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What do we really know about how wealth and income have evolved since the 18th century and what lessons can we take from that for centuries to come? For Thomas Piketty in Capital in the Twenty-First Century, one lesson is clear: inequality is self-generating within a capitalist system.

Capital, a magnificent 650-page work, first appeared in France late last year and already looms, in Paul Krugman’s eyes, as ‘‘the most important economics book of the year — and maybe of the decade’’. It is important because inequality is emerging as what Barack Obama recently called ‘‘the defining challenge of our time’’.

Piketty, whose work on income inequality helped inspire the Occupy Wall Street movement, is particularly well placed to answer these questions. He is a bit of a strange creature in modern economics: as much an economic historian and archeologist as a number-crunching theorist.

An academic at one of France’s elite grandes ecoles, Piketty has spent the past 20 years not only seeking to come to grips with economic inequality but also to make his conclusions digestible for public consumption.

After a period at the top American universities in the 1990s, he returned to France convinced American economics was infused with a ‘‘childish passion for mathematics’’ and was merely a forum ‘‘for purely theoretical and often highly ideological speculation … preoccupied with petty mathematical problems of interest only to themselves’’. In Capital, Piketty has surely avoided that.

This is accordingly a very French sort of a book. In the mid-20th century, French historians revolutionised history by seeking to show how events and institutions evolved over the long term. Memorably derided by Clive James as the ‘‘bean-counting’’ tradition of French intellectuals, the commitment to identifying the enduring rhythms and patterns of history through painstaking titbits of data was ambi­tious, worthwhile and too often forgotten. It is from within this tradition that Piketty embarks. He and his colleagues have dug out and assembled detailed databases documenting patterns of economic growth and distributions of wealth and income in more than 26 countries.

Piketty’s thesis is straightforward. Armed with 200 years of taxation receipts and other economic indices from developed countries (mainly France, Britain and the US) he shows there is one economic law that approaches a constant: the rate of return on capital (r) is usually higher than the rate of economic growth (g). Through time, the return on capital (defined to mean basically any asset) is about 5 per cent and growth averages 1 per cent to 2 per cent. This means in the long run people who have capital are destined to get richer faster than the economy grows. Inequality is inevitable.

Why is this apparently simple intuition such a novel conclusion? For some time the economic orthodoxy has been that as economies grow, inequality shrinks.

Simon Kuznets, the Nobel prize-winning economist more famous for his work on measuring gross domestic product, theorised that most economies would follow what became known as the Kuznets curve: a roughly bell curve-shaped pattern that reflected inequality rising as people left farms to work in factories, then falling as they demanded governments redistribute the benefits of industrialisation.

Writing in the mid-1950s, Kuznets correctly noted inequality had seriously decreased in first half of the 20th century. But his mistake was to think this was due to industrialisation. In fact, world wars and the accumulated budgetary and political shocks of the interwar period saw low savings rates, collapses in foreign capital and financial chaos.

At the same time, governments adopted redistributive policies that served to compress income and wealth distributions. The French government launched a one-off levy on assets in 1945 to fund reconstruction. Income tax rates in the US and Britain went as high as 80 per cent on the highest incomes. Fortunes were wiped out accidentally and deliberately.

But by the late 70s things started to change. Roaring economic growth ground to a halt and the consensus on fiscal redistributions began to fracture. The subsequent divergence in incomes and wealth is marked. Today most Western countries look more like they did in 1910 than 1960.

There is no clearer indication of this than the shift in American wages in the past 30 years. The top 0.1 per cent of households have increased their share of national income from 2 per cent in 1980 to almost 10 per cent today. Three-quarters of the rise of the top 10 per cent of incomes comes from a rise in the incomes of the top 1 per cent. By one estimate, 58c of every dollar of real income growth generated between 1976 and 2007 went to the top 1 per cent of households.

This skewed distribution of income from labour is, Piketty contends, probably higher than anywhere else in human history. Even in colonial India or apartheid-era South Africa, top earners earned less relative to the lowest earners than do Americans today.

What is behind it? Piketty’s primary culprit is the ‘‘rise of the supermanager’’: the increased remuneration flowing to top executives and financiers who disproportionately comprise the top 1 per cent of incomes (there are many more Jamie Dimons than JK Rowlings). And he is sceptical of any arguments that they deserve it. Piketty’s earlier work has shown the most generous pay increases usually track external market conditions rather than internal company performance. Rather than being a reflection of the marginal productivity of a new hyper-meritocratic managerial class, higher pay is due to executives’ greater personal incentives to seek raises once income tax rates were relaxed.

In France, the trend has been more muted but still real. In the first decade of this century, the share of wages going to the top 1 per cent increased by almost 30 per cent, a startling rise in an environment of negligible growth.

Nor has Australia escaped these shifts. The Productivity Commission reported in 2009 that the chief executives of ASX 100 companies had seen their annual compensation rise from an average of $1 million in 1993 (representing 17 times average earnings) to $3m in 2009 (42 times average earnings). The chief executive of BHP in the late 70s earned roughly six or seven times the average Australian earnings but today would earn closer to 250 times.

Inequalities of income are only part of Piketty’s story about rising inequality. Wealth matters almost as much. Absent any intervening shocks, substantial inequalities of income help create substantial inequalities of wealth. This is not Gilded Age plutocracy but the trend is in that direction.

The difference now is the ascent of what Piketty terms the ‘‘patrimonial middle class’’ (roughly the top 10 per cent to 15 per cent) that has been able to transmit sizeable wealth between generations. Inheritances may not be as big now but there are more people receiving them. And they are still pretty big. Today roughly 10 per cent of each age cohort in rich countries receives more in a single inheritance than the lifetime income of someone in the bottom 50 per cent of income earners.

Why does any of this matter? Because, as Piketty sees it, left to its own devices, current economic arrangements mean inequality will get worse, not better. It is a vision of ‘‘patrimonial capitalism’’ where the past devours the future. Declining population growth will lower overall economic growth to the historical trend (1 per cent to 2 per cent a year). But the economic return on capital is likely to remain at its historical average (4 per cent to 5 per cent a year). Without doing anything, the already wealthy are likely to become even wealthier.

Piketty may be too pessimistic about long-run growth rates. The modern, technologically connected economy is a new beast and rapid technological innovation could drive growth in productivity to offset declines in population. A global glut of capital may also lower overall returns.

But Piketty’s dexterity in marshalling evidence across countries, periods and fields becomes more valuable when faced with objections such as these. When he can appeal to several hundred years of tax data to prove a trend, his argument is harder to displace. The real problems of Capital are what it fails to mention.

First, it is a book that is long on description and somewhat short on prescription. Piketty’s solutions to the ‘‘inegalitarian spiral’’ range from the relatively prosaic (cracking down on tax avoidance) to the probably impossible (globally co-ordinated progressive taxes on wealth). Piketty himself seems pessimistic about stopping a putative slide towards plutocracy. Progressive redistribution is, as he sees it, much harder as the rich use their economic power to accrue more political power. While just 3 per cent of Americans are millionaires, nearly half of all congressmen are.

Second, wide-ranging as it is, Capital focuses only on inequality within and not between countries. Inequality is worsening everywhere inside states but declining between most states as developing countries get richer.

Nearly 10 per cent of the 99 per cent of Americans who fall outside the top 1 per cent of income earners in the US are in the global 1 per cent. Even most Americans on an income at the poverty line fall inside the top 10 per cent of global incomes. This would matter more if the policies that led to inequality in the developed world were also those leading to the compression of inequality between the developed and developing world. But it is likelier that the developing world is just profiting from catching up to rich countries.

In 1970, JK Galbraith observed in The Affluent Society that ‘‘few things are more evident in modern social history than the decline of interest in inequality as an economic issue’’. It is an observation that hasn’t worn well. As inequality has grown, interest has followed. Even though it is a work more concerned with the past 200 years, it’s no coincidence that the full title of Piketty’s book is Capital in the Twenty-First Century. Its ambition is to shape debates about the next two centuries, not the past two. And in that it may succeed.

This review originally appeared in The Weekend Australian Review.



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