Une nouvelle belle époque?

We know of the great inequality in England and France in the late 19th century through vivid portrayals in novels, movies and television. A few hundred families owned huge estates; industrialists and the bankers who had financed their enterprises had become enormously wealthy, while the industrial workers in the growing cities lived in poverty. This was the era of Upstairs Downstairs in England, La belle époque in France. The United States did not have the same inequality of land ownership, but the great industrial, oil and banking families lived in the Gilded Age.

After World War One and especially after World War Two, income inequality steadily declined. And there emerged a consensus that economic growth, with its rising levels of education, would lead to greater equality.

However, since the early 1980s, income inequality has been increasing again. The World Economic Forum in Davos identifies severe income inequality as a major global risk. U.S. president Barack Obama has declared income inequality as the defining challenge of our time. In Canada, the tents of the Occupy Movement have been removed, but the political platforms of all parties strive to connect with a middle class that is feeling squeezed.

The most glaring inequality today is the rising share of income going to the “1 percent.”

Historical data on the share of income taken by the top 1 percent reveals the three distinct eras. For example in Britain, the 1 percent share was 22 percent in 1910; then it declined significantly and steadily until 1980, falling to a low of 6 percent; but since 1980, it has risen sharply again and stood at 15 percent in 2010.

In Canada, available data are more recent, but the three-era pattern is similar: from 1920 to 1940, the share of all income taken by the top 1 percent averaged about 16 percent; from 1940 it continued a steady decline to 8 percent by 1980; but since then it has risen to more than 12 percent.

Are we returning to the inequality of the late 19th century? And if so, what can be done?

Dozens of books have been written about income inequality and hundreds of articles. But Capital in the Twenty-First Century, by French economist Thomas Piketty, has commanded more attention than most of these combined, and made him a celebrity intellectual.

How could a 685-page economics book have such an effect? Perhaps this only proves the importance of the issue; and certainly the book, although dense, is very readable and often slyly witty. At its simplest, Piketty’s argument is that there are forces of convergence and divergence in capitalist economies, but there is no a priori reason why there should be greater income equality. The task is to analyze the separate forces of convergence and divergence, and to do so using formal economic theory, complemented by good data and covering as long a history as possible. His historical analysis identifies the conditions for capital accumulation as a fundamental force for divergence. When the rate of return on capital significantly exceeds the growth rate of the economy, “it is almost inevitable that inherited wealth will dominate wealth amassed from a lifetime’s labor by a wide margin, and the concentration of capital will attain extremely high levels—levels potentially incompatible with the meritocratic values and principles of social justice fundamental to modern democratic societies.”

Piketty does economics in a new way; or more accurately, he returns to an older way. He still uses formal economic theory but regards economics as a sub-discipline of social science, alongside history, sociology, anthropology and political science and prefers to characterize his work as political economy rather than economic science. Piketty draws wonderfully upon the novels of Jane Austen and Honoré de Balzac to portray the gross inequality of 19th-century societies. He argues that the degree of inequality is not just the product of economic forces; it is also the product of politics, including the tax, expenditure and regulatory decisions of government, and the discourse of justification of inequality.

The optimism of the 1950s and ’60s that inequality would keep diminishing was based only on the data of the post-war years. Researchers felt that “the two world wars created such a deep discontinuity in both conceptual and statistical analysis that for a while it seemed impossible to study the issue in a long-run perspective, especially from a European point of view.” But Piketty, and collaborating researchers in many countries, have compiled new data series, some beginning in the late 18th century, that allow the required long-run analysis. The book (and its online appendix) is a treasure trove of data, exceptionally well presented in graphs and tables to illustrate the analysis. The focus is France, England and the United States, but Canada is covered as well.

Piketty starts in the 19th century and examines the three eras. He wants to understand the longue durée of capitalism, as did the pioneers of political economy such as Malthus, Ricardo and Marx. And like them, he places the distributional question—the distribution of pre-tax income and the distribution of wealth—at the heart of economic analysis.

This approach, which is both empirical and historical, is much needed if we are to understand income inequality and more generally to understand how capitalist economies operate. The ahistorical perspective of hedge fund managers and their risk pricing models helped cause the financial crisis in 2007–08. Piketty’s methodology is similar to a Canadian tradition of political economy, although that tradition is much attenuated since the mid 1960s. Back then, students studied political science and economics offered through the Department of Political Economy. And there were many courses in economic history. Today, students take a degree in economics through the Department of Economics, with requirements in mathematics and statistics. We need a return to more political economy in Canadian economic analysis.

Capital uses an analytical framework of economics that will be familiar to most readers (although not perhaps some of the nuanced aspects of the definitions).

Gross domestic product is the value of all goods and services produced within the borders of a given country in a given year. GDP is produced by combining capital and labour, using available technology. GDP grows (economic growth) when there is more capital, or more labour, or new technology, or any combination of the three. Growth also occurs when there is “better” labour, through education. Thus, the standard economic analysis of an economy, and its growth, focuses on capital and capital accumulation, population/labour force growth, education and technological change. And these all play their parts in shaping the distribution of income. National income is the sum of all income available to the residents of a given country in a given year. To a very rough approximation, national income will be equal to national product because the value of total output is distributed to the factors of production—capital and labour.

All very Marxian: output is produced by capital and labour, and the pie is divided into payments to capital and payments to labour. And indeed, to centre one’s economic analysis as a conflict between capital and labour is Marxian. But the basic framework of capital, labour and technology is standard mainstream economics as well. Piketty is methodologically mainstream, but he does think Marx had a point.

The distributional question in economics asks how the income to capital and the income to labour are distributed to individuals. An individual’s capital income depends upon how much capital (wealth) he or she owns and the return received from that capital; an individual’s labour income depends upon how many hours he or she works and the hourly earnings (which depend a lot on how much education that person has). The analysis of income inequality in a country can be decomposed into three parts: explanation of the inequality of capital income, explanation of the inequality of labour income and the correlation between them—that is the extent to which those individuals who have the high labour income also have the high capital income.

In Canada and elsewhere, most of the recent books and articles about inequality focus on inequality of labour income, in part, because today, in contrast to the 19th century, much of the income of the top 1 percent comes from labour rather than capital. As an economy grows through technological change, the demand for skilled labour will usually increase, and as the economy grows there will usually be higher levels of education and a greater supply of skilled workers. There is a “race between education and technology,” which sometimes implies rising relative wages of more educated workers—the consensus view of what has been happening over the past 20 years. But Piketty notes that there is no a priori reason why the race should not go the other way and lead to lower relative earnings for more educated workers and, similarly, no a priori reason why the race should lead to greater or lesser wage inequality. He examines the rise of super salaries being given to super managers in business and finance that has been the object of so much attention. Pointing out that the explosion of super salaries is occurring far more in the Anglo-Saxon world, and particularly the United States, he argues that it cannot be caused by economic forces that affect all developed countries similarly; rather, it must be caused by relative bargaining power sustained by social norms. The discourse of justification and politics of inequality in each country shape the outcomes. With gentle irony, he notes how the discourse of justification can shift. The United States in the 19th century was more equal than Europe and took pride that its vigorous pioneer society was more equal than “old aristocratic Europe.” Today the U.S. is much less equal and prides itself that its vigorous entrepreneurial society is more unequal than “old socialist Europe.”

However, Capital’s treatment of inequality in labour income is too thin. The inequality of earnings is a bigger part of what is going on than acknowledged, as are rapid technological change, deregulation, and globalization. These are better analyzed in Chrystia Freeland’s Plutocrats: The Rise of the New Global Super-Rich and the Fall of Everyone Else (reviewed in the March 2013 issue of the LRC by Donald Johnston). The two books complement each other nicely.

Piketty’s focus is not labour income but capital income, and here lies his originality and his importance for the Canadian debate. To fully understand economic inequality, we must study capital. How much capital is there in the economy? What is the annual rate of return to capital? And how unequal is the ownership of capital and so the income from capital? Does inheritance of capital shape life chances? These questions need greater attention in Canada.

He argues that capitalism has a powerful mechanism for divergence: when the economy grows slowly, the rate of return to capital can exceed the rate of growth of the economy, and so capital accumulates faster than the economy grows. Capital becomes more and more important; the capital-to-output ratio grows (assuming that capital owners consume only part of their income). But capital ownership is very unequal. There emerges great inequality in income from capital, and inheritance increasingly shapes life chances.

It is this mechanism that can explain the three eras of inequality.

The great inequality of the late 19th century arose because, for a very long period, the rate of growth of the economy had been much below the rate of return to capital. The value of capital grew faster than the economy; the capital-to-output ratio grew. The extremely unequal ownership of capital meant those with lots of capital could live lavishly and still preserve and even grow their capital. To use the example of belle époque France, in the late 19th century the total value of capital was seven times the annual output of the economy. The top 1 percent owned 60 percent of this capital. Those with the top incomes lived on the returns from this wealth. The surest way to enter this top income group was not education and hard work but inheritance or marriage.

The second era, the era of declining inequality, is explained not as a result of the normal working of the economy but because of the “shocks to capital” of the first war, the Depression and the second war. Capital values fell and the capital-to-output ratio in France fell to 2.5 by 1950. And in the 30 years after the Second World War, the growth rate of the economy was uncharacteristically high relative to the return on capital so that capital did not surge back to its place of importance. Also the post-war era saw high inheritance taxes and high marginal tax rates on high income.

Since 1980, the conditions for capital accumulation have returned. The growth rate has slowed and is well below the return to capital. The capital-to-output ratio is growing—it is now over six in France; capital owners can live well and still increase their capital. Also, since 1980, French inheritance taxes have been reduced and high marginal income tax rates also cut. Inheritance has returned as a substantial determinant of life chances. The French have detailed records on capital ownership and transfers of capital going back over 200 years. Current data show the return of inheritance and also show that more and more of the transfer from parent to child occurs not at the parent’s death but before: wealth transfers are made to help with education and buying a house. We have no such records in Canada, but such transfers sound familiar.

In the United States, the three-era pattern of capital is evident but less extreme: the capital-to-output ratio rose to five by 1910, fell to just below four by 1950, and is now about 4.5. Capital ownership in the U.S. has never been as unequal as in Europe. But the U.S. has an exploding inequality of labour income at the top end. This is becoming correlated with the emerging inequality of capital income, so that the inequality of total income (both capital and labour), measured as the share going to the top 10 percent, is greater than ever before, and is even higher than in the Gilded Age.

We have returned to the inequality of the 19th century, at least in the United States, and Piketty worries it may be the future in other countries. Is this Canada’s future?

The Canadian three-era pattern is also less extreme than in Europe, particularly because as an immigrant society we did not have the great inequality of land ownership. Our capital-to-output ratio grew to over five by 1910, fell to just over three by 1980, and has now risen to over four. We too had higher marginal taxes on high incomes in the second era and cut them since 1980.

The high per capita growth rates in Canada from 1950 to 1990 are not the norm, but an anomaly. Future growth rates for developed countries such as Canada will likely be below 1.5 percent per year, just as they were throughout the 19th century. Canada’s slow growth is not the “new normal” as business commentators have been telling us, but the return to normal. (Developing countries can have higher rates only because they are raising their levels of education and adopting available technology. As they approach the technology frontier, their growth will slow.) In Canada, the return to capital will be higher than the growth rate of the economy: capital is coming back and with it comes rising inequality of capital earnings.

Piketty’s great lesson for Canadians is to force us to think about capital—capital accumulation and capital income—as we think about income inequality, and to think about capital ­accumulation’s ­aftermath: inheritance. Sadly, Canada lacks good data on wealth distribution and its changes; but, like all countries, wealth ownership is much more unequal than income. The most recent data are for 2012 and show that the top 20 percent of households own 67 percent of the wealth and the bottom 40 percent only 2 percent. We will not properly understand income inequality in Canada until we get better wealth data; unfortunately, the Harper government cut support to Statistics Canada.

Capital in the Twenty-First Century, like almost all current writing about income inequality, focuses on the top end of the distribution. This is understandable because data are for the first time available about the very top end and because this is where the most dramatic changes in the distribution of income are occurring. The top decile is often dissected to look at the 1 percent and the 0.1 percent.

However, the distribution of income can only be fully described by looking at the top end, the middle and the bottom end. The political imperatives to address inequality have more to do with the middle and the bottom than the top. The top-end focus means Capital is disconnected from much of the analysis of income distribution, especially that in the 1960s and ’70s, during the “war on poverty” and the creation of a “just society.”

We need to know about the relative and absolute well-being of the lowest income households. Of course, this group had no capital in the 19th century and has none today. Their income comes from working and from government transfers; and their well-being depends on tax rates and public services such as health care and education. The post-1980 era in Canada is filled with paradox. The share going to the 1 percent is rising, so by this measure income inequality is growing. However, although the real after-tax income of the bottom 20 percent fell after the recessions of the early 1980s and ’90s, it has since been rising and has held up well after the Great Recession. And although poverty rates rose until the mid 1990s, they have fallen significantly since. The Canadian record is strikingly different from the United States and the United Kingdom, where poverty rates have been rising in the third era.

And what about the middle class? Again, the recent era has a paradox. The middle 60 percent have lost share slightly compared to the top 20 percent; but their after-tax real incomes, although falling in the mid 1990s, have risen since and have never been higher. This is an odd picture of a squeeze. Again, Canada’s record differs from the U.S. and the UK, where middle class incomes have been declining.

There is a danger that, in reading the many books and articles about inequality, Canadians fail to appreciate that we are different from many countries, except for the rising share to the 1 percent. Canadian progressives are particularly prone to this, which is ironic, because Canada’s difference is due to progressive public policy.

The historical perspective and focus on wealth of Capital in the Twenty-First Century does ­illuminate the special character of today’s middle class. Data are often presented as a decile distribution, grouped as the top decile, and the next 40 percent which Piketty calls the middle class. He recognizes that his definition of middle class is contestable, because by definition the group is above the median. But he captures well the common usage of middle class as “people who are doing distinctly better than the bulk of the population yet still a long way from the true ‘elite.’” In early 20th-century Europe, the top decile owned 90 percent of the wealth. The middle class owned only 5 to 10 percent, and the poorest 50 percent owned 5 percent or less. This was a time of extreme wealth inequality. During the 20th century, there was a great structural transformation: the emergence of a capital-owning middle class. Today, the top decile owns 60 percent, the lower 50 percent still owns 5 percent or less, but the middle 40 percent now owns about 35 percent of the wealth. In Canada, available data give only a quintile distribution: the top quintile own 67 percent of the wealth and the next two quintiles (40 percent of the population), known as the middle class, own 31 percent. Piketty acknowledges that this capital-owning middle class is a profound shift, but does not explore its ramifications.

The middle class in Canada are not being squeezed in terms of their real incomes; but they are feeling vulnerable and worried about the future. As owners of capital, they were hurt by the shocks of the financial crisis and worry about their long-term security—their pension investments and their house values. Their angst has as much to do with their capital as with their labour.

Although Capital, unlike most economics books, emphasizes the importance of politics and government policy, the analysis does not go very far. And the main policy recommendation, a world-wide annual tax on the value of capital, is unrealistic and politically naive. But there is much that can be done.

If we are to look at the longue durée of capitalism to understand inequality, we must look also at the longue durée of the role of government. And here we have not returned to the 19th century. In 19th-century Europe, voters had to own property and the elected assemblies were dominated by large landowners who saw it as their right and duty to rule. Today, we have universal suffrage. And, at least in Canada, our elected politicians are not the 1 percent or owners of huge wealth; they come from the top decile and the middle class. The 19th century had a limited state; today we have a welfare state with publicly funded education, health care and pensions. All this influences the distribution of well-being, life chances and power. And also the politics of what can and cannot be done about income inequality.

There is a profound sense in England, and the United States, and to a degree in Canada, that the system is being run for the 1 percent, that the benefits of growth are not being shared, and that politicians are deaf to the concerns of ordinary people. But the solution is not a world capital tax. The solutions are policies dealing with education, health, pensions and jobs, and with tax rates. Better public services need higher average tax rates for all; and fairer taxes mean higher marginal rates on high incomes.

Piketty shows us that capital is back. But there is much else to the story.