Robert Solow on Piketty

Solow writes,

if the economy is growing at g percent per year, and if it saves s percent of its national income each year, the self-reproducing capital-income ratio is s / g (10 / 2 in the example). Piketty suggests that global growth of output will slow in the coming century from 3 percent to 1.5 percent annually. (This is the sum of the growth rates of population and productivity, both of which he expects to diminish.) He puts the world saving / investment rate at about 10 percent. So he expects the capital-income ratio to climb eventually to something near 7 (or 10 / 1.5). This is a big deal, as will emerge. He is quite aware that the underlying assumptions could turn out to be wrong; no one can see a century ahead. But it could plausibly go this way.

…The labor share of national income is arithmetically the same thing as the real wage divided by the productivity of labor. Would you rather live in a society in which the real wage was rising rapidly but the labor share was falling (because productivity was increasing even faster), or one in which the real wage was stagnating, along with productivity, so the labor share was unchanging? The first is surely better on narrowly economic grounds: you eat your wage, not your share of national income. But there could be political and social advantages to the second option. If a small class of owners of wealth—and it is small—comes to collect a growing share of the national income, it is likely to dominate the society in other ways as well. This dichotomy need not arise, but it is good to be clear.

Both Tyler Cowen and Solow make the same point about wages, but they do so subtly. Let me be blunt: Piketty’s nightmare scenario, in which capital accumulates and has a high return, is a terrific scenario for wages in absolute terms. If workers care about what they can consume, as opposed to the ratio of their net worth to that of the capital owners, they would hate to see any policy that might interfere with the high rates of investment that Piketty is envisioning. Note, however, that I personally would not concede that the distinction between workers and capital-owners is as clear-cut as it is in the Solow growth model.

The tone of Solow’s review is generally laudatory. It also is by far the clearest explanation of Piketty’s argument that I have read. It reflects Solow’s command of the logic of economic growth as well as his abilities as a teacher.

I think that Solow arrives at a higher evaluation of the book than I would for two reasons. First, Solow gives Piketty the benefit of the doubt on nearly every uncertain issue. For example, on the crucial assumption that Piketty makes that the rate of return on capital remains steady even as the capital-income ratio creeps ever higher, Solow writes,

Maybe a little skepticism is in order. For instance, the historically fairly stable long-run rate of return has been the balanced outcome of a tension between diminishing returns and technological progress; perhaps a slower rate of growth in the future will pull the rate of return down drastically. Perhaps. But suppose that Piketty is on the whole right.

On another issue, the fact that inequality is high between different workers, not just between workers and capitalists, Solow offers a hand-waving defense of Piketty. Solow writes,

Another possibility, tempting but still rather vague, is that top management compensation, at least some of it, does not really belong in the category of labor income, but represents instead a sort of adjunct to capital, and should be treated in part as a way of sharing in income from capital…

it is pretty clear that the class of supermanagers belongs socially and politically with the rentiers, not with the larger body of salaried and independent professionals and middle managers

To this, I would say: why draw the line at supermanagers? Why not say that the salaries of college professors that are paid out of university endowments are “a way of sharing income from capital”? The way I look at it, the amount of income that does not represent “a sort of adjunct to capital” (including human capital) is miniscule, perhaps less than 1 percent of GDP.

My second disagreement with Solow is that he, like Piketty, omits any discussion of risk as a component of “r.” In that regard, Tyler Cowen’s skeptical review better accords with my own thinking.

The way I see it, Piketty and Solow work with models that incorporate homogeneous workers (with no differences in human capital) and homogeneous capital (with no differences in ex ante risk or ex post returns). The real world is so far removed from those models that I simply cannot buy into the undertaking.

Greg Mankiw Quotes a Professor of Social Work

Greg cites a piece in the NYT by Mark R. Rank. Before I get to that, let me read to you from Rank’s bio page at Washington University.

Mark R. Rank is widely recognized as one of the foremost experts and speakers in the country on issues of poverty, inequality, and social justice. . .

His next book, “One Nation, Underprivileged: Why American Poverty Affects Us All,” provided a new understanding of poverty in America. His life-course research has demonstrated for the first time that a majority of Americans will experience poverty and will use a social safety net program at some point during their lives.

He is currently completing a book with his long-time collaborator, Thomas Hirschl of Cornell University, entitled, “Chasing the American Dream: Understanding the Dynamics that Shape Our Fortunes.” It explores through a multi-methodological approach the nature of the American Dream and the economic viability of achieving the Dream. The book is designed to shed light on the tenuous nature of the American Dream in today’s society, and how to restore its relevance and vitality.

The NYT piece is based on the latter book. In it, Rank writes,

It turns out that 12 percent of the population will find themselves in the top 1 percent of the income distribution for at least one year. What’s more, 39 percent of Americans will spend a year in the top 5 percent of the income distribution, 56 percent will find themselves in the top 10 percent, and a whopping 73 percent will spend a year in the top 20 percent of the income distribution.

…Likewise, data analyzed by the I.R.S. showed similar findings with respect to the top 400 taxpayers between 1992 and 2009. While 73 percent of people who made the list did so once during this period, only 2 percent of them were on the list for 10 or more years. These analyses further demonstrate the sizable amount of turnover and movement within the top levels of the income distribution.

Some comments:

1. Many people experience having an income below the poverty line for a short period of time. However, I am not sure that one can conclude from this that they “experience poverty.” Think of graduate students, or people who experience a spell of unemployment but otherwise are able to hold a job.

My first year after graduate school, when I got married and started working at the Fed, my salary made us eligible for Montgomery County’s low-income housing assistance (we did not make use of that eligibility). Our household income probably did not exceed the median household income until my 8th or 9th year out of grad school.

2. Similarly, many people experience windfalls. We broke into the top 20 percent for exactly one year, the annus mirabilis 1999 when my Internet business got sold.

3. You would think that the perspective of a social work professor on income dynamics would be less valuable than the perspective of, say, Thomas Piketty. Yet it is possible that Rank’s new book might have something to add, because he is working with longitudinal analysis that follows the same people over time, rather than working with a time series of cross-sections and writing down a model that treats households (really, just abstract social classes) as persistently occupying the same place in the income distribution.

4. I have started reading Chasing the American Dream, and I may write a review. It is much closer to what you would expect from a professor of social work than what you would expect from, say, Greg Mankiw. The book treats economic position as being determined by race and social class.

Brad DeLong on Piketty

Brad writes,

We have a world in which some eminent economists (Larry Summers) say r1 is too low, and other eminent economists (Thomas Piketty) say r2 is too high…

The difference between r1 and r2 is the risk premium. In a well-functioning market economy with well-functioning financial markets, there are powerful reasons to believe that this risk premium should be small: less than 1%-point per year. The fact the risk premium appears to me to be 7%-points per year today is a powerful evidence of the profound dysfunctionality of our financial markets, and of their failure to do their proper catallactic job. But that is a separate and largely independent discussion: that is a dysfunction of our modern market economy which is different from either the dysfunction feared by Summers or the dysfunction freaked by Piketty. For the moment, simply note that it is perfectly possible for all three of these major dysfunctions to occur together.

Pointer from Mark Thoma. Read the whole thing. The risk-premium solution was also suggested here in a comment by Matt Rognlie.

So far, the left-wing journalistic verdict on Piketty is rapture. Economists, even those inclined to agree with Piketty’s conclusions, seem somewhat unsatisfied with with his treatment of capital and interest.

Krugman Reviews Piketty

He sticks to economics, which makes the review quite readable. He drops this sentence into the end of a minor paragraph:

the fact is that the most conspicuous example of soaring inequality in today’s world—the rise of the very rich one percent in the Anglo-Saxon world, especially the United States—doesn’t have all that much to do with capital accumulation, at least so far. It has more to do with remarkably high compensation and incomes.

In fact, that is one of the more damning criticisms of Piketty that one is likely to read. Krugman stops short of calling the book an intellectual swindle, but it appears to be one (I have yet to read it).

Suppose we know two things: First, wealth at the high end of the wealth distribution has increased a lot. Second, the share of wages and salaries in GDP has decreased. Do these two things tell us that capital is gaining at the expense of labor?

The swindle here is to treat “capital” and “labor” as homogeneous, separate categories. You are either a worker or a coupon-clipper. In fact, most people are labor-capitalists. They invest in human capital. They decide how much to save and how much risk to take with their savings. And there is a lot of heterogeneity among these labor-capitalists.

Bill Gates, Jeff Bezos, and Mark Zuckerberg are not coupon-clippers. Their wealth comes from a combination of skill and risk-taking.

Looking at the 21st-century economy through the filter of the Marxist categories of “capital” and “labor” is not particularly insightful. This is not a good era for either a plain coupon-clipper or an ordinary worker to accumulate great wealth. For that purpose, it is better to be a successful entrepreneur or a high-skilled worker.

I think that Krugman correctly views Piketty’s scenario dominated by inherited wealth as offering a speculative analysis of the future. It does not well describe the present.

For example, suppose you look at the Forbes 500 or somesuch, meaning a list of the wealthiest Americans. Compare the list in 2010 to the list in the supposedly egalitarian era of 1950-1970. I will wager that the 2010 list has a smaller fraction of inherited fortunes as opposed to fortunes that were amassed by the wealthy themselves.

Moreover, looking at the low interest rate on risk-free assets today, I would say that the near-term future is one in which the inheritors shall be meek. The next generation of great entrepreneurs should easily surpass the heirs of current fortunes.

UPDATE: Steve Sailer has links to some papers on the Forbes 400. In particular, one paper by Kaplan and Rauh, says

We find that the Forbes 400 in recent years did not grow up as advantaged as in decades past. Those in the Forbes 400 today are less likely to have inherited their wealth or to have grown up wealthy.

Ignorance, Exit, and Voice

In this essay, I suggest that even if voters were knowledgeable about issues, our democratic process would still not be as desirable as having the exit option. This is in the context of talking about a recent book by Ilya Somin. In my view, an even more frustrating problem than voter ignorance is the enchantment that many people have with democratically elected leaders.

As I see it, reasonable government, including the protection of liberty, requires those in office to follow norms of behavior that are bound by Constitutional constraints and principles of limited government. The problem with democratic enchantment is that it sanctions whatever majority-elected political leaders can get away with.

Technology or the Safety Net?

The Financial Times reports,

Non-store retail, which includes online shops, recorded a boom in sales – up 31 per cent to $380bn. But the number of establishments rose only 12 per cent to 66,339 while employment in the sector was down slightly.

Pointer from Tyler Cowen. The gist of the article is that the U.S. economy is becoming more capital intensive.

Casey Mulligan, who gave a talk yesterday on his book The Redistribution Recession, says that 2/3 of the shortfall in employment can be explained by additions to the safety net. The big ones are extending unemployment compensation from 26 weeks to 99 weeks and taxpayers now supplying 65 percent of the cost of COBRA (health benefits) for people who lose jobs. Mulligan combines the various safety-net enhancements made since 2007 with standard estimates of how the “wedge” between the net gain to the worker from employment and the cost of compensation to employers affects hours worked, and that is how he arrives at his 2/3 figure.

In short, the economy has become more capital intensive since 2007 in large part due to the expansion of the safety net. Mulligan pointed out that this does not mean that the expansion was wrong, but he says you should not expect to return to the same rate of labor force participation that we had a few years ago as long as the new measures remain in place. And it will get worse once health care reform takes hold–including many Republican proposals as well as Obamacare. I do not have details on how health reform affects employment–that is the topic of Mulligan’s new book.

Mulligan would like suggestions for a title for the new book. I might suggest “Side Effect: Health Care Reform and the Job Market”


Scott Sumner writes,

I distinctly recall that Robert Shiller did not recommend that people buy stocks in 2009. That made me wonder when Robert Shiller did say it was a good time to buy stocks.

Barry Ritholtz writes,

By one metric — Yale professor Robert Shiller’s cyclically adjusted price-to-earnings ratio, or CAPE ratio — stocks are especially pricey. This has become the bears’ favorite valuation measure. But beware of cherry-picking any particular metric that rationalizes your position. Indeed, over the past 20 years, the CAPE measure has pegged U.S. equities as “overvalued” 85 percent of the time.

But for me, the most interesting Shiller-bashing is in the book I am reading by Duncan Watts, Everything is Obvious. He reproduces a chart created by David Pennock and Dan Reeves, using option prices to derive the probability distribution of future stock prices. The chart shows clearly that the uncertainty about future stock prices is much higher than the variation of past stock prices. That is exactly the criticism that I made of Shiller’s famous “variance bounds” estimates when he first published his work on that topic, and which he told the journal editor to reject. I still think that I was right. I should note that Watts does not make the Shiller connection in his book. However, I think that Watts gives us plenty of reason to be cautious about making statements like “Shiller called the housing bubble.”

I wish that more economists were aware of Watts.

My Review of Brynjolfsson and McAfee

Is here. An excerpt:

Back at the turn of the millennium, these applications seemed to Kurzweil to be on the near-term horizon. These strike me as the same applications that Brynjolfsson and McAfee suggest are on the near-term horizon today. While a few of Kurzweil’s other predictions did materialize, and while some of these applications are certainly closer to reality today than they were in 1999 or 2009, we should be wary that some of what The Second Machine Age tells us to expect may not in fact appear for several decades, if ever.

Trying to Understand

I was sent a review copy of The Moral Foundation of Economic Behavior, by David C. Rose. Here is what I think is a key passage, which is italicized in the book, on p. 140:

the moral foundation of economic behavior is a norm of unconditional trustworthiness made possible by a preponderance of people possessing an ethic of duty-based moral restraint while not regarding moral advocacy as a moral duty.

I have not been able to follow the argument in the book. This podcast with Russ Roberts gets me closer. Here is what I think Rose is saying.

1. Trust is difficult as groups get large. You cannot completely rely on incentives, reputation, and the like.

2. The best way to obtain trust in a large group is for people in the group to be committed to following moral rules. They won’t cheat, even if they can get away with it, because they think that it is wrong to cheat.

3. People have two potential motives to break rules. One motive is to obtain personal gain. Another motive is to achieve some higher moral objective. Rose wants to say that either motive serves to undermine trust. Therefore, telling someone to focus on higher moral objectives (to “think globally, act locally”) is to encourage that person to break rules, which ultimately will lead to a breakdown in trust.

Again, I do not necessarily get the argument, so do not take my interpretation as gospel. In a way, I see this through the lens of the alleged distinction between act-utilitarianism and rule-utilitarianism. Act-utilitarianism says that you should choose each act in order to make people better off. Rule-utilitarianism says that you should follow rules that, if they were always followed, make people better off. I see Rose as saying that rule-utilitarianism is better, because act-utilitarians cannot be trusted. The act-utilitarian may break his promise for what he sees as perfectly defensible reasons. The rule-utilitarian keeps his promise, regardless. (There is a well-known philosophical problem with the distinction between act-utilitarianism and rule-utilitarianism. You can argue that the former reduces to the latter, or vice-versa. Try to ignore that philosophical problem here, since Rose himself does not rely on that distinction.)

4. Another way to put this is that there are two types of opportunism. There is selfish opportunism, which is breaking the rules to gain for yourself. And there is what I might call utilitarian opportunism, which is breaking the rules in order to achieve what you think is a higher good. About this utilitarian opportunism, Rose would say that:

a) our moral intuition, which is based on based on small-group society, is that utilitarian opportunism is fine. However, this is incorrect.
b) in fact, in a large-scale society, utilitarian opportunism does as much to undermine trust as selfish opportunism.
c) our current educational system and elite culture, rather than urging people to follow rules, urges them to behave morally. It encourages, in both individuals and politicians, utilitarian opportunism.
d) This trend in education and culture threatens to undermine trust.

Again, I am just trying to understand. Had I been the editor of this book, I would have gone back and forth with the author until I was satisfied that the points were made clearly.