Thursday, March 13, 2014

Why Do The Rich Get Richer And The Poor Get Poorer?

Thomas Piketty's new book answers that age old question.  The rich do get richer but the poor also get richer over time.  However, it seems as if the only the rich get richer because they get richer at a faster rate.  Piketty's book describes the fundamental dynamic in capitalism that enables the rich to get richer at a faster rate.  The rich own most of the wealth in society and the income that they receive on their capital grows much faster than wage income.  The ratio between income from capital and income from wages has varied over time.  Piketty found that the level of income inequality in a society is correlated with that ratio.  The higher the ratio, the greater the level of inequality.  He argues the the low levels of inequality that we experienced after WW ll was an anomaly.  A lot of capital had been wiped out by the Great Depression and wars.  Moreover, wage income grew faster than usual due to rapid economic growth during the post war period.  The growth in inequality that we are currently experiencing can be explained by the rapid growth in capital and slower growth in wage income since the 1970's. This dynamic is not the result of a market failure.  The return on capital is determined by a very competitive global market for capital.

The battle that we have seen within the economics profession in recent years has been over the explanation for business cycles.  In general, one school of thought argues that they are determined by market forces but subject to occasional shocks.  Moreover, government intervention will not produce an economic recovery.  The other wing of the profession believes that monetary policy and fiscal policy should be used to moderate the business cycle.  It also supports the use of social welfare programs that provides basic necessities to citizens who cannot afford them.  Piketty raises a new problem that we need to solve.  Unless we do something about a dynamic that is built into capitalism, there will be new threats to capitalism itself.  He believes that tax policies can be used to maintain capitalism and our democratic form of government.  He is not optimistic about our prospects, however.  Sovereign states will be unable to make those changes on their own.  Capital is mobile.  It will seek refuge in states that compete with high tax states by keeping taxes low.  Moreover, political power is related to economic power.  States with high levels of inequality are not effectively governed by democratic forces.

I am on the board of a Homeowner's Association that is dealing with an issue that provides a simple illustration of the dynamic described by Piketty.  Our buildings are on leased land.  We pay $1.2 million per year in rent to the landlord. That cost is distributed among the building owners.  Every 15 years the land is reappraised and we pay 8% per year on the reappraised value.  We are negotiating the appraisal process right now with the landlord.  Our rent will obviously increase because of inflation and market forces.  No matter what the outcome of the appraisal process, I was struck by the importance of capital ownership.  The owner of the once vacant land, about the size of city block, has received an income of $1.2 million per year without having to do any work to improve or maintain the land.  The landlord has earned $18 million over the 15 year period of the lease without having to do any work.  That is more than most of the building owners have earned in a lifetime of work.  Even better, the landlord will get a hefty raise under our new lease without making any additional effort.  Piketty's book sends us a message.  If nothing is done to change this dynamic our grandchildren will live in a society dominated by the owners of capital who can watch the value of their capital grow much faster than wage income. 

Piketty is also aware of the problem of global warming.  He believes that it is even a more important problem than income inequality.  The question is whether the dynamic of capital accumulation is controllable.  Will the owners of capital and sovereign governments be able organize themselves to preserve the natural capital upon which the economy and the future of civilization is dependent?

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