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.

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9 Responses to Robert Solow on Piketty

  1. I left a similar comment on TC’s site. The following thought is mostly inspired by your book From Poverty to Prosperity, but also by remarks by Yanis Varoufakis on Econtalk. Modern “capital” doesn’t look like the giant bricks and mortar steel mills of the 19th century. It’s (1) intangible (recipes) (2) utterly dependent (for “rents”) on legal constructs and (3) non-rivalrous. The result is, the barriers to entry (or, presumably, to exit) are very weak. Much of this wealth is shared for free or just looted for free from the piratebay. In this context, Piketty’s vision of stable “capital” that rentiers just sit on seems very 19th century. I’m interested in a synthesis of those ideas in the context of PIketty’s challenge.

  2. Eric Rasmusen says:

    Has anyone broken down capital income into pure time-value-of-money, return to risk, and return to labor (to entrepreneurship and management)?

    A lot of capital income is return to safe assets held by people below the average income. Pension funds and bank accounts are in that category. Housing is also widely held, though I don’t know how much of that is return to risk. Could it be that a bigger amount of national income going to capital— where capital is defined as pure time-value-of- money income— would *reduce* inequality?

    • Donald Weightman says:

      “A lot of capital income is return to safe assets held by people below the average income.”

      How much and what is your evidence for “a lot”?

  3. ed says:

    You would probably be interested in Brad DeLong’s critique of Piketty. According to him, the key response to this seems to be is that somehow the wealthy will use the political system to ensure that workers are not paid their marginal product. “And here we have passed out of neoclassical economics entirely…we have arrived at the point that Piketty needs to write another book.”

  4. Jeff says:

    I’m skeptical that the return structure of “capital” will change much at all, even for the economic reasons outlined by Solow, Cowen, etc. The big take-away from Piketty is that economic determinism is a stronger force than economic equilibrium. The wealthy, by being wealthy, will always find and take on those unexploited, risky opportunities that yield strong returns. On average, it will pay off, certainly plausibly with an r > g, and the cycle will continue.

  5. Kling: Solow’s review is … by far the clearest explanation of Piketty’s argument that I have read.

    I haven’t read Piketty. I infer from Kling that Piketty has continued the tradition among leftist, Marxist economists, at least since Marx. They write long, complicated, hard (or impossible) to understand tomes, subject to much interpretation, with jumps in logic, and a lot of superficial historical analysis and dire prediction. Give control of society to the leftist economists before it is too late!

    Solow: Piketty is quite aware that his underlying assumptions could turn out to be wrong; no one can see a century ahead. But it could plausibly go this way.

    So, Piketty can’t predict the future, but he does it anyway, and people take him seriously. Why? This is the worst of Medicine Man economics. No surprise, Piketty wants to take wealth away from those who have produced it, just because, and fairness, and otherwise things might go wrong. This deserves laughter, not pronouncements that “he might be right, but then again he might not be”.

    Solow: 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.

    Piketty thinks productivity is going to slow down. Based on more gazing into his crystal ball? This premise goes against all of our experience for 200 years. Piketty is just making this up.

    Solow: (summary) Investment now is about 10% of GDP, and the growth rate is 2%, a ratio of 5. Piketty thinks investment will stay the same, but growth will drop to 1.5%, giving a ratio of about 7.

    I apologize if I now show my ignorance. I don’t see any analytic relationship beteen investment as a percent of GDP and growth of GDP. Part of investment each year replaces capital (equipment and organization) which breaks or becomes obsolete. One cannot look at gross investment of 10% and know if net capital investment is increasing or decreasing, and by how much. And, types of investment change, with differing effects on productivity.

    Say there were an iron law that productivity is proportional to net investment, and will be for 100 years. The ratio above does not capture net investment. There is no logic to that ratio. And, there is no such iron law.

    So, if we let Piketty assume that investments will become 50% less effective in the next 100 years, it is predictable that we are going into dire straits. The odd thing is that even so, Piketty wants to remove wealth from the people who invest. Solow points this out indirectly, but doesn’t laugh at Piketty as I would.

    If Piketty can predict the future, especially a future where investments become ineffective, then he should run the most profitable hedge fund in history, and not limit himself to writing Marxist tomes. Maybe he can write a second book that explains this one. Then, people would not have to wonder just what he means or meant to mean.

  6. Michael says:

    In many countries, profit is taxed at a lower rate than wage income (beyond certain thresholds). Hence it is not only owners of capital, CEOs and hedge fund managers who are rewarded with profits, stock, “the carry”, options, etc.
    Many staff get their bonuses in stock. Is this recorded as labour income in the data?
    What about the self-employed, sole-traders or family businesses, who don’t pay themselves much of a wage, but for tax reasons take it all in profits? Is this seen as capital’s share of GDP?

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