Currency and Commodity Markets in 2015

This is the third and final installment of an interview on the outlook for the New Year.

Part 3. Forecasts for International Currency and Commodity Markets

Q – What is your forecast for the U.S. dollar? Do you think maintaining the strong dollar could ultimately help the U.S. economy, or hurt it?

A – The appreciation of the dollar against the euro and the yen in 2014 was precisely what we should have expected from the economic fundamentals: the strengthening of the US recovery at the same time that the euro and Japanese economies have been slumping and the end of US monetary easing at the same time that the ECB and the Bank of Japan have redoubled their efforts at monetary stimulus.

When trying to forecast exchange rates, one does well to recall the “random walk” principle.  One is doing well if one gets the direction of movement right slightly more than half the time.  Having said that, I would guess that the dollar is more likely to appreciate further in 2015 than to fall, for the same macroeconomic reasons as last year.

Would that be a good thing?  Moderate appreciation of the dollar against the euro and yen is the natural concomitant of the monetary and real economic fundamentals.  Europe and Japan need the stimulus of easy money and competitively priced-currencies.   If the US recovery were to falter in the future, the Fed could reverse its plans to raise interest rates and the dollar in that case would probably come back down.   But as of now, the US economy seems to be doing well.

Q -The oil price continues to fall to near $50 a barrel. How do you forecast the oil price for 2015 and beyond? How will it impact the world economy?

A – Among the reasons for the fall in the price of oil, of course, is the US shale energy boom (techniques associated with “fracking”).  Even though the new shale activity will moderate at these low prices, its ability to resume relatively quickly will work to prevent oil prices from rebounding.

The price decline goes beyond oil. Mineral and commodity prices have also fallen over the last year, at least in terms of dollars.  Disappointing levels of economic activity in much of the world are an obvious explanation.  But the business cycle doesn’t explain why commodity prices are down especially in the US, where economic activity strengthened in 2014.  The Economist commodity price index in 2014 was actually up in terms of euros; it was down only in terms of dollars, though that is what everybody focuses on.

The other factor is monetary policy: the end of quantitative easing in the US and renewed monetary stimulus elsewhere.  That is consistent with some commodity prices falling in dollars while simultaneously rising in terms of other currencies.   We could see more of this in the coming year.

I would say that oil prices and other commodity prices are more likely to continue falling in 2015 than to rise.  To the extent that oil prices are down because of the fracking boom or because some of the worst geopolitical fears have not materialized, this is good for the world economy (even though bad for oil producing countries).

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The US Economy in 2015

Following the first installment of a year-end interview on the global outlook, I turn in the second installment to the domestic economy.

Part 2. The US Economy

Q – As economic adviser to President Clinton, you oversaw one of the most prosperous periods in recent U.S. history. How do you assess the economic strategy of the Obama administration? What would you have done differently were you an adviser?

A – In my view President Clinton’s policies did contribute substantially to the outstanding performance of the American economy in the late 1990s.  People did not give him enough credit at the time.  (I myself had nothing to do with it, I assure you.)

The situation that President Obama inherited from the second President Bush was quite different from the situation that Bill Clinton had inherited from the father in January 1993.  As of the day Obama took office in January 2009, the worst financial crisis since the 1930s was still underway, US GDP and employment were in free fall (the numbers turn out to have been much worse, even, than we knew at the time), and the budget deficit was skyrocketing.  People like to say that a favorable judgment regarding Obama’s reaction rests solely on the unprovable proposition that the US would otherwise have experienced a Great Depression.  But in fact a turnaround in the economic statistics is visible to the naked eye. GDP and the rate of job loss stabilized almost immediately after Inauguration Day and the recession ended in June 2009. In my view the three main reasons that things began to turn around so quickly were the Obama fiscal stimulus, the new improved TARP program, and continued innovative monetary expansion by the Fed.

A majority of Americans still don’t yet see it that way.  Among other things, they haven’t seen the data on the 2009 turnaround and they don’t know that the US Treasury was paid back for the “bailouts” with a substantial overall profit.

So I think Obama’s policies did a lot of good during the first two years of his presidency.  This is especially true if one includes two big longer-term reforms: the Affordable Care Act (“Obamacare”) and financial reform (the Dodd-Frank bill).  But it is more difficult to attribute the path of the economy during 2011-2014 to the President, because the Republican Congress blocked almost every bit of legislation that he wanted during this period.

Q – What is the outlook for the US economy?

A – We should be able to grow at 3 per cent in 2015.   In 2001, 2012, and 2013, economic growth was impaired by dysfunctional fiscal politics in Congress – fiscal cliffs, debt ceiling stand-offs, government shutdown, and sequesters.  In my view that knocked at least one percentage point off of the growth rate in each of those years.   This is a more obvious explanation for the slow pace of the recovery in those years than the secular stagnation hypothesis.   In 2014 the Congress managed to refrain from actively impeding the economy in this way.  I believe that is a major reason why economic growth in the second and third quarters of this past  year was so much stronger than in the preceding three years.  On top of that, we have had the frackingboom and lower oil prices.   I see no reason why the good performance should not continue in 2015 – unless Congress screws it up again.

Q – If the Federal Reserve raises interest rates as expected in June 2015, might that choke off the recovery?

A – The Fed might in the end wait slightly longer.   (There is no more sign of inflation now than there has been since the period of near-zero interest rates began.)  But when the Fed does raise interest rates, it will be because the US economic recovery is very well-established.   So that would be good news, not bad news.

Q – Name a threat to the global economy.

A – Many countries are hampered by their own politicians’ habit of following pro-cyclical fiscal policy.  That is, they raise government spending and cut taxes in boom times, which exaggerates the upswing, and then cut spending and raise taxes in recessions, worsening the downturn.  Exactly backwards.

Q – Upon release of Capital in the 21st Century by Thomas Piketty, capitalism again became a hotly debated topic around the world. Do you think the current global economic system is sustainable? What aspects could be improved?

A – No doubt one of the reasons that most Americans are skeptical of the economic recovery is that they don’t feel it because virtually all the gains have gone to the rich.  Real median family income is still more than 8 per cent below where it was in 2000.

I disapprove of the recent increase in inequality in the US and other countries.  But I do not see the inequality either as an inevitable aspect of capitalism nor as unsustainably containing the seeds of destruction of the system.  Piketty’s book treats the big decline of inequality in the years 1913-1973 as a temporary reversal in a long-term trend toward unequal wealth that began in Jane Austen’s time, the early 19th century.  To do so is to treat the rise of democracy as a temporary blip, which it is not.  There is no reason why a democratic system cannot choose policies that give a good combination of growth in the overall size of the pie together with a somewhat more equal distribution of the pie.  Scandinavian countries have done this in their own way.   In the US case, I support such policies as universal pre-school education, universal health care insurance, expansion of the Earned Income Tax Credit, and a more progressive structure to the payroll tax, among others.

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The World Economy in 2015

I am posting in three parts the results of an interview on the year-end outlook.  (The questions come from Chosun Daily, leading Korean newspaper. The interview is to be published there January 1.)

Part 1. The Global Economy in 2015

Q: Around this time next year, which countries do you predict will be the winners, and which will be the losers of the year?

A: The big gainers will be oil-importing economies, particularly China, India and other Asian countries.

Russia will be the big loser. It has now become clear to all how fragile and vulnerable the Russian economy was, especially with respect to world oil prices. It is easy to forget that commentators a few months ago were declaring Russia less vulnerable to Ukraine-related sanctions than Western Europe. Before that, they were judging the $50 billion 2014 winter Olympics in Sochi a triumph.

Q: Even up to last year, Russia was considered a promising market. Which country could be the ‘Next Russia’ in 2015?

A: Cuba. Obama’s decision in December to normalize relations between Washington and Havana is a historic opening. Cuba is a small country, of course, but once it is opened up, the potential for investment and rapid growth is big. Many Republicans in the US Congress will oppose ending the trade embargo; but they are on the wrong side of history and on the wrong side, even, of domestic public opinion.

Q: What key word do you predict will emerge in the global economic scene in the new year? Why?

A: CoP21.  The 21st Conference of Parties of the UN Framework Convention on Climate Change, to be held in Paris in December 2015. The odds of a substantive agreement by countries, rich and poor, to limit their emissions of greenhouse gases are better than they have ever been. The catalyst is the November 2014 breakthrough between Chinese leader Xi Jinping and US President Barack Obama.  That, in turn, was made possible because China’s air pollution has gotten so bad that its government is ready to take serious measures.

Q: What in your opinion is the greatest unforeseen risk to world economy going into 2015?

A: By now, possibilities such as plunges in asset prices or a return of the euro crisis are sufficiently prominent in market awareness that they are not unforeseeable risks or unknown unknowns. Rather they are the known tail of the probability distribution.   I suspect that some of the true black swans come from such areas as technology, the weather, and health.   An example would be a disease that is more contagious than the ones we have seen. Or cyber warfare. Or WMD terrorism. I think of black swans as risks that are supposedly unknowable but in fact should be on the list of possibilities if one takes a broad enough perspective. Of course the risk of any single such disaster happening in any given year is small.

Q: According to the IMF, China has replaced the U.S. as the largest economy (in PPP) this year. Despite that, the Chinese government declared a ‘new normal’ and hinted at slowing down. What is your assessment of the Chinese economy in 2015? Will China eventually replace the U.S. as the superpower in the near future?

A: China has accomplished an economic miracle in raising the standard of living of most of its people over the last three decades and the new PPP measures from the International Comparison Project are indeed the best reflection of this.   However China still has a long way to go. For one thing, if the question is income per capita, then China is still a poor country, even in the ICP rankings. For another thing, if the question is the overall size of the economy, then in my view China’s GDP should be compared to the US economy by means of current exchange rates, not by the PPP measure. The reason is that what matters is how much a yuan buys on world markets, not how much it buys in the interior of China. At current exchange rates, US GDP is still about 80% greater than Chinese GDP.   China is likely to catch up, not this decade, but in the next decade.

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Why Are Commodity Prices Falling?

Oil prices have plummeted 40% since June – good news for oil-importing countries, but bad news for Russia, Venezuela, Nigeria, and other oil exporters. Some attribute the price drop to the US shale-energy boom. Others cite OPEC’s failure to agree on supply restrictions.

But that is not the whole story. The price of iron ore is down, too. So are gold, silver, and platinum prices. And the same is true of sugar, cotton, and soybean prices. In fact, most dollar commodity prices have fallen since the first half of the year. Though a host of sector-specific factors affect the price of each commodity, the fact that the downswing is so broad – as is often the case with big price swings – suggests that macroeconomic factors are at work.

So, what macroeconomic factors could be driving down commodity prices? Perhaps it is deflation. But, though inflation is very low, and even negative in a few countries, something more must be going on, because commodity prices are falling relative to the overall price level. In other words, real commodity prices are falling.

The most common explanation is the global economic slowdown, which has diminished demand for energy, minerals, and agricultural products. Indeed, growth has slowed and GDP forecasts have been revised downward since mid-year in most countries.

But the United States is a major exception. The American expansion seems increasingly well established, with estimated annual growth exceeding 4% over the last two quarters. And yet it is particularly in the US that commodity prices have been falling. The Economist’s euro-denominated Commodity Price Index, for example, has actually risen over the last year; it is only the Index in terms of dollars – which is what gets all of the attention – that is down.

That brings us to monetary policy, the importance of which as a determinant of commodity prices is often forgotten. Monetary tightening is widely anticipated in the US, with the Federal Reserve having ended quantitative easing in October and likely to raise short-term interest rates sometime in the coming year.

This recalls a familiar historical pattern. Falling real (inflation-adjusted) interest rates in the 1970s, 2002-2004, and 2007-2008 were accompanied by rising real commodity prices; sharp increases in US real interest rates in the 1980s sent dollar commodity prices tumbling.

There is something intuitive about the idea that when the Fed “prints money,” the money flows into commodities, among other places, and so bids their prices up – and thus that prices fall when interest rates rise. But, what, exactly, is the causal mechanism?

In fact, there are four channels through which the real interest rate affects real commodity prices (aside from whatever effect it has via the level of economic activity). First, high interest rates reduce the price of storable commodities by increasing the incentive for extraction today rather than tomorrow, thereby boosting the pace at which oil is pumped, gold is mined, or forests are logged. Second, high rates also decrease firms’ desire to carry inventories (think of oil held in tanks).

Third, portfolio managers respond to a rise in interest rates by shifting out of commodity contracts (which are now an “asset class”) and into treasury bills. Finally, high interest rates strengthen the domestic currency, thereby reducing the price of internationally traded commodities in domestic terms (even if the price has not fallen in foreign-currency terms).

US interest rates did not really rise in 2014, so most of these mechanisms are not yet directly at work. But speculators are thinking ahead and shifting out of commodities today in anticipation of future higher interest rates in 2015; the result has been to bring next year’s price decrease forward to today.

The fourth of the channels, the exchange rate, has already been functioning. The prospect of US monetary tightening coincides with moves by the European Central Bank and the Bank of Japan toward enhanced monetary stimulus. The result has been an appreciation of the dollar against the euro and the yen. The euro is down 8% against the dollar since the first half of the year and the yen is down 14%. That explains how so many commodity prices can be down in terms of dollars and up in terms of other currencies.

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8 Policy Recommendations for Newly Elected Members of Congress

On December 3, 2014, I participated in a panel of Harvard University’s Bipartisan  Program  for  Newly Elected Members of Congress.   After establishing that the median US household has not shared in recent strong economic gains, I went on to consider policy remedies.

I offered the Congressmen eight policy recommendations.  Some will sound popular, some very unpopular; some associated with “liberals”, some with “conservatives.”   I would claim that they all have in common heavy support from economists, regardless of party – even the very unpopular ones.

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A Pre-Lima Scorecard for Evaluating Who is Doing their Fair Share in Pledged Carbon Cuts

Those worried about the future of the earth’s climate are hoping that this year’s climate change convention in Lima, Peru, December 2014, will yield progress toward specific national commitments, looking ahead to an international agreement at the make-or-break Paris meeting to take place in December 2015.

The precedent of the Kyoto Protocol negotiated in 1997 is more discouraging than encouraging. It was an encouraging precedent in that countries were politically able to agree on legally binding quantitative limits to their emissions of Greenhouse Gases, to be achieved with the aid of international trading and other market mechanisms. But it was discouraging in that China and other big developing countries would not countenance limits to their own emissions and, largely for that reason, the United States never ratified Kyoto.

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Emissions Reduction by the Numbers

Discussions in Beijing between US President Barack Obama and Chinese President Xi Jinping – the leaders of the world’s two largest carbon-emitting countries – produced an unexpected, groundbreaking bilateral agreement on greenhouse-gas emissions. Under the new deal, the US is to reduce its emissions by 26-28% from 2005 levels within 20 years, and China’s emissions are to peak by 2030. In the absence of a binding global agreement, such unilateral or bilateral commitments by countries to rein in their contribution to global warming represent the most realistic hope for addressing climate change.

The 1997 Kyoto Protocol marked a major step forward in efforts to head off the most disastrous consequences of climate change, establishing a precedent for legally binding limits on emissions. But it lacked commitments by large developing countries, such as China and India, and, largely for that reason, the United States never ratified the treaty.

A loose system of individual commitments, in which each country unilaterally sets emissions targets, can help build trust and momentum for a more inclusive successor to the Kyoto Protocol, which many hope will be forged at the United Nations Climate Change Conference in Paris in 2015. But if such a system is to work, general agreement would need to exist about what constitutes a fair target for each country. Then advocacy groups and researchers could compile scorecards that would show which countries are meeting the standard – and shame those that are not.

At first blush, there would seem to be no agreement on what fair cuts would look like. India point outs that an average American emits ten times as much as an average Indian, and argues that emissions allowances should therefore be allocated according to population. The US insists that it would be unfair to burden its companies if energy-intensive industries could simply relocate to developing countries that had not yet constrained their emissions. Both sides have a point.

Fortunately, a study of the emissions targets to which countries have already agreed – in Kyoto and at the 2010 UN Climate Change Conference in Cancún – allows us to describe, and even quantify, what has historically been considered fair and reasonable. Emission targets implicitly tend to obey a formula that quantifies three major principles: all countries should rein in their emissions, but rich countries should accept bigger cuts than poor countries; countries where emissions have recently increased rapidly should be given some time to bring them back down; and no country or group of countries should suffer disproportionately large economic costs.

In Kyoto, every 10% increase in per capita income corresponded to an agreed emissions reduction of 1.4%. In Cancún, every 10% increase in income corresponded to a cut of 1.6%. If this pattern continues through the rest of the century, with emphasis gradually shifting from historic levels to per capita targets, economic models predict that no country need suffer a loss of more than 1% of GDP in present discounted value (assuming that market mechanisms such as international trading are allowed).

To be sure, the question of how to share the economic burden of any particular global emissions path is completely different from the question of how environmentally ambitious overall climate-change mitigation efforts should be. But, as negotiations proceed, this approach can allow us to evaluate whether the burden of reducing the harmful effects of climate change is being fairly distributed, and to judge whether individual countries are doing their part as they head into the 2014 UN Climate Change Conference in Peru next month.

The graph below compares the per capita income of countries with the emissions cuts that they have pledged to deliver in 2020. Each country’s cut is measured relative to a particular baseline that averages its actual emissions level in 2005 with emissions expected in 2020, absent international action.

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America, the Balanced

When the United States’ current account fell into deficit in 1982, the US Council of Economic Advisers accurately predicted record deficits for years to come, owing to budget deficits, a low national saving rate, and an overvalued dollar. If the US did not adjust, knowledgeable forecasters intoned, it would go from being the world’s largest creditor to its largest debtor. Many of us worried that the imbalances were unsustainable, and might end in a “hard landing” for the dollar if and when global investors tired of holding it.

The indebtedness forecasts were correct. Indeed, every year for more than three decades, the US Bureau of Economic Analysis (BEA) has reported a current-account deficit. And yet now we must ask whether the US current-account deficit is still a problem.

For starters, the world’s investors declared loud and clear in 2008 that they were not concerned about the sustainability of US deficits. When the global financial crisis erupted, they flooded into dollar assets, even though the crisis originated in the United States.

Moreover, a substantial amount of US adjustment has taken place since 1982 – for example, the dollar depreciations of 1985-1987 and 2002-2007 and the fiscal retrenchments of 1992-2000 and 2009-2014. The big increase in domestic output of shale oil and gas has also helped the trade balance recently.

As a result, the US current-account deficit in 2013 had narrowed by half in dollar terms from its 2006 peak, and from 5.8% of GDP to 2.4%. This is a decline of two-thirds when expressed as a share of global output.

A symmetric adjustment has also occurred in China, via real appreciation of its currency and higher prices for labor and land. China’s current-account surplus peaked in 2008 at more than 10% of GDP and has since narrowed dramatically, to 1.9% last year. China’s trade adjustment in some respects followed that of Japan, the original focus of American trade anxieties in the 1980s.

I propose a third, more speculative reason why it may be time to stop worrying about the US current-account deficit. It is possible that, properly measured, the true deficits were smaller than has been reported, and even that, in some years, they were not there at all.

Every year, US residents take some of what they earn in overseas investment income – interest on bonds, dividends on equities, and repatriated profits on direct investment – and reinvest it then and there. For example, corporations plow overseas profits back into their operations, often to avoid paying the high US corporate income tax implied by repatriating those earnings. Technically, this should be recorded as a bigger surplus on the investment-income account, matched by greater acquisition of assets overseas. Often it is counted correctly. But there is reason to think that this is not always the case.

The world has long run a substantial deficit in investment income, even though the correct numbers should sum to zero. The missing income must be going somewhere.

Even for officials as highly competent as those at the BEA, it is impossible to keep track of all of the stocks and flows in the international economy. Everyone knows that errors and omissions are large, especially when it comes to financial transactions. Underfunding of statistical agencies exacerbates measurement problems, but it does not create them.

Less well known, however, is a particular pattern in the revisions of the US international investment position. The currently available historical statistics show that in every year from 1982 to 2000, the initial estimate of the net international investment position was subsequently revised upward, as statisticians found overseas assets about which they previously had no way of knowing. Since then, some subsequent revisions have been positive and some negative. But, despite more frequent surveys of portfolio holdings in recent years, certain new asset acquisitions – for example, some held with foreign custodians – still most likely go unreported.

The numbers are potentially large. The reported US current-account deficits from 1982 to 2013, based on subsequent revisions, total $9.5 trillion. And yet the deterioration in the US international investment position over this period was not much more than half of that amount ($5.7 trillion if measured relative to the revised estimate for 1981).

Certainly a lot of the discrepancy is attributable to valuation effects: since 1982, the dollar value of overseas assets has increased repeatedly, owing to increases in the dollar value of foreign currency and increases in the assets’ foreign-currency value. But part of the discrepancy also reflects the discovery of missing assets, some of which may have originated in the reinvestment of overseas income.

The missing credits also originally could have been earned in other ways. For example, US multinational corporations sometimes over-invoice import bills or under-report export earnings to reduce their tax obligations. Again, this would work to overstate the recorded current-account deficit.

Consider an (admittedly extreme) illustration. If true investment income were double what is reported, the difference was reinvested abroad in the years 1982-2000, and those assets were discovered by 2014, that would explain about half of the upward revision in the US net international investment position.

If something like this under-reporting of reinvested earnings or other balance-of-payments credits has gone on in the past, it may still be going on today – especially with US firms becoming aggressive about arbitraging corporate income tax. And if true investment income is indeed as large as double what is reported, the true US current-account balance entered the black in 2009 and has been in surplus ever since.

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The Return of Voodoo Economics

Paul Krugman’s column in the New York Times today talked of the revival of “Voodoo economics” by some Republican politicians.  This refers to the Laffer Proposition that a cut in income tax rates stimulates economic activity so much that tax revenue goes up rather than down.   Gov. Sam Brownback, who is running for re-election in Kansas, has had to confront the reality that tax revenues went down, not up as he argued they would, when he cut state tax rates.

I disagree with one thing that Krugman wrote in his column: the idea that there was a long break,  particularly after George W. Bush took office, during which Republican politicians did not push this line.  To the contrary, I have collected many quotes from George W. Bush and his top officials claiming the Laffer Proposition during the decade of the 2000s.   The quotes are on pages 35-39 of “Snake-Oil Tax Cuts,” RWP 08-056, Harvard Kennedy School, 2008.   Here is one of many from him: “The best way to get more revenues in the Treasury is…cut taxes to get more economic growth.“ It is true that the chairmen of Bush’s Council of Economic Advisers did not support the Laffer Proposition, known as the centerpiece of “supply-side economics”.  But then that was also the case in the Reagan Administration.

The McCain presidential campaign replayed the pattern yet again in 2008: the candidate said tax cuts would bring in more revenue even though his economic adviser said it wouldn’t.    Voodoo economics is a very hardy perennial.

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Piketty’s Fence

Most of the reviews of Thomas Piketty’s book Capital in the Twenty-First Century have already been written.  But I thought it might be best to read it all the way through before offering my own thoughts on this book, which startlingly rose to the top of the best seller lists last April.  It has taken me five months, but I finished it.

One of the things the book has in common with the Karl Marx’s Das Capital (1867) is that it serves as a rallying point for the many people who are passionately concerned about inequality, regardless whether they understand or agree with the specific arguments contained in the book in question.  To be fair, much of what Marx wrote was bizarre and very little was based on careful economic statistics.  Much of what Piketty says is based on careful economic statistics, and very little of it is bizarre.

A problem with having a debate about “inequality” is that there are many different measures of the distribution of economic resources and criteria for evaluating it.   Yes, we should not be content with summarizing all of economic performance into the single criterion of aggregate GDP.   But neither is it possible to summarize all other important dimensions of the distribution in a single second statistic to measure inequality.  Trends in within-country inequality can look very different from trends in cross-country inequality, for example.  And so forth.

Within the United States, income inequality by most measures has been rising since 1981, and by 2007 had approximately re-attained the peak of the early 20th century [Fig.1.1, p.24].  On this much we should be able to agree. The same is true within other major English-speaking countries (the UK, Canada and Australia).  In these countries, income inequality had declined sharply during the years 1914-1945, as it did also as in France, Germany, Japan and Sweden.  But in the latter group income remains far more equally distributed than it was at the peak of inequality a hundred years ago.

Economists, at least in the United States, have focused on one or the other of several kinds of inequality:

  • First is the difference in wages or incomes between “skilled” and “unskilled” workers, defined according to whether they are college-educated.  Here the higher wages of the better off group are often agreed to reflect the economic value of their skills in an increasingly technological economy, and the question is how to improve the skills of those on the other side of the fence.  (This has little to do with the gap between the upper 1% and the rest.)
  • Second is the very high compensation of corporate executives, and others in the financial sector.   The financial crisis of 2008 left many observers understandably doubtful of claims that this compensation is a return to socially valuable activities.
  • Third is the “winner take all” aspects of many professions, from dentists to university professors to sports and pop stars.   In a society that identifies, thanks to modern technology and culture, who is the best dentist in town or the best football player in the world, relatively small differences in abilities win far bigger differences in income than they used to.
  • Fourth is “assortative mating,” according to which highly accomplished professional men no longer marry their secretaries but instead marry highly accomplished professional women.

Piketty’s main concern is none of the above.   He discounts the skills gap explanation.  [“This theory is in some respects limited and naïve.” (p.30­5)]    He doesn’t say much about the “winner take all” or “assortative mating” phenomena.  He does have definite concerns about excessive executive compensation in areas like finance, but they are not the primary concern of this book.

The central concern of the book is none of these varieties of income inequality, all of which have to do with “earned income” (wages and salaries).  It is, rather, what he sees as a 21stcentury trend toward inequality of wealth, to be brought about by steady accumulation of savings among the better off, passed down along with accrued interest to the next generations in their inheritances.

This is a prediction about what will happen in the future more than an observation about a recent trend [figures 10.3-10.5; pages 344-349].   The increases in various measures of inequality since the 1970s have had more to do with earned income than with wealth.

It is true that the capital share of income (interest, dividends and capital gains) rose gradually in major rich countries during the period 1975-2007, and the labor share (wages and salaries) fell [Fig.6.5, p.222].   This trend would support Piketty’s hypothesis if it continued.  He deserves credit for pointing out the lack of foundations behind assertions that capital’s share will necessarily revert to a long-run constant, which used to be declared as approximately 0.25.

His vision is focused squarely on the truly long run, however: century-long trends, not decade-long fluctuations.  For example the Global Financial Crisis is a blip for him.   Incidentally, it is a blip that runs counter to his ultra-long-run hypothesis:  His statistics clearly show a discrete fallin inequality and in capital’s share in 2008-09, because asset prices plummeted.

Three century-long movements constitute the essence of the book:  a rise in inequality in the 19th century, a fall in inequality in the 20th century, and a predicted return to high inequality in the 21st century.

  • Piketty argues convincingly — not just with statistics but also with frequent citations of the novels of Honoré de Balzac and Jane Austen (as remarked by most reviewers) – that the first increase in inequality in France and Britain, mostly from 1800 to 1860, took the form of capital accumulation.   A fence divided the rich rentiers, who lived off their interest, from everybody else, who had to work for a living.
  • The most dramatic movement in Piketty’s graphs is the second one, the fall in inequality concentrated in the period from 1914 to 1950 [figures 8.1, 8.5, 9.2, 9.3 and 9.5, on pages 272, 291, 316, 317, and 317, respectively].  It is attributable to the destruction of capital in two world wars, inflation, the 1929 stock market crash, and a historic social movement in the 1930s and 1940s toward big government and progressive taxation.
  • What is surprisingly scarce in his numbers is evidence that the third movement, the renewed upswing in inequality, which he thinks may have already started since 1980 in the English-speaking countries, is due to a shift from labor back to capital.  The share of capital income in the UK and France remains far lower than it was in 1860. The increases in various measures of inequality since the 1970s have had more to do with shifts withinlabor’s share (between different categories of earned income) than with wealth. Today’s rich work, unlike those characters in Balzac and Austen and Balzac.

Thus the hypothesis is much less of an explanation for the past (whether the past 6 years, 35 years, or 150 years), than it is a prediction about the future:  a prediction that capital will accumulate and the rich will get richer through inheritance and capital income (”unearned income”) rather than through outlandish salaries and stock options (“earned income”).  For all the impressive collection of historical data, the prediction is based mainly on a priori reasoning:  income distribution must tend to inequality because savings accumulate.

But one could just easily find other a priori grounds for reasoning that countervailing forces might kick in if things get bad enough.  Democracy is one such force.  Progressive taxation arose in the 20th century, following the excesses of the Belle Époque.  A political trend of that sort could recur in this century if the gap between rich and poor continues to grow.

A few years ago, American voters and politicians were persuaded to reduce federal taxes on capital income and estates.  They phased out the estate tax completely (effective in 2010), even though this would benefit only the upper 1 per cent.   This is standardly viewed as an example of the rich manipulating the political economy for their own benefit.  Indeed, we know that campaign contributions buy some very effective advertising.  But imagine that in the future we lived in a Piketty world, a return to the golden age of Austen and Balzac, where inheritance and unearned income were the sources of stratospheric income inequality.  Would a majority of the 99 % still be persuaded to vote against their self-interest ?


Frank, Robert H., and Philip J. Cook. 2010. The Winner-take-all Society: Why the Few at the Top Get So Much More Than the Rest of Us. (Random House).

Goldin, Claudia, and Lawrence Katz. 2009. The Race Between Education and Technology (Harvard University Press).

Greenwood, Jeremy, Nezih Guner, Georgi Kocharkov, and Cezar Santos. 2014. “Marry Your Like: Assortative Mating and Income Inequality.” American Economic Review, 104(5): 348-53.

Piketty, Thomas. 2014. Capital in the Twenty-First Century (Belknap Press).

[A shorter version appeared at Project Syndicate.]

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