Putting the Distributional Question Back at the Heart of Economic Analysis

When Thomas Piketty came to speak at the Harvard Kennedy School last month I could not attend due to a class conflict. I later read The Economist's review titled A Modern Marx, which called Piketty's Capital a "blockbuster" and "a great piece of scholarship", but also "a poor guide to policy". Professors and colleagues kept talking in similar terms until I was finally convinced that I should read it for myself.

So, I started reading the book a few days ago. As a student of development economics interested in the evolution of inequality, I am finding it difficult to put the book down. This is not because it affirms my education but because it calls into question the theories predicting a plateauing or lessening of inequality such as the famous Kuznets curve. Piketty explains the Kuznets curve:

According to this theory, inequality everywhere can be expected to follow a “bell curve.” In other words, it should first increase and then decrease over the course of industrialization and economic development. According to Kuznets, a first phase of naturally increasing inequality associated with the early stages of industrialization, which in the United States meant, broadly speaking, the nineteenth century, would be followed by a phase of sharply decreasing inequality, which in the United States allegedly began in the first half of the twentieth century.

Indeed, this optimistic argument has also been applied to other policy subjects including global warming. For example, the environmental Kuznets curve is a hypothesized relationship between various indicators of environmental degradation and income per capita. In the early stages of economic growth degradation and pollution increase, but beyond some level of income per capita the trend reverses, so that at high-income levels economic growth leads to environmental improvement.

Piketty argues that the inverted U-shape found by Kuznets with regards to inequality rests on shaky empirical grounds. The goal of Piketty's book is to put the distributional question back at the heart of economic analysis. He writes,

Nevertheless, the magical Kuznets curve theory was formulated in large part for the wrong reasons, and its empirical underpinnings were extremely fragile. The sharp reduction in income inequality that we observe in almost all the rich countries between 1914 and 1945 was due above all to the world wars and the violent economic and political shocks they entailed (especially for people with large fortunes). It had little to do with the tranquil process of intersectoral mobility described by Kuznets.

For far too long, economists have neglected the distribution of wealth, partly because of Kuznets’s optimistic conclusions and partly because of the profession’s undue enthusiasm for simplistic mathematical models based on so-called representative agents. As such his approach is to extend Kuznets's series not just for the US (for which the original research was based) but for France, UK, Canada, Japan, India, Spain, etc. His key finding, also the heart of his book, is that

The dynamics of wealth distribution reveal powerful mechanisms pushing alternately toward convergence and divergence. Furthermore, there is no natural, spontaneous process to prevent destabilizing, inegalitarian forces from prevailing permanently....Knowledge and skill diffusion is the key to overall productivity growth as well as the reduction of inequality both within and between countries....More important, there is a set of forces of divergence associated with the process of accumulation and concentration of wealth when growth is weak and the return on capital is high.

Instead of the inverted U-shape, Piketty finds a U shape when analyzing income share of the top 10% after extending Kuznets's series for the US to 2010. The top decile claimed as much as 45–50 percent of national income in the 1910s–1920s before dropping to 30–35 percent by the end of the 1940s. Inequality then stabilized at that level from 1950 to 1970. We subsequently see a rapid rise in inequality in the 1980s, until by 2000 we have returned to a level on the order of 45–50 percent of national income. According to Piketty, a regime of relatively slow growth explains this spike in inequality. In times of slow growth, inherited wealth naturally takes on disproportionate importance, because it takes only a small flow of new savings to increase the stock of wealth steadily and substantially.

If, moreover, the rate of return on capital remains significantly above the growth rate for an extended period of time (which is more likely when the growth rate is low, though not automatic), then the risk of divergence in the distribution of wealth is very high. This fundamental inequality, which I will write as r > g (where r stands for the average annual rate of return on capital, including profits, dividends, interest, rents, and other income from capital, expressed as a percentage of its total value, and g stands for the rate of growth of the economy, that is, the annual increase in income or output), plays a crucial role in the book, and sums up the overall logic of its conclusions.