Adam Smith’s invisible hand has always been the take-away from ECON 101. Smith used the phrase once, when arguing that states should not give a private company the monopoly over a domestic market. It would be wrong for the government, say, to force tea grown in Scotland onto everyone in the United Kingdom. It’s very difficult to grow tea in Scotland, so any tea that could be grown there would be very expensive and, due to geography and climate, disgusting. Tea drinkers would not benefit from the Scottish-Hibernian Institute for Tea having a monopoly over the U.K. market. Only those who own, or own shares in, that Institute would gain. But, Smith suggested, the alternative to private monopoly is a good one: if you let everyone invest their capital wherever they want, they will be guided, despite themselves, to help the domestic economy. The unintended consequences of their actions will benefit everyone. Smith’s hand has stayed with us, and become the centerpiece of our political-economic discourse. Libertarianism is the most intellectually respectable, consistent, and politically powerful twenty-first century version of this discourse.
Libertarianism greatly expands Smith’s argument: he made a case for the invisible hand in the production of economic goods; libertarianism makes the case for it in distribution and consumption, as well. The theory holds that we are all rational actors, and we all know our best interests; if we all act in our best interests, and have access to perfect information, everything will work out for the best. But if governments intervene by, e.g., forcing Scottish tea on us, or subsidizing medical care, the natural processes of rational deciding will be interrupted, and the outcome will be bad. Therefore we can blame all problems on government intervention.
In addition to the economic benefits, this view holds that doing away with government intervention would greatly simplify our moral lives. If the government’s always poking its nose in our business, it’s hard to tell whether successful people deserve their success. But if we are all free to act in our best interests, any given individual’s failure can only be caused by his own failure to act rationally; and if things work out spectacularly well for another individual, that can only be because she acted with perfect rationality. He deserved his failure, and she deserved her success. The inequalities of these outcomes are morally justifiable. This, libertarian discourse suggests, is the essence of true capitalism: markets, left to their own devices, will apportion goods efficiently and effectively; and they will also apportion them justly.
Now, Smith’s original, more limited argument was based on important assumptions. He believed that a capitalist would invest his capital near his home and therefore support domestic industry, unless he could make far more from his capital overseas. But the latter was extremely unlikely, because, so far as Smith knew, the return on capital was almost perfectly stable. You would earn the same amount from an investment in 1767 as you would have done in 1676. Nor did it vary greatly among European countries, which all grew at roughly the same rate, that is, not very much. Under these conditions, there really is no good reason to invest overseas.
And those conditions were the basic assumptions of political economy in the eighteenth and nineteenth centuries: the return on capital would be about 5 percent, and economic growth would be negligible. Growth is tied to population growth and economically relevant changes to the processes of production; there was very little of either until the nineteenth century (even during the industrial revolution, from 1820-1913, worldwide economic output grew at only about 1.5 percent per year). To the best of our knowledge, the rate of return on capital (r) has always been higher than the growth rate of the world’s economy (g). Or, r > g.
This general trend, and its reversal, is the central theme of Thomas Piketty’s Capital in the Twenty-First Century, probably the most ballyhooed work of political economics since the days of Milton Friedman. Friedman’s popular books (Capitalism and Freedom , Free to Choose ) helped to make libertarian thought central to public discourse. They start from his intuition that “the free man” will ask how we can “keep the government we create from becoming a Frankenstein [sic] that will destroy the very freedom we establish it to protect.” Friedman’s answer is that we should limit governmental interference, particularly in economic decisions, because our “minds tell us, and history confirms, that the great threat to freedom is the concentration of power.” That Friedman didn’t know who Frankenstein was makes his generalizations rather dubious. But luckily, it’s clear what he meant by “history confirms”: there was a great concentration of power in the USSR; the USSR was the greatest threat to freedom. Q.E.D. This was an economic discourse born from Cold War concerns.
Thomas Piketty, by contrast, begins with actual historical statistics, and they paint a picture very different from the one we find in Friedman’s work. Capital in the Twenty-First Century describes a remarkable economic phenomenon: Since 1950, the world’s population has grown rapidly, as has per capita output, so that world GDP has grown at 4 percent per year. Over the same period, the return on capital has dipped substantially. The basic assumptions of classical political economy, from Smith to Marx, have ceased to hold: returns on capital are lower than usual, growth has been extraordinarily high, and, for the first time that we know of, g > r. Piketty’s book explains how we got to this point, the consequences of it and, most importantly, the political and economic trends that are leading us back towards the standard r > g. It turns out that, far from producing morally just economic outcomes, limiting government interference in the economy will guarantee injustice.
The results of r > g are clear: capital can grow more quickly than the rest of the economy, so the rich get richer over time. Under these conditions, it’s no surprise that, in the early twentieth century, the Western world’s economies were as unequal as any we have ever seen. The top one percent of France’s population, for instance, received over 20 percent of the national income. By the end of World War II, it received under 8 percent, and has never recovered. The fall in that share was due entirely to a loss of income from capital: large bodies of capital were lost in both wars, and postwar tax policies helped redistribute whatever remained. Over the course of the twentieth century, France changed from a society dominated by rentiers, living off inherited wealth, to a society dominated by wage-earning managers.
In the United States, the one percent received between 18 and 20 percent of national income before the first war. Its share fluctuated between the wars, reaching a high of nearly 25 percent in 1928, and falling to just over 15 percent in the early Thirties—unlike France, the U.S. did not suffer from the destruction of capital in the first war. Nor was the concentration of capital as unequal in the U.S. as it was in Europe. However, as in France, the one percent’s share of income did fall quickly after the Thirties. The U.S. was hit much harder by the Great Depression than the European economies, and Roosevelt’s policies were far harder on capital than those of the European governments.
These combined shocks—destruction in the wars, economic chaos in the Great Depression, and highly progressive tax policies—combined to reduce the amount of capital, its concentration and the share of income that went to its holders. At the same time, populations and productivity grew, and the major industrialized economies caught up to their prewar capabilities. Economies grew more quickly than ever before. Hence, g > r.
The effects were remarkable: the postwar was a period of great equalization. The very wealthy no longer owned astronomically more than those in the middle class, and high earners no longer earned astronomically more than others.
And yet, as Piketty documents, the amount of capital has grown substantially since 1970. In that year, in most countries, private capital was worth three to four years of the nation’s yearly income. By 2010, it was worth between five and eight years. The last time it reached those levels was just before World War I. Similarly, capital received between 16 and 24 percent of national income in 1975. By 2010, that had risen to between 25 and 31 percent.
Why has capital made such a comeback in such a short period? Changes in the tax systems. In the early 1980s, Reagan and Thatcher both won elections based on the perception that the British and American economies were failing (Piketty shows that this was not the case); they promptly dismantled the progressive tax systems that had helped to reduce capital’s dominance since the wars. Governments everywhere have been moving in this direction ever since. Today, tax laws are generally regressive: the middle class pays a higher proportion of its wealth and income in taxes than do the wealthy, who pay about what the very poorest pay.
The growth of capital has helped to increase inequality both of wealth (as capital grows in volume, it becomes more centralized), and income (because income from capital is far more unequally distributed than income from wages). And since large bodies of capital grow more quickly than small bodies, the largest capitalists will continue to accrue more and more of the world’s economic output to themselves.1 That leaves less for the small capitalists (your 401K), and it leaves less for wages. Thanks to all this, we’ll probably soon return to the normal situation: r > g. The rate of growth will be lower than the return on capital investment, and capital will once again be the great winner of the world’s economy.
Piketty makes it very clear that, in the absence of the century’s horrific geopolitical history, the twentieth century’s equalization would not have happened: there is no reason to believe that the massive inequalities of the prewar years would have naturally corrected themselves. The equalization was the product of historical trauma (the wars), unrepeatable population and productivity growth, and highly progressive taxation. And contra the dogma of popular economic discourse, the current return to low growth and high returns “has nothing to do with market imperfections and will not disappear as markets become freer and more competitive. The idea that unrestricted competition will … move toward a more meritocratic world is a dangerous illusion.” One of the laws of capitalism is its tendency, when working perfectly and without government interference, to reward the holders of capital unfairly well, simply because r > g. Absent a revolution, only extremely strong taxes on both income and wealth can restrain the cycle in which the wealthy get wealthier, and the 99(.99) percent get increasingly close to nothing.
What should we do about this? Piketty’s policy recommendations will be disappointing to American liberals and conservatives alike. Economic growth could, in theory, slowly reduce the real burden of the national debt—but we have no reason to think that growth will return to late twentieth-century rates. And even if growth did help, Piketty points out that increasing the national debt will increase inequality: government debt means private credit, and those who hold government debt receive payments from the public. Government debt creates capitalist rentiers. As for taxes, taxation in the U.S. has stabilized at about thirty percent of national income since the Fifties, and shows no sign of increasing very much—nor, of course, will it decrease any time soon. And nor should it. Piketty’s evidence demonstrates that letting the stallions of job creation gallop would do nothing for equality, or the economy, because entrepreneurs become rentiers very quickly when the return on capital is high. America’s economic policies might keep share prices rising, but they won’t help inequality or encourage sustainable economic growth.
Instead, Piketty suggests that the tax burden be shifted onto those who, through no merits of their own, benefit the most from capitalist economics. His ideal is a highly progressive, worldwide tax on capital. Only this, he suggests, could keep our g > r economy in place, given all the forces nudging us back toward r > g. But the most important aspect of this tax, for Piketty, is that it would provide actual information about how much wealth there is, what it’s used for, where it’s kept, and so on. He ends his book with the suggestion that economics is a social science, not a mathematical one; that social scientists should provide accurate information about human institutions; that economics should therefore be a historical, empirical undertaking, not a game played with algorithms; and that, in order for economists to do this work, they need access to information about the way money and goods slosh around the world. Once we actually know how unequally and unjustly economic rewards are distributed, we might be motivated to do something about it. And, indeed, Piketty’s work is at the root of arguments and protests about “the 99 percent.”
Of course, Piketty’s is only the most recent of many books to show readers what actually existing capitalism looks like. His title alludes, a little rashly, to the most famous of them—Marx’s Kapital. The comparison could make Piketty’s policy recommendations look very pale: Marx is the hot-blooded revolutionary who famously declared that the point was not to understand the world but to change it. But Marx was also, even predominantly, a researcher. Das Kapital was the product of many years in the library, putting in order the sparse evidence available to him. Marx wanted change, certainly, but he spent his last years writing a work of history and philosophy that included arguments with ancient philosophers and was structured in part around Dante’s Divine Comedy. Piketty lives up to this heritage as well as an economist can in the ultra-specialized twenty-first century: Capital includes footnotes to contemporary philosophy and uses the nineteenth-century novel to make economic arguments (as well as economic history to make literary-critical arguments).
But the most important similarity between Capital and Kapital is that they both describe the injustice of capitalism’s deep structures. Capital’s policy recommendations make for interesting reading, but they are relatively unimportant compared to the book’s descriptive task: to show, empirically, that the inequalities of the capitalist world are structural, not moral. We can’t blame the poor for remaining poor, any more than we should praise rich kids for adding to the wealth of their parents, because the more money you have to begin with, the more money you will end up with: large capital grows faster, “parents’ income has become an almost perfect predictor of university access,” and “when the rate of return on capital significantly exceeds the growth rate of the economy … it logically follows that inherited wealth grows faster than output and income.” That is just how capitalism works.
And that fact decisively undercuts the dominant economic dogma of our time: that capitalism is a naturally just system in which the rational are rewarded for their intelligence. It is clear that, this side of the Cold War, the greatest threat to freedom is not the concentration of power at all. It is the concentration of capital. The evident injustice of our economic system should, by rights, lead us to turn the world upside down. But recognition of that injustice should have led us to turn the world upside down in the nineteenth century, and the twentieth, too. Perhaps the most important question Piketty’s book raises is: If the evidence is so clear, why do we keep ignoring it?