What Piketty Missed in Measuring Wealth

Despite assembling a formidable data set and leveling a bold argument, Thomas Piketty’s Capital in the Twenty-First Century has theoretical and accounting flaws that distort its central findings

Thomas Piketty’s Capital in the Twenty-First Century aims to analyze changes, and their determinants, in the distribution of income and wealth in a set of developed countries from the nineteenth century to the present. The objective is a bold one, and made even more so by the fact that Piketty pursues it not only from a theoretical, but also from an empirical point of view. His study is particularly impressive not least because of the enormous effort required in collecting and organizing data over a time span of almost two centuries, thereby forcing comparison between numbers coming from very different contexts.

But although from the outset almost everyone recognized the book’s importance, many critics, including Robert Solow, criticized Piketty’s decision to conflate “wealth” with “capital.” My paper undertakes a detailed analysis of Piketty’s research in light of internationally accepted standards of national income accounting. It considers the deep implications of Piketty’s choice for many widely discussed parts of his analysis, especially his use of the wealth income ratio as an analytic term.

This recalls the capital/output ratio commonly used in growth theory, but it does not correspond to the usual meaning attached to it: the ratio of the value of installed, accumulated productive capital to the quantity of net output which it is able to generate. Inconsistencies also emerge when going through the sequence of non-financial accounts. The UN System of National Accounts defines GDP as the sum of “incomes that accrue to institutional units as a consequence of their involvement in processes of production or ownership of assets that may be needed for purposes of production.” GNI is obtained by adding to GDP the net balance with the rest of the world of primary incomes payable and receivable, and of net property incomes payable and receivable. Wages and profits accrue to the corresponding institutional units due to their involvement in production (wages) and the ownership of the means of production (profits). Property income, which is ultimately rents, is something entirely different, and as such is kept separated from profits by national accountants.

The difference is subtle but apparent. In the case of profits, the flow of income is justified by the fact that assets are productively employed and therefore generate new income. In the case of rents, the flow of income derives from the fact that the assets are put at the disposal of another institutional unit for purposes other than productive activity. As the two kinds of income are kept separated being deeply different in their nature, so should the two kinds of assets that give rise to them.

When related to the corresponding stocks, GDP describes how they actually generate the flows of income. The logic at the basis of this comparison is that accumulation generates income, and hence savings. Disposable income is given by GNI after taxes on income and wealth, social contribution, and net current transfers to the rest of the world, and represents income as it is actually available for consumption and savings. Hence, when related to the corresponding stocks, it describes the way in which flows of savings out of income actually determine the change in stocks. The logic being that savings generate investments, and hence accumulation.

Since Piketty’s analysis is of the second type—the former being closer to Classical and Keynesian point of view—the concept of income which should be consistently used in such analyses is that of disposable income, not that of GNI as Piketty does.

Moreover, Piketty’s definition of national wealth includes the net worth of the private sector, defined as Households only, plus the net worth of the General Government. Corporations are excluded since, according to Piketty, their capital stock is completely included in the market value of equities and corporate bonds possessed by the private sector.

But this is true only when the market value of corporations is equal to the replacement cost of their installed productive capacity, that is, when Tobin’s Q = 1. There is no reason for this to hold in general, since stock prices are often disconnected from companies’ productive activity. Companies also hold shares of other national and foreign companies, as well as a number of other financial assets, which makes it really heroic to connect replacement cost of capital, financial net worth, and stock prices.

Moreover, in the Corporations sector we find banks, including the central bank with its own assets and liabilities. Recalling that public debt corresponds to private credits, whenever public bonds are held by the private sector, debts and credits cancel out and there is no change in national wealth. Similarly, when public bonds are held by foreign entities, national wealth includes only the general government debt, while the credits are registered elsewhere, so that this represents a loss of national wealth. Disregarding corporations implies treating banks as foreign units: were they to hold public bonds, this would immediately translate into a loss of national wealth. Accepting Piketty’s definition implies accepting that the central bank, or public banks holding public debt securities, would impoverish the country.

This makes it hard to compare, for example, the period when the Bank of Italy acted as last resort lender for the Treasury to the following years. It also makes it difficult to compare Japan, where the central bank still has the power to be the last resort lender, to other countries. The case of Germany is also peculiar, given that in the EU public banksEuropean Central Bank still act as last resort lenders buying relevant amounts of public bonds.

These definitional issues have major implications for Piketty famous ‘second fundamental law of capitalism”—which states that the capital/income ratio is given by the ratio of the savings rate to the growth rate. This, the paper argues, is actually a long run equilibrium condition—i.e. the condition for capital/income ratio to be stable over time—and not an accounting identity. Piketty’s interpretation is the usual neoclassical one: an economic system is subject to secular forces which left to themselves would lead it to reach long run equilibrium, while short run shocks disturb this convergence process without changing the long run trajectory.

Piketty argues that, after a marked decrease due to the destruction of physical capital brought about by World War II, the capital/income ratio is now increasing again, getting closer to its historical norm. This “capital comeback” is due to many reasons, including a tendency to lower rates of growth, and a relatively higher rate of savings.

But if we reproduce Piketty’s exercise by using the appropriate definition of income, we can see that there is no correlation between actual capital/income ratios and the corresponding ‘long run value.’ Nor is it possible to use the latter to anticipate the movements of the former.

What data actually tell us is that, in France, wealth has been growing at the same pace as disposable income in the second half of the 1990s, then started growing faster in the 2000s, dropped in 2008, recovered in 2009 and 2010, and then started growing slower than disposable income, a trend which is still ongoing.

What happened, then, in the ten years between 1998 and 2007?

An answer can be given by reversing Piketty’s logic, i.e. by looking at how much income can be squeezed out of the given stock of existing wealth.

Capital/income ratios increased between 1998 and 2007 due to the sharp increase in the value of non-financial assets, driven by price rather than volume effects. This increase was mainly due to the increase in construction prices, which could be associated with the bubble that originated the crisis, so much so that the positive dynamics came to a halt precisely in 2007, when the bubble burst.

To conclude, Piketty’s empirical exercise is flawded in many respects. First, excluding Corporations from the computation of national wealth strongly distorts results. Second, physical and financial capital should be kept separate, also in order to interpret results consistently with a reference theoretical paradigm. Third, Neoclassical theory normally considers accumulation as generated by income, and hence the concept to be used is that of disposable income, and not of GNI. Finally, in line with Classical/Keynesian tradition, an analysis of capital accumulation should reverse Neoclassical logic: it is accumulation that generates income, and not the other way around. Hence, the concept to be used is that of GDP, as compared to the stock of physical capital which generated it.

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