially disastrous long-term effects of capitalism.
In the 20th century, the unnatural intervention were the wars, but those were experiences that no one wants to repeat these days. So, short of starting a war, what are the alternatives to regulating the disproportionate inequalities in our societies? The solution is as simple as it is complex: a progressive global annual tax on capital. This would allow wealth to be put under democratic scrutiny.
It is a utopian idea, to be sure. It would require all the countries in the world to work together to create and enforce this tax, and it is highly unlikely that an accord could be reached on such a scale. It could, however, be attempted on a continental scale.
Such a tax would have to be progressive, meaning it would need to be adjusted, depending on how much a single person possesses. It would need to tax individual wealth as well, since there are individuals today who are as wealthy as entire countries. So, as an example, net assets below one million euros could have a tax rate of 0%, those with one to five million, a tax of 1%, and 2% for those above five million.
Such a tax would effectively put an end to the r > g discrepancy since capital revenue would level out to a similar rate as the growth rate, and the gap between rich and poor would not be widened any further.
Introducing such a tax would also demand international financial transparency. To know how wealth should be taxed at an international level, data would be required to determine how much wealth existed in the first place. Transparency would also be in line with democratic principles: having insights into the global distribution of wealth would allow for a much more rational debate on the challenges facing the world.
Even though the idea is utopian, Piketty says it would offer a standard against which alternative experiments in the future could be measured.
Capitalism is built on frameworks that favor the rich. Even in phases of stagnant economic growth, those with savings will be favored by the system. This is intensified by the fact that revenue on capital will always be higher than economic growth – so the rich are favored doubly by a capitalist system. To counteract these forces of divergence, a global, progressive tax on income is the ideal solution – however, this comes with its own difficulties since it would demand international cooperation and financial transparency.
In its 600-page-long dense analysis, “Capital in the Twenty-First Century” presents a strong statement on social equality including an actual framework of how this could be achieved.
Given how capitalism favors those with savings, how about opening up your own savings account?
Thomas Piketty is a French economist who holds a chair at both the Paris and London Schools of Economics. Arguably the world’s leading expert on income and wealth inequality, he is considered an essential thinker... (Read more)
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