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Piketty is Overrated

June 9, 2014

CAVEAT: I haven’t read Capital in the 21st Century, and I probably never will. I have, however ready dozens of reviews and analyses which have been pouring into my media feeds. I’m going to avoid “As far as I know, to the best of my knowledge, probably, etc.” language because I prefer a writing style without incessant hedging, but feel free to use your imagination to sprinkle them in.

Piketty’s basic model is that the rate of return on capital is greater than economic growth. For example, an economy that is growing at 2% when capital returns are 6% in the long run. Recent history in the U.S. and Europe has fit this criterion. If capital returns are reinvested, the growth of capital income relative to other types of income will increase.

Direct Quote: “When the rate of return on capital significantly exceeds the growth rate of the economy (as it did through much of history until the nineteenth century and as is likely to be the case again in the twenty-first century), then it logically follows that inherited wealth grows faster than output and income.”

No, it does not follow. Not even remotely.

The rate of growth in capital income is not the same as the return on capital. Not everyone gets this point, not even most economists.

Lets say you own an apple farm, which is worth $1 million dollars. Each year, the apple farm produces 100k apples, which you sell for $2, and your average costs are $1 per apple. That means the return on capital is 10%. But the apple farm doesn’t magically get 10% bigger every year, or produce 10% more apples, so the growth of capital income is still 0%. The r in Piketty’s model is the return on capital. It can be larger than growth, smaller than growth, or the same as growth and have no distributional implications whatsoever. Yes, the owner of the apple farm might earn more than apple pickers, but there won’t be upwardly spiraling inequality without additional assumptions.

UNLESS… you have reinvestment of profits. So, suppose instead of just spending the $100k every year on food/housing/yachts/whatever, the apple farm owner buys up stock in some other company also earning 10%. Eventually, that capital stock will grow from $1 million to $1.1 million to $1.21 million, on and on. However, remember the fallacy of composition. Just because one person can do something doesn’t mean that everyone can at the same time. If everyone reinvests their profits, capital stock will increase. In our model, someone somewhere will have to build more farms. But there are two forces pushing against this: capital has decreasing returns in aggregate relative to labor, and capital depreciates. You can’t add more machines to a fixed labor pool and continue to get the same productivity out of each machine. Eventually, you need more humans to oversee the production and make sure things are going smoothly. Maybe the efficient capital to labor ratio has increased, but it is not infinite.

Secondly, capital eventually wears down and needs to be replaced. Parts wear down, roads need repair, computers become obsolete, etc. A society which invests a large fraction of its income will accumulate a lot of capital and thus each year spend a large amount of money maintaining that capital stock. For a given depreciate rate and rate of return, there is an optimal level of investment which maximizes consumption. As long as capital eventually faces diminishing returns, there will be a point where it is more expensive to maintain capital than you earn from owning that capital. The rate of return net of depreciation, cannot be greater than the rate of growth indefinitely (See Tabarrok).

Capital income is not “rich people income”
Capital is fairly concentrated, but the richest of the rich get their money through labor income primarily. That was true in the Gilded Age as well. The Rockefeller and Carnegie as well as Jobs and Gates all got their money through labor income, not through capital income. The top 1% may be overpaid, but they work for their money and they don’t just sit around watching huge stock market portfolios grow at 6% per year. Even investment gurus engage in active management. Warren Buffet’s above market returns are not due to being good at picking stocks, they are good because he knows how to properly run firms and can guide them to making good decisions. This is also how private equity firms run. They don’t just pick stocks and sit on them, they engage in active management and reorganization. Without those skills, incomes diminish. Picketty’s story is about intergenerational wealth, but intergenerational wealth is not driving the top of the income brackets.

Inheritance loopholes
Rich people don’t necessarily give money to children. Bill Gate’s children are not going to go hungry, but neither will they inherit enough to put themselves in the top 1% of income on capital gains alone. This is not uncommon in the U.S. Most billionaires do not leave tremendous sums of money for their children to frivol away.

The number of children is not always 1. Sometimes it’s 0, sometimes it’s 2 or more. Even if you do assume all wealth is transferred between generations, what if the billionaire doesn’t have any kids? What if they have 4 kids and split up their fortune evenly. You need exactly one child per billionaire for Piketty’s story to hold up.

The model assumes rich people never spend down their fortunes on consumer goods and only either reinvest their money or use it for political influence. Of all the unrealistic assumptions, this is the most bizarre. The extremely wealthy often spend even vaster sums and sometimes even die penniless because of it. A drug addiction, a favored charitable cause, or simple extravagance is all it takes to reduce a fortune to chump change in the span of a few years. This is especially true of inherited wealth. With no skills of their own to fall back on, many children of extremely wealthy individuals fritter away their inheritance and wind up back in the 99% with the rest of us.

Wealth inequality != Bad political institutions
Sweden has extremely high wealth inequality and excellent political institutions. The Soviet Union had perfect wealth equality (everyone had 0 wealth), and horribly repressive political institutions. Money does not influence elections as much as popular opinion would have you believe.

Furthermore, it is no simple task to turn a capital portfolio into a reliable stream of publicly funded largesse. Imagine LeBron James trying to get Congress to pass a “Give LeBron James tons of money” Bill. How far would that get? You need to have at least some excuse of providing some public benefit. Even industries supported by lobbying are prone to disruptive competition and reform efforts. If you want to argue that wealth inequality leads to government largesse toward the extremely wealthy, we need to start talking about causal mechanisms and plausible ways for that to happen. It’s just not that simple, especially in developed democratic countries.

Given the number of red flags and spurious argumentation, I’m not going to waste my time on this tome, unless I see some seriously compelling reasons why I should.

Other articles:
Sumner on how he misrepresents his opponents.

Larry Summers.

Piketty’s savings rate assumptions are implausible.

Wolfers on Piketty

G and R aren’t correlated with inequality.

4 Comments leave one →
  1. June 10, 2014 9:50 am

    Great post Piketty seems ridiculous to me. Even Leon Helmsley as ill tempered as she was gave away most of her money on her death (

    It is not inherited wealth that is at the top now so why worry about it now? One charitable generation, one bad investing generation, one spend thrift generation, one barren generation, one fecund generation can disperse a fortune. Since inherited wealth is getting less at the top why seek to tax it away.

    • June 10, 2014 11:51 am

      I’m glad you liked it. Just the sheer number of implausible assumptions and then sweeping unnuanced claims he makes from the results of his model is just too much for me to swallow. I prefer writers who do the reverse – a fortiori models, solid real world examples, and then hedged and subtle policy implication sections.

  2. joan permalink
    June 12, 2014 7:40 am

    Piketty second Law is K/Y=(S-dK)/g where S is the total savings rate of the economy d K is depreciation rate for assets and g is growth rate of output Y so it can be written as investment divided by growth rate is proportional; to Capital divided by output which seems to be what you are saying. If you believe he did not account of depreciation of assets shows that the reviews are misleading. It is possible to invest so much that the return on capital falls, but that is not our problem, we save too little not too much so must borrow from other countries that save more.
    I do not think any economists question that the richer you are the larger fraction of your income you save on average. That is reason people believe cutting taxes on high incomes that grows the economy.
    However you are right that people can spend their returns on Capital and not reinvest it and that seems to be what they have been doing which is why our savings rate it so low and that cutting taxes did not increase the growth rate of GDP, so what is a problem in France may not be one in the US..

    • June 12, 2014 8:30 am

      The whole point is that r > g, and if you put depreciation in the model, r becomes dependent on the capital stock, and you can’t just have upwardly spiraling capital stock anymore. Increasing capital is the thing driving the whole model, but it’s also the thing which invalidates the key assumption. There are several countries, especially in East Asia, where capital has increased beyond the golden rule ratio, and hence further investment just leads to losses. I’m sure Piketty didn’t simply forget about depreciation, but I don’t think he took it seriously enough.

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