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The Bear's Lair: Ending Bernankeism will reduce inequality

March 31, 2014

Thomas Piketty's "Capital in the Twenty-First Century" has received rave reviews among the sort of commentators who are looking always for reasons to dump capitalism in the dustbin of history and resuscitate the Marxism they enjoyed in college (there are a LOT of these people). His central thesis is that if the return on capital exceeds the growth rate, then the rich get richer and society bifurcates ad infinitum, with capital owners and those controlling capital resources impoverishing the rest of us. It's an enjoyable theory for those that like such things and appears validated by the history of the last quarter century. However, it rests on fallacious economics and is only made spuriously plausible by the even more fallacious policies currently being pursued by the world's monetary authorities.

Piketty's central thesis that capital accumulates until its owners control everything suffers from a core fallacy: the tendency of capital owners to spend their returns. It's not a new theory; indeed the miserly King Henry VII over 24 years to 1509 got quite close to Piketty's goal of owning everything in his country by piling up satisfactory returns on his capital (and employing efficient tax gatherers). Unfortunately, his spendthrift son Henry VIII dissipated the Royal Treasury and even seizing the wealth of the monasteries was not enough to prevent insolvency by the time of his death in 1547. In more modern times, the excess returns on capital have accumulated for only short periods of time and, as we shall see, permanent concentration has never happened and is unlikely to.

Piketty's database is a valuable contribution, available on the Internet on: http://topincomes.parisschoolofeconomics.eu/#Database:

The data can best be considered by examining, not the income share of the top 1 percent, which includes a lot of doctors, middle-level bankers and other middle-class types, but that of the top 0.01 percent, who can truly be reckoned as the wealthy. That top 0.01 percent of U.S. residents (representing 9,700 people in 1913 and 31,500 today) enjoyed a 4.08 percent share of U.S. national income in 2012, (and without a doubt a bit more in 2013) compared to only 2.76 percent in 1913. 2012's figure isn't the record, however—their share reached 4.40 percent of national income in 1916, a year when war profits were high but taxes remained low. On the other hand, the top 0.01 percent's share of national income bottomed out at a mere 0.50 percent in 1973, a year when it was wonderful to be a blue-collar GM worker, but barely worth the trouble to be top 0.01 percent. (No wonder I found it easy to get into Harvard Business School around that time!)

Britain was somewhat more elitist than the U. S. in its peak year, 1913, when the top 0.01 percent earned 4.25 percent of national income. But it was already more egalitarian than today's U.S., at a 2.94 percent share for the top 0.01percent in the "Downton Abbey" year of 1920. On the other hand, Britain became even more egalitarian than the U.S in the 1970s. At the trough in 1978, the top 0.01 percent earned a measly 0.28 percent of national income. Actually, one has to confess a teensy worry about the statistics here. Since Piketty's figures are based on income tax returns, and since the top rate of UK income tax in 1978 was 98 percent, it's just possible—far be it from me to cast aspersions—that the top 5,000 Brits didn't declare every last farthing of their income to the taxman. Alas, more recent British figures are not available, but since the Russian mafia living in London don't pay British tax, the true level of inequality in current British society would be rather understated by tax records, anyway.

Other countries include France, whose most recent income share of the top 0.01 percent was 0.83 percent, Germany at 1.57 percent and Japan at 0.68 percent. On the other hand, in 1913, all three countries had top 0.01 percent income shares between 2.73 percent and 3.13 percent, leaving only Britain outside that range in the last pre-war idyll of low income taxes, sound money and very little state redistribution of income. Can we stamp out mindless egalitarianism therefore and assert that nature's level of inequality for a moderately wealthy country, without heavy taxation, subsidized leverage or government meddling, has the top 0.01 percent earning about 2.5-3 percent of national income? Thus, shares below two percent of national income for the top 0.01 percent are just as indicative of a problem as figures above four percent. In that sense, the U.S. was excessively egalitarian from 1938 to 1991 inclusive, and was excessively inegalitarian in 1915-1916 and since 2012.

Narrowing the problem down like that, so that only the pathologically unequal years are concerning, makes the problem's nature clear. It's not a long-term inevitable trend as Piketty claims, it's a short-term pathology caused by evanescent economic factors. In 1915-16 while World War I was raging, the U.S. economy was running at above capacity and many of the very rich, such as the Du Ponts, were making outrageous returns gouging the foolish Allied powers on sales of war materiel. After March 1917, when the U.S. entered the war, outrageous profits were no longer gouging foolish foreigners but unpatriotic, while taxes rose sharply. Consequently the income share of the top 0.01 percent fell rapidly, to 3.33 percent in 1917 and 2.45 percent in 1918.

Since 2012 the U.S. economy has equally suffered from a pathology: the long-term damage caused by nearly two decades of sloppy monetary policies, culminating in six years of zero interest rates. This has caused stock prices and asset prices to soar, concentrating wealth in the owners of capital (and those such as corporate top management able to siphon off capital's returns.) For 2013, Piketty's thesis is absolutely correct; in a year when the Standard and Poor's 500 index is up 30 percent, wealth will indeed concentrate among the owners of U.S. shares. In addition, leverage is much more readily available at cheap rates to those already wealthy, so a period of rapid growth in asset and share prices and very cheap money concentrates wealth further. As I have written, the Downton Abbey economy was a period of modest egalitarianism compared to that we are experiencing currently.

However, those sufficiently economically aware to realize the S&P 500 can't rise 30 percent every year will also be aware that the current economic situation is highly unstable and can't last forever, any more than could the war-fueled profiteering of 1915-16. Philadelphia Fed President Charles Plosser said this week that the federal-funds rate would reach 4 percent by the end of 2016. Since neither he nor any of the other Federal Open Market Committee members expect a resurgence of inflation, his forecast implies substantially positive real interest rates by that time. We may disagree with the FOMC about the likelihood of an inflationary resurgence, but if one occurred, the Treasury bond market would fall out of bed, and at least nominal interest rates would be much higher than they are currently.

Higher interest rates imply lower share prices and lower asset prices, it's as simple as that. Once that occurs, the effects of leverage go into reverse. Further, the flood of tech IPOs at highly questionable valuations that we have seen in the last couple of years will dry up. With capital values declining, easy money no longer available from the market and leverage more expensive, waves of bankruptcies will occur and the income share of the top 0.01 percent will decline rapidly, as it did in 1917-18. Not only will the returns on capital not allow the rich to take over the world economy, they will actually become negative, so that the rich get poorer in absolute terms. Since the current generation of rich has shown an ability to match Henry VIII in its profligate spending patterns, its wealth will collapse, fueled by its debt—and there is no Dissolution of the Monasteries available to bail these people out.

A world without the ultra-rich will not necessarily be hugely happier for the rest of us. Those middle-class types dependent on IRA and 401(k) money-purchase pension plans for their retirement will find themselves unable to retire, and those with homes will find that higher interest rates have reduced their home equity and made it difficult to move, let alone to "cash out" and buy that sailboat. Also, the chances of a major geopolitical disruption in 2015-16 must now be rated as significant; while such a disruption would be even more unpleasant for the rich (at least economically) than for the rest of us it would be wealth-destroying for all.

However, in the longer term the underlying economy will be strengthened, not weakened, by the return of substantially positive real interest rates; savings will increase and factories will return to the U.S. as there will no longer be floods of cheap global money propelling them towards emerging markets. The wealth of the rich will be increased by this strengthening—but so will that of everybody else. There will no longer be artificial asset-price inflation tending to make the rich richer at the expense of the rest of us.

Ben Bernanke did a great deal to make Piketty's theory look convincing. But Bernankeism won't be with us forever, thank goodness, and in the longer term, Piketty's theory is nonsense. Politically of course it will remain dangerous, because it provides a plausible pretext for redistributionist and state-control policies, just as Keynesianism and environmentalism did before it.

But then in politics, economic rationality plays very little role. 

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.



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