I’ve frequently been asked what I think about the current book du jour, Thomas Piketty’s Capital in the Twenty-First Century. Larry Summers suggested just this week in his review that the book deserves the Nobel Prize in Economics. Well, I’ve finally gotten around to reading and rereading it—all 577 pages. Like most reviewers, I found many things to like, as well as some things to be concerned about. I’ll start with the strengths.
Good comparative data
It’s a treat to have data about all the major countries over the last couple of hundred years and see how they stack up, both with their own past and between each other.
For instance, how interesting that Europe suffered the same decline in per capita growth rates in the period 1970-1990 to the period 1990-2010 as the US, i.e. from 2.2 percent to 1.5 percent! This ties in with the Shift Index finding of the decline in the rates of return on assets of US firms by three-quarters from 1965 to 2011.
How fascinating to see that per capita GDP growth over recent decades is the same in the US and Europe although taxes are much lower in the US than in Europe:
“In contrast to what many people in Britain and the United States believe, the true figures on growth… show that Britain and the United States have not grown any more rapidly since 1980 than Germany, France, Japan, Denmark, or Sweden. In other words, the reduction of top marginal income tax rates and the rise of top incomes do not seem to have stimulated productivity (contrary to the predictions of supply-side theory) or at any rate did not stimulate productivity enough to be statistically detectable at the macro level.”
I was also intrigued to learn how the US went from being one of the most egalitarian countries a century ago, to being the least egalitarian of all: it’s easy to forget that in this country there was once a frontier spirit of looking out for others that has all but vanished from the political sphere.
How interesting to learn also that inequality in Europe, after declining for the much of the 20th Century, has now returned to pre-World War I levels, i.e. the time when Marcel Proust was writing his novel about gaining access to a world of aristocratic luxury!
The same information could have been communicated in a much shorter book, but it’s good to have it available, along with the massive store of online data and graphs that is provided.
Excessive executive compensation
The book has much useful information on the compensation of those Piketty calls (ironically) the ‘super-managers,’ who make up most the top 0.1 percent of income earners.
“The vast majority (60 percent to 70 percent, depending on what definitions one chooses) of the top 0.1 percent of the income hierarchy in 2000– 2010 consists of top managers. By comparison, athletes, actors, and artists of all kinds make up less than 5 percent of this group. In this sense, the new US inequality has much more to do with the advent of “super-managers” than with that of ‘superstars.’… The financial professions (including both managers of banks and other financial institutions and traders operating on the financial markets) are about twice as common in the very high income groups as in the economy overall (roughly 20 percent of the top 0.1 percent, whereas finance accounts for less than 10 percent of GDP).
After a long (and somewhat rambling) search for any rational basis for the explosion in pay, the book comes to the implausible conclusion that the explosion is caused by variations in the marginal tax rate. That conclusion may fit the numbers, but it ignores what's really going on here.
There is no mention of the actual driving force behind increased executive compensation, namely, the shareholder value movement which explicitly proposed compensating executives with stock so that their actions would be aligned with shareholder value. This began with Milton Friedman—another Nobel Prize winner in Economics—who proposed back in 1970 that the purpose of a firm is to make money for its shareholders. In 1976, Professors Meckling and Jensen gave an economic rationale for generously compensating managers with stock to encourage them to focus on short-term shareholder value. Ronald Reagan and Margaret Thatcher gave this political cover and the rest is history. The C-suite simply took advantage of it. It has become pervasive throughout large organizations, with the devastating financial and economic consequences that are now documented in Deloitte’s Shift Index and in a Harvard Business School report.
Piketty treats this explosion in compensation as a “rent” that companies are paying to “super-managers” and concludes that the right way to deal with the problem is to increase taxes on the rentiers. The book misses the more obvious solution: removing the intellectual foundations of the pay increases by rejecting the shareholder value theory.
Growth will be positive
I had been told that the book was as negative about the economic prospects as Robert Gordon’s theory that I discussed last week, namely, that economic growth in developed countries would decline to almost zero by 2050.
As it turns out, the book offers no projection at all, but instead provides "a median scenario" of per capita output growth of 1.2 percent. “I am unable,” he writes, “to predict whether the actual rate will be 0.5 percent, 1 percent, or 1.5 percent. The median scenario I will present here is based on a long-term per capita output growth rate of 1.2 percent in the wealthy countries, which is relatively optimistic compared with Robert Gordon’s predictions (which I think are a little too dark).”
On more careful reading and re-reading the book, one can see how the impression of negativity emerges elliptically. The book suggests an extrapolation from the past, then notes that it would be foolish to suggest that such a thing might actually happen in the future, but then implies that such a thing will happen as part of the continuing discussion.
For instance, at one point, Piketty discusses Ricardo’s apocalyptic worry that land prices would escalate without end, and then shows his economic smarts by explaining why this didn’t actually happen: supply and demand.
But, the book warns, the apocalypse may happen with something else, say, real estate in urban capitals for which rents may escalate without end. Thus
“if the trend over the period 1970– 2010 is extrapolated to the period 2010–2050 or 2010– 2100, the result is economic, social, and political disequilibria of considerable magnitude… disequilibria that inevitably call to mind the Ricardian apocalypse. To be sure, there exists in principle a quite simple economic mechanism that should restore equilibrium to the process: the mechanism of supply and demand…. Never mind that such adjustments might be unpleasant or complicated… As always, the worst is never certain to arrive. It is much too soon to warn readers that by 2050 they may be paying rent to the emir of Qatar. I will consider the matter in due course, and my answer will be more nuanced, albeit only moderately reassuring.”
Although by the end of the book, we never learn whether we will be paying rent to the emir of Qatar in 2050, we are left with the distinct impression that some kind of Ricardo-style apocalypse is just around the corner. If the book had given us the specifics of the apocalypse that is going to happen, we could have checked out whether it is likely. By leaving out the specifics, the menace becomes all that more terrifying. It is here that Piketty’s background in 19th Century fiction comes in handy.
But growing inequality is inevitable
The central thesis of the book is decidedly negative. It argues that the rate of return on wealth has remained roughly stable for all countries over all time periods at around 4 percent to 5 percent, while per capita economic output rarely gets above 1.5 percent, and then only in exceptional “catch-up” phases. He draws the conclusion that income inequality is bound to increase ad infinitum until some event like a war or an economic depression or government intervention.
This leads him to propose a government intervention, which he explicitly describes as “utopian”: i.e. a global wealth tax should be imposed. He admits that this would be both technically difficult and politically impossible to implement. But he can see no other way out of rapidly growing inequality (apart from a war or a depression) and thinks the idea should be discussed.
The danger is that a quixotic proposal like this will cause so much noise, attention will be distracted from more practical actions, like getting reporting going on the specifics of what is actually happening in tax havens, that could actually get implemented.
Many economists have questioned whether the basic statement of the problem is correct. Is the growth rate really 4 percent to 5 percent? Is it cumulative? Are the returns invested? If it were true, why are so many of the Forbes 400 newcomers, rather than old wealth? And so on.
There has been less discussion as to whether the ceiling of 1.5 percent per capita growth rate is correct. The US and Europe did in fact achieve per capita growth rates above 2 percent in the period 1950 to 1990. Why can’t they repeat that? What would it take?
The book doesn’t discuss these questions. Instead, it embraces the emerging pessimistic consensus of the Great Stagnation (Tyler Cowen) and the “Secular Stagnation” (Larry Summers), namely, that the economic growth is going to be slow for the foreseeable future, no matter what happens.
This is understandable given the macro-economic character of Piketty’s analysis. It basically says that our economic institutions are what they are. A corporation is a corporation. A bank is a bank. They are black boxes so far as macroeconomics is concerned. Nothing much we can do about them from a macroeconomic perspective.
But is that the only perspective?
Capitalism is about rents
Piketty is a fan of 19th Century novels and quotes extensively from them in the book. We have much to learn, he believes from Jane Austen’s landed gentry who were doing little but investing in government bonds and peaceably living off the rents of their tenants, with an occasional sortie to the West Indies.
“When Honoré de Balzac and Jane Austen wrote their novels at the beginning of the nineteenth century, the nature of wealth was relatively clear to all readers. Wealth seemed to exist in order to produce rents, that is, dependable, regular payments to the owners of certain assets, which usually took the form of land or government bonds… Has the deep structure of capital really changed? Capital is never quiet: it is always risk-oriented and entrepreneurial, at least at its inception, yet it always tends to transform itself into rents as it accumulates in large enough amounts— that is its vocation, its logical destination.”
Piketty's book seems to have a deep-seated assumption about capitalism’s destination: it always ends being about providing rents. The current slowdown in economic growth is thus a sign that the rentiers may be taking over. The remedy to these rent-seekers is always the same: tax them!
The role of management
One has to wonder whether Piketty, in addition to reading 19th Century novels, might also spend some time reading about management and the Creative Economy.
It’s true that there is a problem of slowing economic growth and growing inequality. But to imply, as he does so charmingly, that the root causes of these problems—defunct corporate management, excessive executive compensation and an out-of-control financial sector—are like the world of Jane Austen is madness. Bill Gates is not a reincarnation of Mr. Darcy. The two worlds operate on fundamentally different dynamics.
The book's deep assumption that the vocation of capital is to acquire capital so as to be able to charge rents is an 19th Century mindset applied to a 21st Century world. According to the book, nothing has really changed.
But in fact everything has changed: any CEO who announced that the goal of his or her firm was to accumulate property so as to be able to collect steady rents wouldn’t last long. The book however doesn’t seem interested in such differences. Instead it tries—unsuccessfully, in my view—to establish the similarities.
Having established that super-managers are rentiers, the solution becomes obvious: tax them and confiscate the rents they are extracting!
This is where the 19th Century mindset of capitalism being about “rentiers” leads Piketty astray. The solution to rotten corporate management and an out-of-control financial sector is not more taxes on rentiers. It’s fixing corporate management and refocusing the financial sector on its proper mission: financing the boring but real economy that provides goods and services.
It should be no surprise that when the corporate world pursues maximizing shareholder value—which even Jack Welch has called “the dumbest idea in the world”—that the rates of return on assets and on invested capital on US firms should decline. If corporate rates of return on assets are around 1 percent, it should be no surprise that economic growth rates are low. And if economic growth rates are low, it should be no surprise that the economic pie won’t be growing fast enough to enable greater income equality. After the top takes its share, there won’t be enough left for the rest.
The principal root cause of the problem of growing inequality is not the rentiers who have taken over the economy but slow economic growth. The solution is accelerating economic growth. Low economic growth in turn is caused principally by obsolete corporate management.
Nor should it be any surprise when the financial sector spends most of its energies in creating, not just a vast global gambling casino with more than a trillion dollars of derivatives in play, but a rigged gambling casino, in which the house has advance notification of which bets will win, that the real economy suffers. When the financiers are busy “making money out of money” and acting like “rats in the granary” as Charlie Munger put it, it should be no surprise that economic growth in terms of real goods and services is imperiled. These are not rentiers fulfilling capitalism’s true destiny of providing rents. These are "rats in the granary" who need to be gotten out of the granary and focused on activities that are actually useful to the economy.
What would it take to actually fix the problem?
Fixing the root cause of the problem of inequality means fixing the root cause of the decline in economic growth. This in turn means fixing obsolete management practices. Corporate managements have to stop pursuing defunct management principles and start managing the organizations in a way that is appropriate to the 21st Century.
We know what needs to be done to get things right again and back on the path of corporate and economic growth. More than a score of books have been written about it. Some large corporations, and very many small and medium size corporations, are already practicing the new principles.
Thus corporatiosn need to be focusing, as Peter Drucker saw back in 1973, on “the only valid goal for a corporation”, namely, delivering value to customers. And they need to be implementing all the other principles that make this a reality—a shift from controlling individuals to enabling teams and ecosystems, a shift from bureaucracy to agility and dynamic linking, a shift from values of efficiency to those of continuous improvement and transparency; and a shift from one-way top-down communications. This is Management 101 for the 21st Century. Yet few big organizations are practicing it. Those that do, like Apple [AAPL] and Amazon [AMZN] among many other lesser-known firms, are remarkably successful.
Time that macro-economists found out about it.
And read also:
The dumbest idea in the world: maximizing shareholder value
Most of what we know about management is wrong
Navigating the phase change to the Creative Economy
Is the Creative Economy Also in Trouble?
The Five Big Surprises of Radical Management
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