Understanding Thomas Piketty and His Critics

From Curtis S. Dubay and Salim Furth of The Heritage Foundation. Abstract and excerpts:

"Abstract
Thomas Piketty’s Capital in the Twenty-First Century is a treatise on how wealth inequality evolves in capitalistic economies. Piketty uses data stretching back to the 18th century to describe the historical evolution of wealth and inequality, proposes a model that matches the data, and uses that model to predict rising wealth inequality in the 21st century. He recommends punitive taxes on high incomes and wealth to prevent the scenario that he predicts. However, the best critiques of Piketty have shown that most of the links in his argument are broken. Piketty’s model does not match his data as well as he claims. His prediction of permanently rising wealth inequality rests on two implausible modeling assumptions. And his recommendation of punitive taxes is based on the glib assumption that capital accumulation is unimportant for wage growth, an assumption at odds with the data and even with his own model. As a result, almost nothing in Capital in the Twenty-First Century can be applied usefully to policymaking"

"Piketty’s Errors 

Piketty’s argument is an elegant explanation of how the rich stay rich under capitalism. The mechanism is clear: Wealth usually grows faster than wages, and capital can effectively replace labor, so the rich grow perpetually richer unless some outside force—a world war or a confiscatory tax—intervenes. However, when subjected to rigorous review, Piketty’s tidy argument quickly falls apart.

Accounting for Housing Prices. Piketty argues that since wealth-to-income ratios generally move in the same direction as capital’s share of income, capital will be able to effectively replace labor in the future. Yet this argument relies on conflating home prices with capital investment and ignoring Piketty’s own evidence from the 19th century.

Housing is a substantial portion of wealth (roughly half) in the countries that Piketty studied.[18] The rise of housing neatly explains why wealth-to-income ratios have risen since 1950, but wealth inequality has remained low: Much of the new wealth is the homes owned by middle-class families.

A study by fellow French economists used an alternate method of measuring the investment value of housing and found that the capital–income ratio has actually been stable since the 1970s, contrary to Piketty’s major claim.[19] According to Piketty’s explanation, the rise of wealth should take the form of reinvested profits earned by the very rich. Instead, the increase in capital is largely taking place in real estate and depends on using a particular method of accounting for price and rent changes.

Matthew Rognlie, in a thorough and technical critique of Piketty’s model, concludes that Piketty’s “justification … —the simultaneous long-term rise in the capital/income ratio and the net capital share of income—vanishes once we remove housing.”[20]
 
Piketty’s claim thus fails to explain the dynamics of wealth in the late 20th century, and his model also fails to explain his own data in the 19th century. Figures 6.1 and 6.2 in his book show that wealth’s share of income in France and Britain grew rapidly in the first half of the 19th century and fell rapidly in the second half.[21] According to Piketty’s claim, this major historical rise and fall of wealth should echo similar changes in the wealth-to-income ratio. Instead, wealth-to-income ratios in France and Britain remained steady throughout the 18th century.[22]
 
In the 21st century, as in the 19th century, movements in wealth’s share of income may occur for many reasons, but Piketty’s model explains very few of those changes.

The Misspecified Savings Function. As in the classic Solow model, Piketty’s wealthy save a fixed fraction of their income. This is a simplification of reality, but perhaps an acceptable one. However, Piketty first takes out the fraction of income that is lost due to depreciation, a fraction that becomes larger as the wealth-to-income ratio grows (as he says it will). Economists Per Krusell and Tony Smith corrected Piketty’s poor choice and found that his prediction of rapidly growing wealth depended heavily on the misspecification.[23]
 
Again, Piketty’s own research should have shown him that his savings function was wrong. He records that the wealthy “in the interwar years did not reduce expenses sufficiently rapidly to compensate for the shocks to their fortunes … so they eventually had to eat into their capital to finance current expenditures.”[24] If the wealthy of the 20th century did not save slavishly to keep up the value of their estates, why expect the wealthy of the 21st century to do so?

Wealth and Workers Are Poor Substitutes. A final problem with Piketty’s model is that he takes an extreme view of the substitutability of capital and labor. Discussed at greater length in the Appendix, the value that Piketty chooses “is far outside the range of values that most economists studying this issue believe empirically plausible.”[25] Chart 1 tabulates scholarly attempts to measure the relevant parameter (the elasticity of substitution between labor and capital) and compares them to the value that Piketty chooses in order to reach his desired result.

Rognlie shows that using a value close to consensus, instead of Piketty’s outlying value, would actually reverse the model’s prediction of how capital accumulation affects the return on capital.

Intuitively, this makes sense when one remembers that half of all wealth is residential structures, and commercial and industrial buildings account for a significant share as well. Stefan Homburg uses publicly available data for France to show that machinery and equipment constitute a small and shrinking share of wealth.[26] While ATMs and robots might displace human labor, a house would be a worthless substitute.

Once this error is corrected, Piketty’s model fails to predict rising wealth inequality or a rising wealth-to-income ratio.

Piketty’s Disastrous Solution

Although Piketty’s case for a future of perpetually rising inequality based on inherited wealth is weak, any future, even such an unlikely one, is possible. Hence, it is necessary to understand why Piketty’s proposed cure would be worse than the purported disease.

While inherited wealth is central in Piketty’s world, he is disgusted by the high incomes of “supermanagers,” especially in the U.S. (He defines supermanagers as executives in large businesses and managers of financial institutions.) Their high annual salaries allow these top 0.1 percent of earners to become nouveaux riches after a few years of elite earnings."