Capital in the Twenty-First Century
by thomas piketty
belknap, 696 pages, $39.95

My life as an economist started in October 1990, when I arrived at college with the firm conviction that I would make economics my profession. (In old Europe you select your major the summer before starting college. Yes, I know, it does not make much sense, but nothing makes that much sense in European universities.) Since then, no other book on economics has had an impact on the general public even remotely close to Thomas Piketty’s Capital in the Twenty-First Century. The New York Times has transformed itself into the newsletter of the Piketty fan club, and rumor has it that many coffee shops in Brooklyn only serve you your cappuccino-with-soy if you enter their establishment carrying this scripture.

Scores of reviews have been written. There is even a guide for writing a review of the book in ten easy steps. Larry Summers wrote a very good one from a left-of-center perspective, and Tyler Cowen from right of center. There may be little point in rehashing the minutiae of the terribly dull arguments we economists perversely love to throw at each other. But if you’ll indulge me, I’ll relate three ­observations.

First, Piketty invokes his now-­famous and (for his purposes) conceptually fundamental formula, r>g: the rate of return on capital (r) is greater than the rate of economic growth. From this he draws a social and political conclusion: “When the rate of return on capital exceeds the rate of growth of output and income, as it did in the nineteenth century and seems quite likely to do again in the twenty-first, capitalism generates arbitrary and unsustainable ­inequalities.” This is a bold statement—yet inaccurate.

Economists have understood for decades that circumstances in which the rate of return on capital is higher than the rate of growth are consistent with rising, constant, or falling wealth inequality. The reason is that r>g creates incentives for aggregate savings, but it does not tell us much about the incentives any particular individual has for saving. Some may decide to consume so much that, even when r>g, they lower their capital, while other individuals may do just the opposite, depending on their age, health, family condition, labor market situation, and dozens of other factors identified by a rich and vibrant research literature on consumption and saving choices. Put simply: The reasons we invest rather than consume involve many other factors beyond the rate of return on capital.

Second, Piketty enunciates two fundamental laws of capitalism. The first fundamental law is that the share of income from capital in national income is equal to r, the rate of return on capital, times the capital/income ratio. This “law” is just an accounting identity and, beyond its usefulness to organize our thinking, it is of limited relevance. Piketty’s second fundamental law of capitalism states that in the long run, the capital/­income ratio is equal to the savings rate divided by the growth rate of the economy. Since Piketty forecasts a low economic growth rate over the coming decades, his second law implies that the capital/income ratio will grow significantly—or, in his own words, “in a quasi-stagnant society, wealth accumulated in the past will inevitably acquire disproportionate importance.”

However, Piketty’s second fundamental law relies on a very particular assumption: that the “net” savings rate of an economy (the savings rate once we have paid for depreciation) is constant and positive. As Per Krusell and Tony Smith have pointed out, this assumption has a rather problematic implication: As the growth rate of an economy goes to zero, the economy will save 100 percent of the gross domestic product (GDP). Furthermore, even when the growth rate is not zero, relatively small drops in the growth rate of an economy will translate into large increases in the savings rate as a fraction of GDP. Both observations defy standard economic theory, our intuition, and, most likely, the empirical evidence.

Third, Piketty’s reading of the evidence requires a large set of additional assumptions. Let me set aside for a moment the possible problems in the data construction highlighted by Chris Giles at the Financial Times. Many of the numbers reported in the book are subject to high levels of measurement error because of the limitations in sources. Yet Piketty makes sweeping claims about how to interpret them. For example, while we are relatively sure that income inequality has increased in the U.S., there is much less compelling evidence, even if we take Piketty’s numbers at face value, that wealth inequality has worsened over the last few decades. Furthermore, intergenerational income mobility has remained stable over time, which means poorer people get rich today at the same rate as they did in the past (and richer people are dropping down the income ladder as well, again at rates similar to those in the past). This speaks against Piketty’s ­apocalyptic forebodings that we’re heading into a period of oligarchic control of wealth.

For these reasons and others, a fair-minded reader is drawn to the conclusion that Piketty’s policy recommendations, including a punitive wealth tax, are more a product of his own preferences for aggressive redistribution than the inescapable consequences of the analysis. But even here, we economists have our objections. Wojciech Kopczuk and Allison Schrager have convincingly argued, following a well-established research agenda in economics, that a wealth tax may be both counterproductive and highly inefficient. If we want effective redistribution, Piketty’s approach isn’t the way to achieve it.

There are other problems as well (involving, for example, the evidence about the elasticity of substitution of capital and labor). But let me now take off my economist’s hat. It’s more useful to reflect on why Piketty’s book has become such a bestseller.

We must start from a fundamental observation: The world economy has changed dramatically over the last several decades, and it is bound to change even more. Most of us intuit that these changes are reshaping our societies in profound ways. As a consequence, we’re eager for explanations and solutions to help us deal with new realities.

First, the rise of China and other emerging nations has thoroughly reorganized how we produce, trade, and consume. The consequences of this rearrangement are just starting to be felt. If, for example, ­Africa has really turned a corner since 2000—as some perceptive observers claim—your car in 2030 might be manufactured in Tanzania or Kenya. (Do not be surprised: How many of the American soldiers who fought in the Korean War forecasted that their sons would be driving a Hyundai?)

Second, the fall in the price of computers is spawning a new technological age. The $2,000 MacBook Pro on which I am writing this review is more powerful than the multimillion-dollar supercomputer I used for my Ph.D. dissertation in the late 1990s. Indeed, chances are you will not be driving your 2030 African car: A sophisticated computer will do it. As Google has shown, the engineering problem of driverless cars has been solved. All that remains is for society to adapt to it. But while driverless cars will bring more comfortable morning commutes (an opportunity for a nap before work), they also mean that our grandchildren will add truck drivers to stagecoach drivers in the same fuzzy group of professions that appear only in old black-and-white films.

But technological innovation is not only about replacing workers with capital (truck drivers with computers). And globalization isn’t just about companies searching for low-cost labor. It is also about raising the rewards of those whose skills complement technology and whose products appeal to larger and larger populations of consumers.

Soccer players, the ultimate international workers, illustrate this point. In 1897, Aston Villa was the most successful professional soccer team in the world. Its star, ­Charlie ­Athersmith, was earning around $55,000 in today’s money, making him either the best or among the best-paid soccer players of his time. ­Athersmith played at Villa Park, which had opened that same year and could hold up to 40,000 spectators (although a normal crowd was closer to 20,000). Without radio or TV, only those at Villa Park or the stadiums Aston Villa visited could pay to see Athersmith.

Real Madrid is the Aston Villa of our time: the most valuable soccer team in the world. (Full disclosure: The team is unconditionally loved by my family.) Its star, Cristiano Ronaldo, earns around $44 million annually. Often, Ronaldo’s games draw global audiences of more than 100 million people. While Ronaldo makes less money per spectator than ­Athersmith did (making him “cheaper” entertainment), technology has made him fabulously wealthier.

Global economic integration and the technological revolution are positive on the whole. (Tanzanians will be much better off—and who wouldn’t want to watch Real Madrid play?) But these powerful forces nevertheless create winners and losers. Top lawyers, famous professors, successful entrepreneurs, talented actors, and insightful consultants win. Adjunct professors, paralegals, truck drivers, manufacturing workers, and low-level administrative staff lose. Winners accumulate income and wealth. Losers do not.

Even if we tried to arrest them, these changes are probably unstoppable for any open society. Instead, the real questions are, first, how to think about them and, second, what sorts of policies are most likely to serve the common good. Market economies rely on the participants’ beliefs that the outcomes they produce are fair. Without a belief in fairness, economic agents will not engage in productive exchanges. More important, as voters, they will overregulate and stifle markets.

The success of Piketty’s book shows that confidence in the fairness of the market economy has weakened, and if we ignore Piketty’s allure because we find his arguments wrong and his policy recommendations misguided, we run the risk of being blind to the concerns of a large, increasingly disaffected sector of our society. Many Americans feel that the fortunes made in finance over the last two decades are nothing but rents extracted by a few entrenched firms that enjoy a special relationship with Washington. Workers in many corporations instinctively understand that the compensation of their CEOs has more to do with inadequate governance rules than with the value added by top management. Voters react with horror to the constant spectacle of interest groups determining public policy.

At an even more fundamental level, we need to be careful not to deny the obvious. Globalization and technological change are disruptive and rewrite the rules of economic success and failure so rapidly that many people are disoriented—and frustrated. Although there are many factors, by my reckoning these fundamental forces, which have gathered momentum in recent decades, explain the stagnation of the incomes of most Americans. This economic reality will surely influence politics. Voters will sooner or later gravitate toward those who offer an alternative, no matter how unwise.

A society’s institutions must be judged by their ability to help humans flourish. Excessive income and wealth inequality strongly suggest that too many Americans cannot lead productive, fulfilling working lives. This in turn indicates that many of our institutions are failing to adapt to new economic realities. In these circumstances we must undertake a vigorous program of reform. What, then, should we do?

The first order of business is to transform our educational system to provide as many children as possible with the abilities required by the new economy. Too often when we discuss our inadequate schools, we talk about inner-city schools. Yes, the status of inner-city schools should cause moral outrage. But we forget the extent to which our educational system also fails the middle and the upper-middle class. A recent international study demonstrates that the son of an American with a professional degree does worse in math, on average, than the son of a janitor in Shanghai.

The second priority must be to slow the rise in health care spending. We spend around 18 percent of national output on health care. Much of the income stagnation of the middle and working class in the U.S. can be accounted for by the growth in health costs.

Third, we need to ensure that the rules of the economic game are the same for all. The government should not help well-connected industries, in particular financial services firms. Market economies and many of the inequalities they create are felt to be legitimate when the outcomes they produce are thought to be fair. That’s hard to sustain when the rules are crafted or bent to favor the well-connected.

Fourth, we must decide, in an honest way, how much of the current entitlement state we want to keep and how we are going to pay for it.

As Nobel laureate James­ Heckman and his coauthors have reminded us, the seeds of productive lives are the non-cognitive abilities (self-discipline, patience, curiosity, creativity, fidelity) instilled by families during early childhood. More than ever, we must foster an environment where families can play their role as the fundamental cells of our society. Our national policy over the last several decades has forgotten this lesson, often neglecting the need to provide economic support for families. Today we need to revise the tax treatment of married couples, mandate more generous maternity leave and child care facilities, and otherwise think about how to structure government and employer-mandated benefits to better serve the interests of families.

Americans are increasingly anxious about the fairness of our society. Many are losing faith in our institutions. Piketty has tapped into such discontent. The buyers of his book are expressing, in a slightly more intellectual fashion, the same anxieties as the voters who support populist candidates on the right and on the left. The liberal Piketty reader in Seattle and the libertarian, “abolish the Fed” agitator in North Carolina seem very different. But at the deepest level, they share the same instinctive sense that the old social contract in ­America is under a great deal of stress. They both are looking for an alternative to a system that doesn’t seem to work well, at least not for those who aren’t “winners.”

The problem is that both are misled by the wrong solutions. It’s up to us to work to find the right ones.

Jesús Fernández-Villaverde is professor of economics at the University of Pennsylvania.