When American Airlines announced last month that it would boost the pay of its pilots and flight attendants by around $1 billion, investors were livid. One Citi analyst fumed: “This is frustrating. Labor is being paid first. Shareholders get leftovers.” Traders swiftly punished the company for its temerity, with American Airlines’ market capitalization shrinking by 9.7 percent, or $2.2 billion, in the three days following the news.
But while the amusing outrage and simple narrative of the American Airlines story caused it to attract a good deal of attention, it is far from unique. Quarterly earnings statements and company announcements regularly send the market value of businesses soaring or plummeting. As shareholder expectations about the future profits of companies change, so too does the price of corporate shares.
This basic point lies at the core of some recently published critiques of Thomas Piketty’s seminal work Capital in the Twenty-First Century. According to economists like Suresh Naidu, a contributor to the new volume After Piketty, asset valuation dynamics like those at American Airlines could be at the heart of the changing wealth landscape in the US and other developed economies.
If Naidu and others are right, Piketty’s theory of how wealth and income inequality develop may be exactly backwards. And his prescriptions for reversing skyrocketing inequality may suffer accordingly.
Despite being a surprise bestseller, Piketty’s Capital was likely read by no more than a handful of people. Even famous economists like Larry Summers and Justin Wolfers, who commented extensively on the seven-hundred-page tome, didn’t bother to read it — or at least their severely mistaken descriptions of its contents would suggest as much. This is the natural hazard of writing an iconic book that is also punishingly long and technical: many will feel compelled to talk about it, but few will actually wade through it.
That’s a shame, because the central theory of Capital in the Twenty-First Century is fairly simple. It goes like this: when a country’s growth rate declines and its saving rate holds steady, its wealth-to-income ratio will increase. Why? Because, in the period just after growth falls, a country’s stock of savings will accumulate at a faster rate than its annual income increases.
When a country’s wealth-to-income ratio jumps while the rate of investment return on wealth stays the same, a larger percentage of the country’s annual income will be paid out to owners of wealth and a smaller percentage will be paid out to workers. This is a matter of basic math: the percent of a nation’s income that wealth owners receive (known as the “capital share”) is equal to its wealth-to-income ratio multiplied by the rate of investment return.
After outlining this accounting framework, Piketty notes that growth rates in developed countries have declined and are likely to continue to do so in the future. Then he points out that historical data going back hundreds of years shows that the rate of investment return has remained remarkably steady at 5 percent.
Assuming Piketty’s underlying theory is correct — and no significant moves are taken to reverse the trend he identifies — our future is dystopic: owners of wealth will capture a larger share of income, and inequality will expand apace.
The bulk of Piketty criticism has focused, rather boringly, on whether the rate of investment return will remain steady when the wealth-to-income ratio soars. But economists like Dean Baker, J. W. Mason, and now Naidu have pioneered a more interesting line of attack. According to them, Piketty has not made some mistake in judging elasticities. Rather, he has the entire order of events backwards. It is not an increase in the wealth-to-income ratio that prompts capital’s share to rise — it’s the exact opposite dynamic.
Piketty’s account of how wealth builds over time centers on savings. In his telling, the capitalist is prudent, dutifully investing large amounts of his income every year into capital goods. As these investments steadily accumulate, so too does the national wealth (which, according to this account, is the sum of all the previous years of savings minus depreciation). When the quantity of total past savings becomes very high in relation to the country’s annual income, the seemingly permanent 5 percent rate of return on wealth drives up the capital share.
The problem with Piketty’s story, which Naidu and his peers get at in various ways, is that it doesn’t match reality. Assets like real estate, equity, and debt are not assessed according to the quantity of savings that go into creating them. They are assessed according to the expectations of how much income those assets will deliver to their owners in the future. Put simply: asset values are forward-looking, not backward-looking.
This has quite startling implications for the way we think about the nature of wealth in a capitalist economy. Ownership of something like a company share does not entail ownership of capital goods in any real sense. It amounts to owning a bundle of legal rights to future flows of income. Thus, the value of assets, and therefore wealth, reflects the value of the rights to future income flows — not the value of accumulated savings.
Once this truth is understood, it becomes easy to see why Piketty may well have everything backwards. If capital increases its ability to extract income from the economy, that would boost the future flow of income that goes to owners of existing assets, and thereby increase the capital share. When a greater portion of the national income is being funneled to owners of assets, the market value of those assets will go up, causing measured wealth to go up as well.
In other words, the capital share drives the wealth-to-income ratio, not the other way around.
Support for Naidu's Approach
If this seems like a fanciful alternative theory, or an academic exercise with little real-world import, that’s hardly the case. Over the last few decades, market concentration has increased substantially, driving up consumer prices and elevating profits. During that same period, organized labor has been eviscerated, especially in the private sector, and the economy has operated below full employment for at least the last decade. Weak unions and weak labor markets tend to increase capital’s ability to capture larger shares of the national output.
Additionally, housing supply constraints and lax price regulation in booming urban centers have massively increased the share of national income going to housing rents. A rapid rise in patenting activity and other expansions in intellectual property rights have strengthened companies’ ability to extract rents from IP ownership. And globalization has enabled companies to push down unit labor costs by moving production to lower-paying areas.
Taken together, these developments, which are driven by changes that have nothing to do with savings, could easily boost the percentage of national income going to capital and, more importantly, expectations about the future flow of income that will go to capital. Existing wealth assets would then trade at higher values, driving up wealth and the wealth-to-income ratio without altering anything about the quantity of capital goods in society.
Accepting Naidu’s account of the nature of wealth means seeing Piketty’s corresponding remedy as far too narrow in scope.
If you believe, as Piketty argues in his book, that a reduction in growth will inexorably lead to a higher wealth-to-income ratio and a higher capital share, then perhaps the best you can do is pare down wealth accumulation and spread out its ownership through a progressive wealth tax.
But if you believe instead that the capital share does not rise inevitably but only as a result of capitalists getting the upper hand in the perpetual battle over the distribution of output in society, then many more solutions become plausible. Increasing housing supply and imposing rent controls, weakening intellectual property protections, empowering workers to fight for a bigger piece of the pie — all would have the same or even greater egalitarian effects.
American Airlines’ decision to increase its workers’ compensation caused over $2.2 billion of national wealth to vanish almost instantly — not because actual capital goods were destroyed, but because capital’s share was ever so slightly reduced. Empowering workers to repeat this fairly mundane episode again and again, throughout the economy, would likely be a much stronger brake on runaway wealth accumulation and inequality than a global wealth tax or other similarly elaborate strategies.
Class struggle still gets the goods.