Thomas Piketty’s Capital in the Twentieth Century, published this April, has been reviewed, analyzed and criticized by every major journal of record, most high-profile commentators in all branches of the media and more than a few Nobel Laureates. If you Google “Piketty,” you will get as many as 178,999,990 links (This Commentary makes it 178,999,991). The book has gone into a second printing in less than two months.
Piketty’s work is a tour de force of economic history enriched by remarkable statistical underpinnings, and deserves attention. What interests us most is his really quite unique effort to define and measure wealth and to understand its relationship to income and the dynamics that make wealth grow.
It is our view that wealth is as important an economic concept as income. Wealth provides the capital that funds the supply side of the market system. The accumulation of wealth allows workers to transfer the benefits of their labor over time – specifically to fund retirement.
We believe we need more wealth and broader access to holding wealth. Correspondingly, we need new economics that can provide guidance on how to increase the stability of the financial system in order to preserve wealth over time. Piketty thinks we need a global wealth tax.
Understanding and Measuring Wealth
Piketty hijacks his own work with his emphasis on the role of wealth in increasing inequality and the perceived need to redress it. The most powerful part of his book lies in the first 234 pages where he defines wealth and describes his view of how it relates to income.
It is in this discussion that we find unique links between the “income” economy and the “wealth” economy. And, it is in these links that we find important insights into the sources of financial instability – with different consequences from those cited by Piketty.
The sources of instability arise from the fact that assets and liabilities in the financial system are huge relative to income and that, thanks to Piketty’s “laws” of capital, they tend to grow much faster than the economy over time. The value of U.S. household assets totals about $94 trillion. Total GDP is about $16 trillion. Total assets, including real assets like housing and financial assets like stocks, are roughly six times the value of GDP (Chart 1).
The reason for the broad divergence is that assets are a stock and GDP is a flow. Total assets represent accumulated savings in the economy over time plus reinvested returns and capital appreciation held in the form of tangible assets like housing or financial assets.
Piketty’s first fundamental “law” of capitalism is that the share of capital income relative to labor income is determined by the rate of return on capital (say, 5 percent) times the share of capital to GDP. (In the U.S. case, six times or 600 percent.) This means that if we divide national income into labor and capital, the capital share will be 30 percent and the labor share will be 70 percent. This calculation pretty much reflects the current shares of labor and capital in the U.S. economy.
Assets are not wealth, however. Wealth is net worth – the value of assets minus related debt. For example, real estate is an important part of both sides of the household balance sheet. Owner-occupied housing accounts for about 70 percent of all nonfinancial assets and home mortgages are about 70 percent of all liabilities.
Looking at the ratios of household assets to GDP and net worth to GDP, a couple of things become clear. First, these ratios are relatively stable until the late 1990s. Second, since that time, they both have risen and become more unstable. Total household assets run at about six times GDP and net worth averages four to five times GDP (Chart 2).
The Financial Stability Challenge
Given that both asset values and debt levels are several times larger than incomes, is it any wonder that the delicate balance of the financial system suffers from periodic instability?
As Piketty documents, financial crises are an effective break on capital accumulation (much as wildfires regulate the metabolism of forests), as are wars. Mismanagement of the financial system can destroy capital. The literal destruction of physical (and human) capital to redirect savings to a war effort also destroys capital. Both of these outcomes increase equality but do so at a heavy human, social and economic cost.
Piketty focuses so much on the growth of wealth and its effects on inequality that he misses the financially destabilizing consequences of his second “law” of capitalism. This “law” relates the size of the asset base to savings and economic growth. When the gap between savings rates and economic growth rates widens, wealth rises relative to income to such an extent that it becomes top-heavy – and therefore destabilizing. This economic fact probably explains some of the economic and financial underpinnings of the 1929 stock market crash and likely contributes to the instability we have seen since the late 1990s.
Wealth and Future Income
Had Piketty dug deeper into his own data on wealth and future income, he would have seen the composition of wealth more clearly. Pension assets/entitlements and household real estate are by far the largest household asset classes. Pension assets total about $20 trillion; household real estate totals about $19 trillion (Chart 3).
Public retirement entitlements are also important but are not shown as part of private wealth. Social Security and Medicare assets total about $2 trillion. Because public pensions operate on a pay-as-you-go basis, today’s $2 trillion will provide another $20 trillion in retirement support in future years.
The United States does indeed have a small class of super-rich. However, the overwhelming share of wealth in America is held in owner-occupied housing and retirement-related assets. In other words, things are not as unequal as they seem. Retirement needs are one possible reason that this remarkable accumulation of wealth has not resulted in a boom in inheritances – one of Piketty’s overarching preoccupations.
The share of wealth distributed through inheritances fell dramatically between 1989 and 2007, according to “Inheritances and Wealth Or Whatever Happened to the Great Inheritance Boom?,” a 2011 Bureau of Labor Statistics working paper. More important to Piketty’s social concerns about the perpetuation of a “rentier” class, inheritances have not changed the distribution of wealth and in some cases have increased equality.
In June of last year, we published an article titled “Wealth – Sin or Necessary Evil?,” where we concluded that, on a global basis, retirees’ income needs will begin to reduce the stock of household financial assets before 2020. On this question, Piketty would surely come down on the side of “sin.” We, on the other hand, believe that wealth is a necessary evil, one that we not only need more of but which we need to understand better.
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