Capital in the Twenty-First Century
I never gave much thought to economics or the economy. They always seemed like bigger issues that I couldn’t impact or influence. There’s no point in understanding something over which you have no influence – at least that’s how my reasoning went. However, I saw a reference to Capital in the Twenty-First Century while attending a meeting about a new technology designed to improve knowledge management. The connection intrigued me. With my work on knowledge management and education, perhaps I could affect inequalities after all.
Societal Context
When I started reading Capital, there was not as much unrest as there is today. Today, the very needed and more visible Black Lives Matter movement reverberates through the United States. The movement is distorted by those who would use it for political gain or those who feel it’s an opportunity to express their violence in socially acceptable ways.
I’ve quietly initiated private conversations with some of my black friends to better understand the problems and look for the ways that I can help reduce the inequalities. I mean this from primarily the perspective of respect and acceptance of others and secondarily (but importantly) from an economic standpoint.
The reason this is relevant to the review of Capital is because it opened my eyes to the capacity to transform inequities. I was already aware of the reasons for the Sesame Street program, including the desire to level the educational playing field through “G” is for Growing. By minimizing the education gap and through teaching emotional regulation skills that were often not available to economically-disadvantaged children, the playing field could be leveled a bit. (See Emotional Intelligence for more on emotional regulation and The Years That Matter Most for how the instability of being poor impacts children.)
There were two core realizations from my conversations with my friends. The first mechanism used to repress black Americans was to disadvantage them economically. The second mechanism was to (over) criminalize their coping behaviors through drugs. (I won’t further cover this here, but I’d encourage those interested to look at Dreamland and particularly Chasing the Scream.) It is my hope is that some of the insights from Capital can ease the struggle for equality.
Communism
For some, Marx had it right. If we all lived equally, then all our problems would be gone. However, the Soviet experience proved that even communism has its limitations and faults. Largely we’ve escaped the arguments about whether a democratic, capitalist, free-market system is a better approach or communism. However, both sides admit that neither system is perfect. A more open discussion of the benefits of each can help to avoid situations like the Cuban missile crisis – and One Minute to Midnight.
Capital explains that Marx totally neglected the impacts of technological progress and steadily increasing productivity in his analysis and that these forces can – to some extent – serve as a counterweight to the steady accumulation of capital. This counterweight, when used with other counterweights such as excessive taxation on the highest incomes, can help keep the inequalities of the free-market system in relative check.
The final point to Capital is that democracy and capitalism must be reinvented again and again. The same can be said for every form of government and societal regulation system. If Capital revealed anything, it revealed that even when the overall things remain the same, the structure can and does change.
Inequality
In the United States, there’s a general disdain for those whose fortunes are conveyed by inheritance. We look down our noses on those who didn’t gain their lifestyle through their hard work. Historically, it’s been difficult for someone to elevate themselves socially or financially. In fact, it’s not been until the 21st century that people anywhere had a shot at making their own fortunes. However, in the United States in the last 50 years it has become – or at least it was – possible to make your own fortune and elevate your status within your lifetime. Throughout the history of the human race, such a feat has largely not been possible.
Still, one must be in the 99.5% percentile of income before more income comes from capital than one’s labor. The idea that there are many people who live solely off their inherited fortunes is largely an illusion. For the most part, those who have money make at least half of it themselves.
These numbers may be slightly skewed in ways that Thomas Piketty may not have expected. As Paul Tough notes in The Years That Matter Most, those who go to the most prestigious colleges appear to earn more than their peers. The point here is that some of the income that Piketty is accounting for as labor or mixed income may be attributable to the ability to attend these colleges. Piketty does acknowledge that there is a conspicuous change in gifts to endowments during the period when a parent has children of college going age.
Published well before the spotlight, this is the legal side of the 2019 college admissions bribery scandal. If there is no quid pro quo for the contributions to the endowment, then nothing is wrong. However, only the naivest would believe that there isn’t some impact to the admissions of children of large donors.
The fundamental problem with income inequality is that forms a potentially large positive feedback loop that continues until a powerful external force comes and addresses it. (See Thinking in Systems for more on feedback loops.) The size of the reinforcing impact is shaped by the savings rate, the inflation rate, the rate of taxation, and the rate of growth in the economy. When you combine a modest savings rate (20%), an average return rate of 8% (the historic average), and an inflation rate at about 2% (the historic average), after about 29 years, you’re earning more income than you need. At that point, unless your consumption rate changes, you’ll continue to develop more capital than you consume. While 29 years seems like a very long time, it’s not such a long time when considered in generational terms.
The Structure of Income
Of primary concern to Capital is the creation of capital and its effects. The ratio between capital and income is expressed repeatedly as a framework for understanding the impacts of capital on the economy. The interesting observation is that, though the nature and structure of capital has changed over the long term, capital is generally six times the income of a country. There are variations over time and from country to country, but the results generally return to these values.
Also, over the long term, the ratio between capital and income can be defined by the savings rate (how much is being saved) and the rate of growth in the economy. It’s important to note that this doesn’t take immediate effect – this works over decades.
These truths lead to some interesting observations. Given the average return rate of 8% and a 6:1 ratio between capital and labor, we find that roughly two thirds of the income comes from labor and roughly one third comes from interest on capital.
There are nuances to the analysis that escape the quick eye but for which Piketty has provided careful explanation. For instance, nations hold capital in the form of land and buildings. This capital is different than the kind of capital that private individuals and institutions hold. Similarly, not all income from labor is the same.
Risk and Entrepreneurship
Richard Cantillon coined the term entrepreneur to literally mean “bearer of risk.” (See Originals for more.) When we’re looking at the return on capital – that’s put at risk – and the labor of the entrepreneur themselves to transform that capital into something more, the line between labor and capital gets blurry. This is an area where Piketty creates a category which is mixed. That is, the income is accounted for partially by labor and partially by capital.
By assuming higher risks, entrepreneurs can get radically higher returns. Of course, many of these attempts won’t work, as we see with many startups and the business failure rate statistics. (40% of businesses fail within three years.) However, the allure of greater returns, often described as ten times, is what draws entrepreneurs to take the risks.
One of the reinforcing characteristics of return on capital is that the greater the size of the capital, the greater the possible return. This is in part due to the marginal cost of hiring experts to help generate higher returns is smaller and in part is due to the ability to take greater risks due to a greater safety net of a larger base of capital. The ability to earn larger returns on larger sums of capital is an accelerator to the reinforcing loop.
The Shift to Labor
One of the interesting observations is that the top centile (1%) of society moved from passively living on their wealth in the form of rent to actively working to increase their wealth. Instead of simply accepting that rent will continue to flow, we’re now combining our capital resources with our labor to amplify the results of both.
Perhaps this is a natural consequence of our post-World War II transitions to where work and study could allow one to transform their economic situation so dramatically. If you work your way up to the top of the income hierarchy, it may be hard to give up the habit of working. Conversely, if you’ve been comfortable resting on your laurels at the top and you see new upstarts challenging your relative financial dominance, you may be motivated to action. In either case, we’re working harder to make our money work for us.
Inflation
I was introduced to the power of inflation to radically transform an economy through The History of Iceland. Iceland has used inflation to virtually eliminate debt on a few occasions. Piketty explains that inflation is one of the rather blunt tools that central banks have on redistributing wealth inside of a nation – and decreasing the impact of national debt. The problem with inflation it seems is that for all the powers to reduce impact of national debt, it seems to be most harmful to those who have the least wealth.
The most intriguing thing to me was that inflation is a relatively new phenomenon, having only appeared in the 20th century. Prior to that, inflation was effectively nil. This to some extent makes sense. The growth of productivity was similarly very small. As our productivity increases get larger, the variations in the economic systems invariably get larger as well, and inflation is one of the controls.
Diffusion of Knowledge
One of the great forces that counterbalances the concentration of capital is the diffusion of knowledge. This is something of great interest as we enter an age where it’s increasingly easy to access information and accumulate knowledge. Some of the ways that knowledge gets spread aren’t obvious.
One challenge in developed countries is that the average rate of return on capital is stagnating and therefore is less than the rate of return that can be earned in other parts of the world. However, to recognize these returns, it’s necessary to share knowledge with the other parts of the world to make them more productive. We see this in the form of the increased benefits of free trade, where studies indicate that the diffusion of knowledge is the primary factor leading to productivity gains. We also see it as organizations spread their operations throughout the world, thereby spreading their knowledge.
Availability of Knowledge
Sitting where I do, with decades of experience in both internet technologies and knowledge management in particular, I’m excited about the impact of the underlying technologies and the increased awareness that we have about how knowledge is shared, how adults learn, and how to help people be productive. I know that we have a greater capacity to learn and teach than we have ever had in history.
For all the serious consequences of COVID-19, it has given us all an increased awareness of our ability to learn remotely. From the kindergarten classroom to the college degree, we’re now in an era where instruction is delivered on demand to your doorstep. The change has been coming for a few decades now, but COVID-19 crystalized its place. Simple challenges like finding the books that you wanted were radically transformed by Amazon.com. Kindle brought the ability to deliver a book to someone in moments.
Jonathan Haidt makes the point in The Righteous Mind that we’ve become the dominant species on the planet through our ability to work together. A simple glance is turned into shared intentionality. Our internet-fueled world removes the need to be geographically close to be able to develop that shared intentionality – and the shared knowledge.
The Eighth Wonder
It’s often reported that Einstein thought that compound interest was the 8th Wonder of the World or, alternatively, the most powerful force in the universe. The rules of compound interest would be that, ultimately, those who started with more – or got a better return – would eventually have immeasurably more than most. It is a powerful engine to separate people and create inequality. However, often it doesn’t seem that way.
When the growth or compounding occurs at a tiny rate, it takes a long time before the differences start to show up. During most of our time on the planet, the growth rate of our output has been barely 1% – but over time, even this trivial amount adds up. As was reported in The Halo Effect, in absolute terms, Kmart made great advances in its core metrics. However, its competitor, Wal-Mart was making even more dramatic increases in its inventory turns and ultimately drove its profitability up a few percentage points. This allowed for greater investments and optimizations, which further drove their performance increases. Wal-Mart is a retail powerhouse and Kmart has never really emerged from its bankruptcy filings and virtual irrelevance.
The diffusion of knowledge and expertise works as a counterbalance to the forces that would allow organizations to continue to improve unconstrained. In The Rise of Superman, Steven Kotler explains how moderate improvements over a long period of time have the capacity to make human feats seem superhuman. However, as the knowledge of the superhuman feats is diffused to everyone, they lose their luster, their uniqueness, and they become the new performance level that everyone expects. Roger Banister cracked the four-minute mile after 9 years of people attempting to break the previous record. He held the record for two months before someone bested his record. Once everyone knew that it was possible to run the mile in four minutes, it seemed like everyone was doing it.
In fact, in a decade, high school runners were running the mile in less than 4 minutes. Evolution doesn’t work that fast. The runners weren’t better because they had better or different genes. They were able to run that fast because we learned how to better coach runners to achieve those speeds.
Perception of Inheritance
Historically inheritance was a measure of your position in society. The more you inherited the better your class. However, the upstarts in the United States developed a particular aversion to large inheritances. The perception was that real people worked for their money – and to some degree this perception remains. Citizens of the United States are sold on their image of hard work, and they’re likely to snub their nose at “old money.”
There’s not a good or bad to it. Our perceptions have simply shifted – just like they’ve shifted with regard to the role of taxation.
The Role of Taxation
Despite the nearly universal distain for taxes, we all accept that we must pay them. We can no longer dump tea in Boston Harbor. We must develop and leverage a tax system that allows us to finance the operations of the government – and serves to constrain capitalism’s imbalances. The truth of capital taxes is that they rarely have a substantial impact on the overall finances of a country. Capital taxes are more useful in their ability to constrain capitalism and to establish socially acceptable norms – like not having large inheritance.
Ultimately, Piketty sees the role of capital tax as necessary but insufficient tool to constrain capitalism and the natural expansion of Capital. Take a read yourself and decide how Capital works for you.