Focus on inequality

Thomas Piketty has brought the popular discussion of inequality and its causes and consequences to the forefront.

THOMAS PIKETTY’S Capital in the Twenty-First Century , translated from French, was published in April this year and has already become a bestseller, even overtaking those in the fiction category. It is about the first book in economics to claim this distinction. Obviously, not only economists have contributed to the book’s popularity. It has become something of a classic which, as the saying goes, people talk about whether they have read it or not. Within the profession, the young (44-year-old) French economist had already established a reputation for himself in Europe and also in the English-speaking world for his published works on income and wealth inequalities. Even so, the reception Capital has received has come as a surprise.

What accounts for the instant success of this book? It is partly the title, which brings to mind Karl Marx’s Capital, but Piketty is known to be not against capitalism. It is also, and perhaps more importantly, because of the contemporary significance of the main theme it deals with, the growing and palpable increase in the inequalities in the distribution of income and wealth in most parts of the world, in capitalist United States, Europe, in socialist China, and even in ambivalent India. The open fight against inequality caught global attention in 2011 when an angry mob occupied Wall Street claiming “we are the 99 per cent” against the 1 per cent symbolically represented by the finance capital of the world.

The book opens with the sentence: “The distribution of wealth is one of today’s most widely discussed and controversial issues.” He is also concerned about the “dialogue of the deaf” between opposing sides and hopes that “by patiently searching for facts and patterns and calmly analysing the economic, social and political mechanisms that might explain them, it can inform democratic debate and focus attention on the right questions”(page 3). Thus, Piketty’s professed objective has been to make a quantitative and qualitative contribution to the growing and angry discussions on inequality, to invite scholars from the different branches of the study of society to join in the quest, and to indicate some policy options to deal with the problem.

Kuznets curve On the academic side, Piketty takes off from what is known in the profession as Kuznets Curve, the theory which claimed in the early 1950s that income inequality was an inverted “U”, increasing initially but then almost automatically reversing as economies reached higher levels of income. Piketty says that this “came as Good News” in the middle of the Cold War. The American economist Simon Kuznets, whose research led to this finding, had used the available U.S. data for the period between 1913 and 1948. The explanation given for the initial increase in income inequality and its subsequent reversal was that productivity and income were higher in the industrial (or secondary) sector than in the agricultural (or primary) sector, resulting in higher earnings even for workers as they moved to the latter. With workers moving out of agriculture into manufacturing and subsequently into services (or the tertiary sector), earnings would become generally higher and more equal.

Kuznets was aware of the limitations of his analysis but did not hide the fact that his optimistic predictions would maintain the underdeveloped countries “within the orbit of the free world”, points out Piketty. Many years later, Kuznets won the Nobel Prize in Economics for his pioneering quantitative research in this area. Many economists (including some leading figures in India) swear by Kuznets’ findings, holding the diffusion of knowledge and increase in skills as the rationale for reduction of inequalities and treating the ongoing and glaring recent inequalities as temporary aberrations which would be corrected by “growth”. There is also the widely used cliché that “the cake has to grow larger if everybody has to have more”, thus making growth the mantra that will eliminate all economic maladies.

Some political leaders, such as the Conservative British Prime Minister Margaret Thatcher and even Tony Blair of the “new” Labour party, had maintained that the rich should be treated with respect as they were the ones who bring about growth.

Piketty uses historical data of a much longer period, almost two and a half centuries, and from many countries, to show that over a longer period, the emerging pattern is quite different from what Kuznets and his followers had anticipated. Examining the U.S. data for the period between 1910 and 2010, he found the share of the top 10 per cent of the population going up from 40 per cent to 50 per cent by the late 1920s, then coming down to 30 per cent to 35 per cent by the end of the 1940s, thus validating the findings of Kuznets for the period he had dealt with. It remained more or less stable until about 1980 but ascended sharply until 2010, manifesting the ascending limb of the U.

Piketty provides an explanation. Concentrating on the recent steep increase in inequality, he says: “I will show that this spectacular increase in inequality largely reflects an unprecedented explosion of very elevated incomes from labour, a veritable separation of the top managers of large firms from the rest of the population…. These top managers have the power to set their own remuneration, in some cases without limit and in many cases without any clear relation to their individual productivity.…” (page 24). Data for Britain, Germany and France over the period from 1870 to 2010 appear to lend support to Piketty’s position.

Hence, he sums up: “[T]he process by which wealth is accumulated and distributed contains powerful forces pushing towards divergence or at any rate towards an extremely high level of inequality” (page 27). He offers many explanations for the observed phenomenon, stating that the emergence of inequality after 1980 “is due largely to the political shifts of the past several decades, especially in regard to taxation and finance” (page 20). He predicts that in the immediate future (the rest of the 21st century at least) the situation is likely to become more worrisome. He also brings to light the fact that within the category of those described as rich (let us say the top 10 per cent of income earners), the top 1 per cent, the top 0.1 per cent and the top 0.01 per cent have a disproportionately large share. Though he concentrates on the economic aspects of this problem, he concedes that “the history of the distribution of wealth has always been deeply political, and it cannot be reduced to a purely economic mechanism”.

Having documented the problem, Piketty then turns to provide his explanation. The classical writers in economics, familiar names such as Adam Smith, David Ricardo and Karl Marx were all concerned in their own ways with the generation and distribution of wealth, trying to provide explanations for what they saw and reflected upon. Of these, the most clearly worked and widely known is that of Marx, who anticipated the critical feature of the emerging capitalist economic system to be the eagerness of the owners of capital to accumulate more capital (generated by the workers) which would lead to the concentration and centralisation of capital, and thus to increase the “divergence” in Piketty’s terminology. To Piketty that appears to be too deterministic. He claims too that the history of inequality is shaped by the way economic, social and political actors view what is just and what is not and the relative power of those actors.

Piketty takes the position that inequality must be contextually dealt with. So he does not present any grand theory or sophisticated mathematical model. Instead, he presents “a treasure trove of data”, as another commentator on Piketty’s work has stated, and resorts to some simple devices to make sense of the empirical findings.

Of these, what has already been widely discussed is: r > g which, Piketty claims, to be the “Fundamental Force for Divergence” or “the fundamental inequality”, where r is the average rate of return on capital and g is the rate of growth of the economy. To understand this expression, one has to know what capital is and what growth is. The latter is a more familiar concept (though some questions will have to be raised about it), but capital is not an unambiguous term.

So, Piketty provides the explanation that the rate of return on capital must include profits, dividends, interests, rents, and other income from capital, “expressed as a percentage of its total value”. Not surprisingly, Piketty admits that he uses “capital” and “wealth” interchangeably, “as if they were perfectly synonymous” (page 47). The problem with this procedure is that it makes it difficult to distinguish between profits from production and from various forms of transactions, and glides over the crucial economic and social distinction between the two activities. In productive activity, “profit” basically is the difference between the value generated by the use of labour power and the wages paid out to workers by the owners of capital. In trade, on the other hand, the buyer and the seller are at “the same level”, both being owners of the goods they transact, and so profit arises from circumstantial conditions such as asymmetry of information. While dealing with wealth over time, across decades and centuries, therefore, the source of profit has to be a matter of major significance.

A quick look back at history will bring out the difference. Wealth probably became a social issue only after settled agricultural production emerged in different parts of the world. Production then was the cooperation between human labour and land, nature’s free gift. Land emerged as wealth when some sections of society claimed ownership over it, thus becoming a source of inheritance but not much of transactions. The next stage was when commerce emerged as the source to make “profit”. A major breakthrough came when industrial production based on produced means of production (capital) and the use of hired labour became the basic source of profit and accumulation. In this transformation, technology played a crucial role. Ownership then became critical for accumulation and inheritance. Output substantially increased, leading to close collaboration between production and transaction. A social innovation of the early 17th century of sharing liability through a legal diffusion of ownership, intended initially to promote long-distance trade (joint-stock companies) soon moved into the industrial sphere as well, facilitating transaction in ownership with major ramifications on the process of accumulation, ownership and inheritance. With the introduction of formal credit (naturally and simultaneously of debt as well) and its rapid acceptance in practically all aspects of economic intercourse, profit-making soon shifted from the sphere of production to that of transaction. The discovery of nature’s hidden resources, coal and more particularly oil and natural gas, gave new impetus to ownership, both private and public (the latter via the state), as well as transaction as a source of profit and wealth.

From about 1980, some major changes have come about that affect all realms of economic activity. The spread of absentee-ownership across national boundaries and the consequent rapid movement of capital, especially liquid capital, to different parts of the world, commonly referred to as globalisation, aided by phenomenal technical innovations, is one of them. Speculative trading in free-floating national currencies is another. The rapidly changing role of the banking system, especially in rich countries where banking is essentially a private activity, though readily underwritten by the state, has been another significant change. Banks have come to take on investment functions by turning to the risky venture of creating debt instruments—several times removed from initial real collateral—the sales of which initially leading to profit for those who have funds to play with, but soon resulting in a sudden collapse of the system, of production and transactions. Intellectual property rights provide new meaning to what wealth is. The age of finance is here where interchanging capital and wealth is highly misleading, and returns to capital are increasingly based on transactions of items of wealth real to some extent, but substantially fictitious. Under these circumstances, can Piketty’s little r in the “fundamental inequality” be all that innocent?

What about the g in that inequality which, unlike r , has not received much attention from the commentators of the book? In Piketty’s schema, g , as noted already, is the rate of growth of the economy, the annual increase in income or output. The critical issue is whether over time the changes that come about in output will undergo any qualitative difference that can affect the analysis. Let us take a look at one of the findings of Kuznets, known as the sectoral transformation of the economy over time, which has been accepted as law that has logic to support it and has been validated by a great deal of empirical evidence. The general pattern that has been widely observed is that over time, as economies develop, the workforce moves out of the primary or agricultural sector to the secondary or manufacturing sector and then to the tertiary or service sector. The movement of workers from the agricultural to the manufacturing sector leads to an increase in national product and income because of the greater use of technology in the latter. There is, of course, a qualitative difference between output in the first two sectors and the third, the former being tangible and the latter quite different. Indeed, in the service sector, the output is what gets paid to the workers, whereas in the former two the output is what workers produce (converted into value categories).

What gets paid to them is only a fraction of it. In many countries that were relatively late to enter the growth process, it is seen that the movement of workers out of agriculture is very slow, and when it takes place it is more into the service sector. And, in the top layers of the service sector, especially in the new technology-driven segments, remunerations are possibly comparable to levels elsewhere in the world but artificially high compared with what obtains in the rest of the domestic economy.

Thus,treating the income of those who possess wealth (whether through production or transaction, including various forms of gambling and sophisticated ways of cheating, indirectly at least colluded by those who exercise authority) as equivalent to r, the returns to capital, is not a particularly robust analytical procedure. We know from the Indian experience that periods of high growth have been accompanied by the swelling of the share of the services sector and the poor performance, if not stagnation, of the productive sectors. Even more ironic is the fact that the visibly striking performance of the service sector has frequently been associated with what has come to be described as “jobless growth”. And, if it is granted that growth, which is conventionally expressed as a number, is essentially the result of different kinds of social processes, it should not be difficult to grasp that (the pattern of) growth can have a differential and not easily predictable impact on different sections of society. It must be pointed out immediately that the underlying problem of treatment in terms of “real” vs “value ” categories is something that economists in general face. In Piketty’s case, it becomes of added significance because he deals with a much longer period and many different countries.

Financial globalisation However, two major conclusions that Piketty arrives at appear to be of general validity. Inequalities in incomes and wealth tend to increase over time mainly because those who have wealth and deal in it have many ways of ensuring that their wealth and earnings from them increase. He admits that financial globalisation tends to even greater concentration of capital and wealth. “[T]he largest fortunes… have grown at very high rates in recent decades… significantly higher than the average growth rate of wealth” (page 431). Second, inheritance is perhaps the most important factor for the wealthy becoming wealthier.

One would have expected that after arriving at these conclusions and showing moral indignation about them, Piketty would have put forward some radical policy recommendations to deal with them. Here he disappoints. Having attributed the increase in inequalities to policy decisions right at the beginning, Piketty cannot turn to any structural factors to deal with the problem. Hence, he calls for careful study of empirical evidence over long periods, eschewing all prejudgements. He points out that economic factors such as “prices and wages, incomes and fortunes, help to shape political perceptions and attitudes, and in turn these representations engender political institutions, rules and policies that ultimately shape social and economic change” (page 576). But he has objectified his r and g to such an extent that to reduce the gap between the two, the only way he can suggest (other than governmental intervention) is growth, which to him is also the natural way. Growth of any kind, including growth resulting from high returns to wealth from speculative trade, high salaries that the top managers of big corporations fix for themselves, huge profits by repeated turnover of easily created paper assets, quick profits made from global trade of fluctuating currencies? Surely, there is the fallacy of misplaced concreteness here? Many country studies show that accelerated growth via the Washington Consensus has largely benefited the FIRE sectors—finance, insurance and real estate—and consequently increased inequalities. A recent study of India during the period 1922-99 using the World Top Income Database (the primary source of data for Piketty, too) claims that “inequalities steadily decreased in the planning period, driven by a fall in real incomes at the top of the distribution. This decline reversed itself in the early 1980s. The 1990s saw an increasing divergence between the rich (top 1 per cent) and the rest of the country” (Amit Basole, Economic & Political Weekly, October 4, 2014). The fact is that Piketty’s casual treatment of capital and wealth and his decision that at least growth is an undisputed given lands him trouble.

To deal with the problem of inherited wealth, again, Piketty makes what appears to be a bold recommendation. “[T]he ideal policy for avoiding an endless inegalitarian spiral and regaining control over the dynamics of accumulation would be a progressive global tax on wealth” (page 471).

He envisages a “social state” (not a redistributive state) that will ensure that resources flow into education and public health within each country and calls for international financial transparency. As for the novel proposal of a global tax on capital, he recognises the difficulties. “To achieve this goal they [the nations of the world] would have to establish a tax schedule applicable to all wealth around the world and then to decide how to apportion the revenues” (page 515). While this is desirable and useful, Piketty admits that it is utopian.

To conclude on this negative note would be unfair to Piketty. The vastness and richness of the data that he has gathered and processed are phenomenal. His observation that financial capitalism has “run amok” and the statement that if the globalised patrimonial capitalism of the 21st century ran into its first crisis in 2008 it is unlikely to be the last are candid. His plea for education and health care for all is genuine. His exposition of the recent explosion of executive salaries is forthright. His call for automatic transmission of banking information across the globe and for restriction of the powers of central banks to create money is not likely to be heeded but is a pointer in the right direction. His plea for a “political and historical economics” is refreshing. And his readable style with frequent references to popular fiction is commendable. Above all, he has brought the popular discussion of inequality and its causes and consequences to the forefront.

I recommend that those who wish to follow the trail set by Piketty should take the time and the trouble to read the entire book. The World Economic Association in one of its recent publications has brought together over a dozen reviews of the book written by scholars from different parts of the world, which will also be helpful. It can be downloaded from the following link: http://www.paecon. net/PAEReview/issue69/ whole69.pdf

(I gratefully acknowledge that Prabhat Patnaik made available to me his review of Piketty’s book published elsewhere.)