Dual Endogeneity: Capital Share, Institutional Failure, and Piketty

While much of the economics and finance commentariat has been debating Thomas Piketty's epic Captial in the Twenty-First Century in recent months, one point I have not seen raised is whether a concern for inequality is increasing in national income. That is to say, do countries begin to care more about inequality more as they become richer? (I am analogizing this to the construction employed by Brad DeLong regarding government services as a normal good on a country-wide level. See his 2010 IAS 107 lectures.)

So the hypothesis here is that "concern for economic inequality" is a normal good, in the sense that, as nations become wealthier, they demand more of it. This is a loquacious way of saying, in effect, that this is a first-world problem. 

This is not, of course, to minimize the seriousness of the issue. Whether one believes that the marked increase in income and wealth inequality in the developed world over the last thirty or forty years is justified (the "wages are determined by the value of the marginal product" argument), or not justified (the "wages include economic rents and are determined, at least in part, by market power" argument), or if one subscribes to some hybrid of these two views, the plain fact is that economic inequality is rising. In the former view, the earnings of lower-income workers have been stagnant because their skills have not kept pace with technology, and globalization has exposed them to foreign competition. In this view, people with less capital have chosen to save less of their income than people with more capital. In the latter view, institutional changes have stripped lower-income workers of the bargaining power to negotiate wages that keep pace with increases in productivity, and these workers have consequently saved less as their wages tend toward subsistence.

Just as there is a continuum of views as to the reasons for rising economic inequality, there are (at least) two views about what this rise means. First is the "negative feedback" view, popular among those whose economic views tend toward those of the New Classical school. In this view, rising inequality serves as an incentive to technological progress, which is inherently egalitarian. As new technologies emerge, some economic hegemonies are broken, while new ones are made. Thus, (some of) the rich become poorer and (some of) the poor become richer. From this perspective, economic inequality is likely periodic over longer time horizons.

The alternate view about the meaning of a rise in economic inequality is the "positive feedback" view. This is Piketty's prediction. His now-famous "r > g" framework describes a relationship among returns to capital, economic growth, the elasticity of substitution between capital and labor, and the capital share of income in which returns to capital are sufficiently high so as to increase the capital share steadily over time. In this framework, the capital share of income rises asymptotically. This leads to economic inequality as the stock of capital is disproportionately concentrated in the hands of a small fraction of the populations of industrial countries.

Neither view about the justification of rising economic inequality is inherently incompatible with either view about the implication of the rise. That is to say, the view that all incomes are "rightly earned" (determined by the value of one's marginal product) is not intellectually inconsistent with the view that the capital share is tending toward infinity. Nor is it intellectually inconsistent to simultaneously believe that wages are largely determined by market power and that economic inequality is cyclical and self-correcting. 

Whether or not economic inequality is justified, if its rise is not self-correcting, the end result would be disastrously destabilizing. Whether this means the Marx-Engels story about workers casting off their bonds, or it means the Acemoglu-Robinson story about a decreased faith in democratic and market institutions, leading to greater political corruption and a breakdown of property rights and other norms, the story is certain to end in tears. Even if the rise in economic inequality is self-correcting, there is a danger that the correction looks less like the "creative-destruction-through-technological-progress" story, and more closely resembles the "industrial-sabotage-and-torching-the-estates" story. 

Piketty's remedy for this problem is a global wealth tax. This policy is likely practically difficult and politically impossible, but it is important that it be discussed; income taxes were once thought practically difficult and politically impossible, but most of the industrial world has now had them for a hundred years. In the United States, this would actually mean an expanded wealth tax, as most communities already tax developed and undeveloped land, leading to a deeply regressive wealth tax, as the share of total wealth represented by one's home is decreasing in income. 

So this brings us back to "concern for economic inequality" as a normal good. Maybe rich countries care about this issue because people in rich countries have more to lose in a upheaval. That's a pretty unsatisfactory answer; whatever people have got, "most of it" is always a lot to lose. Maybe rich countries care more about this issue because their citizens have grown comfortably unaccustomed to riots and burning factories, while people in less-developed countries expect that there will be those sorts of things, and are chiefly concerned with feeding, clothing, and housing their families. 

Whatever the reason, economic inequality is rising, and has been for a few decades. And whatever the reason, people have begun to notice, and to care. So what is to be done about it? As noted above, the only wealth tax that is within the Overton Window is the regressive property tax model in place in most of the United States. If Piketty's prediction holds, and the capital share of income continues to rise, the frontier of politically acceptable policies will retreat further from any policy that might reverse that trend. This is grim.

Another approach could be a policy portfolio that aims to democratize capital ownership. This could take the form of government-managed individual stock and bond portfolios, sort of a government 401k. One problem with this is that people are going to want to liquidate them prematurely. Can that be disallowed? This plan seems problematic. Another possibility is a US sovereign wealth fund. If the federal government raised revenue in this manner, it would allow tax rate reductions for poorer people, reducing inequality indirectly.

There are some that would argue that the moral way to organize society is to establish some set of rules and then let the market sort it out. Implicit in this view is that there are no externalities, no irrationalities or other behavioral inefficiencies, and no information asymmetries. Also implicit in this view is that the effect of market power imbalances on trade are either immaterial, or a feature of the system. It is a natural result of this view that "limited government" could be viewed as a virtue in and of itself. 

The fact is, free-marketeer rhetoric aside, there is neither a divinely-ordained income and wealth distribution, nor a divinely-ordained optimal mix of command and markets. It's all choices. This is why democratic institutions are so important. The increased concentration of wealth and incomes has begun to erode both democratic institutions, via the sanction of purchased political favors, and the belief in the utility of markets. The dung heap of history is teeming with the rotten carcasses of civilizations that lost faith in democracy and markets. If we are lucky, the path dependency of this condition is weak.

For an excellent mathematical treatment of r > g, including a necessary discussion of the different components of r, see Brad DeLong.