Liberal hero Piketty ready to walk back his theory

  • By James McCusker
  • Wednesday, March 11, 2015 2:15pm
  • Business

Bicycles, motorcycles and airplanes have one thing in common: There’s no reverse gear. People are different, though and while backing up can be awkward we can usually manage when it’s necessary.

In April 2014, economist Thomas Piketty’s book, “Capital in The 21st Century” was published and quickly moved to the number one position on the best-seller list. The book was about income inequality and self-sustaining class distinctions that threaten democratic ideals and even capitalism itself.

It was an immediate hit with liberal policy wonks (who may have actually read the book) and political activists (who didn’t) wishing the federal government would take action against income inequality by taxing the rich.

In the process of developing his analysis, Piketty had mined an extensive cache of historical tax data from a number of countries. And in taking particular note of the outsized wealth gap at the tail end of nineteenth century and before World War I, his overarching theory was that the return on capital (g) was higher that than the economic growth rate — written in its math format as “r > g” in the book.

Now, just about a year after the book’s triumphant landing in the U.S., Piketty is looking for reverse gear. In an article set for publication in the American Economic Review he now says that r > g is not the only or the best explanation for the income and wealth gaps of either the 20th or the 21st century. It might be a plausible explanation for the “Golden Age” of mansions, manors and liveried servants in the two decades spanning the turn of the 19th century, but that’s it.

In economics, there are things which are relatively easy to understand at the micro level but become more mysterious when we’re looking at the total picture. An “economy” is such a complex mix of elements that it presents a daunting theoretical problem for economists to assemble it all into a coherent, meaningful theory.

That is why the initial simplicity of Keynesian economics — total output equals consumption plus investment plus government expenditures, or Y= C+I+G, — has such enduring appeal despite its theoretical and practical issues.

Much the same is true of Piketty’s economics. The simplicity of “r > g” had a magnetic appeal to many people that it made reading further into his book, or reading it at all, seem unnecessary. The result was that the tax-the-rich crowd picked up Piketty’s theory as if it were a loose football and ran with it toward the goal of higher taxes.

This was not a very satisfying result for someone who wants to be considered a serious economic theorist — not an untypical reaction on the part of an author. Karl Marx, for example, after seeing his theories reformulated in France, famously wrote, “…I myself am not a Marxist.”

For his part, Piketty has decided to clarify part of his analytical work by recognizing some of its limitations. He was and is, correct in seeing that there is a relationship between the return to capital and economic growth, but it is not clear which is the cause and which is the effect.

If we consider that the interest rate is one way to measure return on capital — analysts would call it a “proxy variable” — we can trace its historical relationship with Gross Domestic Product (GDP) growth rates.

There is a force of attraction between interest rates and economic growth, an almost romantic tendency for them to be equal partners in economic life. That said, this attraction can be offset or even overwhelmed, temporarily, by outside forces such as monetary policy, rapid technological change, or even administrative actions.

We can see all of that in the data history. In a chart comparing the interest rate to the economic growth rate in the U.S, for example, we can immediately see the effect of the Civil War, World Wars I and II and the Great Depression of the 1930s. These events created major disruptions to the relationship between the two variables. Wars tend to push economic growth higher than interest rates and depressions have the opposite effect.

Significantly, as the U.S. economy continued to expand and mature after 1950, the relationship between interest rates and growth rates grew even closer. The disturbances were less severe, revealing with more clarity the fundamental relationship.

Piketty’s backtracking will probably be ignored by the “tax the rich” movement. But it is very helpful to economists, many of whom had found that his soaring conclusions exceeded the structural limits of his analysis.

The wings have fallen off his theory, but his book did rekindle interest in economic theory and that could help us unravel the mysteries still surrounding economic growth and income distribution.

James McCusker is a Bothell economist, educator and consultant. He also writes a column for the monthly Herald Business Journal.

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