Fairy tale capitalism

As students of economics, we are quite used to being told fairy tales. The most famous one is the Invisible Hand of Adam Smith. Another fairy tale, not as well-known, is the Kuznets Curve. The name derives (rather unfairly as we shall see) from the Belarusian-American 1971 Nobel Prize winning economist, Simon Kuznets. So goes the tale: the natural progression of development is towards industrialisation and urbanisation. Initially, this leads to increased inequality in society, as capitalists get richer and the influx of rural labour holds wages down.

But as employment opportunities grow and the flow of rural labour dries up, wages rise and an equalisation tendency appears, which gets stronger over time. Thus, if we plot inequality against time, we get an inverted-U or bell-shaped curve, the Kuznets Curve. If this hypothesis were true, it would show that the “trickle down” of the benefits of growth to all is a natural and automatic part of capitalist development. In former US president John F. Kennedy’s memorable phrase, “a rising tide lifts all boats”.

The recent work of Thomas Piketty, Capital in the Twenty-First Century, provides the strongest demolition of the Kuznets Curve hypothesis so far. Piketty’s biggest achievement is that he is able to match the monumental statistical edifice that Kuznets pioneered. The publication in 1953 of Kuznets’s Shares of Upper Income Groups in Income and Savings was a truly landmark event i

n the history of economics. Kuznets showed that between 1913 and 1948, there was a sharp decline in income inequality in the United States. His work was transparent in a manner that was unprecedented in the history of economics, with every source and method revealed in the finest detail. And what gave even greater credence to the Kuznets Curve was that the trend of declining inequality persisted right up to the 1970s.

Piketty adopts both Kuznets’s methods and his data, and extends their coverage over time and space. He shows that since 1980, there has been a sharp rise in inequality in the US, Japan and Europe. Mind you, Piketty is no loony left-winger. He makes it abundantly clear that he has never felt “the slightest affection or nostalgia” for the collapsed communist regimes of his youth. He also unabashedly speaks of having “experienced the American dream” when he came to the US at the age of 22.

So it is not ideology but the robust 200-year data he marshals that makes Piketty decisively reject the Kuznets Curve. Indeed, his data shows a U-curve in the trends of inequality in the advanced capitalist nations of the world — US, Japan, Germany, France and Great Britain — the exact opposite of the Kuznets Curve. Inequality grows sharply after having fallen initially for a few years.

The first insight Piketty provides is that there is nothing natural or automatic about declining inequality under capitalism. It is the shocks of war, the policies of a Keynesian welfare state and a strong labour movement that led to a decline in inequality in the 60-year period (1914-1974) that Paul Krugman has called “the great compression”. These were the decades that saw the emergence of what John Kenneth Galbraith termed “countervailing power”. And it is the unravelling of this balancing power and a shift towards free-market fundamentalism that led to the rise in inequality after 1980. So much so that levels of inequality in the US in the first decade of the 21st century were higher than the extreme disparities of the 1920s.

Of course, the Kuznets Curve being projected as a natural law under capitalism owes more to the way many made an ideology out of his research than the work of the master himself. And contrary to what even Piketty claims, in his presidential address to the American Economic Association in 1954, “Economic Growth and Income Inequality”, Kuznets is extremely cautious. Given the fragility of the data he has to depend on, Kuznets describes even his empirical findings as being “perilously close to guesswork”. He adds: “we are at a relatively early stage in a long process of interplay among tentative summaries of evidence, preliminary hypotheses, and search for additional evidence that might lead to reformulation and revisions… The paper is perhaps 5 per cent empirical information and 95 per cent speculation, some of it possibly tainted by wishful thinking.” Kuznets provides an illuminating analysis of the factors that lead to a divergence and convergence in incomes. In this analysis, government policies and social and political factors are given a prime role.

Piketty clearly recognises that there are powerful forces that can mitigate inequality. He specifically identifies diffusion of knowledge and skill as a key factor. But these too depend on state policies on education, access to training and skill development. Much more worrisome for Piketty is the fact that there are powerful forces of divergence that exacerbate inequality, even when there is sufficient investment in skills and training.

In recent decades, especially in the US and Britain, corporate CEOs appear to be able to raise their own pay (especially via stock options) almost without limit and with no apparent relation to their own productivity. As Krugman has shown, real wages for most US workers have virtually stagnated since the 1970s, but wages for the top 1 per cent have risen 165 per cent, and for the top 0.1 per cent have risen 362 per cent. At the same time, over the last 40 years, the top marginal tax rate in the US has declined from 70 to 35 per cent. But the biggest tax reductions have come on capital income, including corporate and inheritance taxes.

Thus, the most important engine that drives inequality up, according to Piketty, is the higher rate of return on capital compared to the low overall growth rate of the economy. In slowly growing economies, past wealth takes on a disproportionately higher importance. Inherited wealth grows faster than overall output and income. Further aggravating this tendency is the fact that savings rates tend to increase faster with greater wealth and that the average effective rate of return on capital is higher for those with higher initial capital endowments. Finally, a “Ricardian” rise in prices of oil and real estate makes the forces of divergence in incomes even stronger.

The power of Piketty’s work has been acknowledged across the ideological spectrum, including in favourable reviews in right-wing journals such as The Economist. In her recent Richard Dimbleby lecture (February 2014), Christine Lagarde, managing director of the IMF, states that “seven out of 10 people in the world today live in countries where inequality has increased over the past three decades… the richest 85 people in the world own the same amount of wealth as the bottom half of the world’s population… In India, the net worth of the billionaire community increased 12-fold in 15 years, enough to eliminate absolute poverty in this country twice over”.

To suggest that we can now speak of a Piketty U-curve of growing inequality, a new “natural law of capitalism” would, in my view, be a mistake. But it is clear that without serious debates around Piketty’s proposal for a global progressive tax on capital based on closer international co-ordination, the stability of the global economic system could be at risk, with all its attendant social consequences. Recent work at the IMF also suggests that in emerging economies, longer growth spells are robustly associated with more equality in the distribution of income. And that appropriate attention to inequality can bring significant longer-run benefits for growth. Piketty’s work provides a strong theoretical and empirical basis for the need to address the social legitimacy of the capitalist system within the framework of democratic governance. To repeat the last line of Kuznets’ 1954 lecture: “Effective work in this field necessarily calls for a shift from market economics to political and social economy.”

The writer is member, Planning Commission

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