Krugman’s review of Piketty

by on April 9, 2014 at 9:20 pm in Books, Economics | Permalink

You will find it here.  Excerpt:

Just about all economic models tell us that if g falls—which it has since 1970, a decline that is likely to continue due to slower growth in the working-age population and slower technological progress—r will fall too. But Piketty asserts that r will fall less than g. This doesn’t have to be true. However, if it’s sufficiently easy to replace workers with machines—if, to use the technical jargon, the elasticity of substitution between capital and labor is greater than one—slow growth, and the resulting rise in the ratio of capital to income, will indeed widen the gap between r and g. And Piketty argues that this is what the historical record shows will happen.

Krugman calls the book “awesome,” but here are his critical remarks:

I don’t think Capital in the Twenty-First Century adequately answers the most telling criticism of the executive power hypothesis: the concentration of very high incomes in finance, where performance actually can, after a fashion, be evaluated. I didn’t mention hedge fund managers idly: such people are paid based on their ability to attract clients and achieve investment returns. You can question the social value of modern finance, but the Gordon Gekkos out there are clearly good at something, and their rise can’t be attributed solely to power relations, although I guess you could argue that willingness to engage in morally dubious wheeling and dealing, like willingness to flout pay norms, is encouraged by low marginal tax rates.

My own review is still due out in about a week’s time.

1 bmcburney April 9, 2014 at 9:25 pm

Is a “willingness to flout pay norms”, morally dubious?

If so, it occurs to me that Krugman is pretty well paid.

2 Michael April 9, 2014 at 9:30 pm

I couldn’t find Krugman’s salary after 5 minutes of Googling, but considering he recently bought a $1.7m apartment, I don’t think he’s paid much more than the norm for a Nobel laureate professor.

3 bmcburney April 9, 2014 at 9:57 pm

Oh, I see. We are defining “norms” narrowly it comes to Nobel Laureate professors. By that reasoning, however, we should only compare the “pay norms” of successful hedge fund managers to the “norms” of other successful hedge fund managers.

Finding morally dubious people to disapprove of might be more difficult than it seemed initially.

4 Jan April 9, 2014 at 10:10 pm

Average hedge fund manager gets paid $2.2M. I’ve no idea what Krugman makes though he doesn’t enjoy the 15% tax date that the hedgies do.

If we were to draw a line for morally dubious pay, where should that line be? Does it apply to athletes, just people getting special tax treatment? I really don’t know.

5 jpe April 9, 2014 at 10:17 pm

Hedgies don’t enjoy that rate either. Long term cap gains are 25% at the top now, and in any event hedgies typically generate short term gains and ordinary income taxed at the top rate of around 45%.

6 bmcburney April 9, 2014 at 10:29 pm


I believe you are confusing the tax rate paid by the hedge fund itself with the rate paid on income obtained by the manager. In general, hedge fund managers and Nobel Laureate professors pay the same rate on their personal income.

7 Brad April 10, 2014 at 12:06 am

Re: carried interest
You’re thinking PE guys not hedge fund guys.

8 prior_approval April 10, 2014 at 1:20 am

How quickly one forgets, even only a couple of years past, and even if there has been ‘reform’ (or not – ) –

‘Carried Interest: Why Mitt Romney’s Tax Rate Is 15 Percent

As you know by now, Mitt Romney’s tax rate is somewhere — well below the 35 percent income tax rate for the highest earners.

Romney hasn’t released the details yet, but the NYT that, as part of his retirement agreement with Bain Capital, Romney “has probably qualified for a lower tax rate than ordinary income under a tax provision favorable to hedge fund and private equity managers.”

That tax provision applies to something called “carried interest.”


Many private-equity managers are paid under a structure popularly known as “two and twenty”: They get a paid a fee that’s two percent of the assets under management, and they also get to keep 20 percent of the profits from their funds. That 20 percent is carried interest.’

9 Ricardo April 10, 2014 at 5:27 am

Looking at the industry average misses the point entirely. Piketty (and Krugman) are making claims about the dispersion of wealth and income and taking the average across an entire occupation almost by definition ignores this. According to Forbes, the top 10 hedge fund managers earned more than $700 million each with the top 6 crossing the $1 billion per year mark. The “average” of $2.2 million is going to include portfolio managers of no-name funds. But Piketty and Krugman are not interested in “average.”

10 Jan April 10, 2014 at 6:50 am

jpe, thanks. I didn’t know that.

11 Ricardo April 10, 2014 at 5:19 am

The full context of the quote is that Krugman is expressing mild skepticism toward Piketty’s claims about excessive CEO compensation and invokes hedge fund managers — people who are compensated handsomely in highly competitive markets on the basis of clearly quantifiable performance — as a counterexample.

Average CEO compensation for Fortune 500 companies has been higher than $10 million per year in recent years. Krugman has never denied being rich (and lucky) but it is unlikely his earnings are anywhere near those of the average Fortune 500 CEO.

12 bmcburney April 10, 2014 at 12:53 pm


Yes, adjusting “pay norms” by occupation and success within an occupation (e.g., “Nobel Laureate Professors”) makes nonsense of the whole “income inequality” project (at least to the extent it applies to non-inherited wealth). Yes, I think it likely that Fortune 500 CEOs and successful hedge fund managers both make more money than Krugman and those are evidently the people Krugman urges us to disapprove of for their flouting-type behaviour.

But, at least compared to me, Krugman himself is shamelessly flouting pay norms. I see no evidence, however, that Krugman considers himself to be morally dubious. Quite the contrary. I mean, really, really, really, to the contrary. It appears, therefore, that those “moraly dubious” people who “flout pay norms” are, as a practical matter, defined by Krugman as those people who make a little more money than Krugman. No doubt, Piketty defines them as people who make a little more money than Piketty.

13 P A April 11, 2014 at 1:11 pm


14 Louis April 9, 2014 at 10:30 pm

Read the quote in context. Piketty claims that compensation for top executives is largely self – determined, given the coziness of boards and comp committees with CEOs. He says historically norms of restraint on top pay were more binding and helped to regulate inequality. High marginal tax rates made the benefit of pushing against those norms small relative to the social cost.
Krugman is actually taking a skeptical eye to such a theory with the paragraph Cowen quotes.

15 bmcburney April 9, 2014 at 11:27 pm

But it is Krugman, not Piketty, who claims that a willingness to disregard pay norms is per se morally dubious (of course, Piketty may also say this). If so, Krugman (and Piketty, if it applies to him) ought to explain why we should listen to such a morally dubious fellow as himself.

I don’t entirely disagree with Krugman’s suggestion that the income obtained by senior corporate executives is (or should be) placed in a different category than NBA players, or hedge fund managers. However, this is a long-standing problem in corporate governance not a novel insight. In any case, restricting the pay of corporate executives, by means of social norms or otherwise, would seem to increase, rather than decrease, the “problem” of returns on capital exceeding returns on labor. More importantly, the real wealth generators (for themselves and others) are the actual founder/managers of successful corporations. You know, the kinds of people Eric Cantor was talking about (Gates, Bezos, Brin, Page, Ellison, etc.). So how much was Steve Jobs “worth” to the stockholders, employees and customers of Apple from about 1998 to about 2010? I don’t know how to calculate the number but I think it would have to be a fairly large one. But if Job’s income was restricted by social norms or taxation, would he still return to Apple and save the company from bankruptcy? Considered from the point of view of the worst-paid Apple employee, was Jobs over-paid?

16 Steve Sailer April 10, 2014 at 5:46 am

Jobs didn’t get all that rich off his second stint at Apple. When he died, Apple was fighting Exxon for highest market cap in the world, but Jobs’ net worth was almost an order of magnitude less than a Gates’s or a Slim’s. And yet, the opportunity to make a mere $5 or $10 billion seemed to be adequate motivation for Jobs to get him to get out of bed and come to work in the morning. I know it sounds nuts, but making a few billion seems to be almost as motivating as making a few dozen billion.

17 mavery April 10, 2014 at 9:48 am

It’s like the marginal utility of money diminishes as you get more of it or something!

18 bmcburney April 10, 2014 at 1:17 pm

Indeed. But would Jobs continue to get out of bed if his wealth or income were limited (whether by taxation or “pay norms” or something else) to some relatively low multiple of the wealth or income of the lowest paid Apple employee or American? If he doesn’t and Apple goes the way of Commodore, Burroughs, Everex, etc. is the lowest paid Apple employee better off? Are Apple shareholder’s better off? Is even Krugman and Piketty better off?

As I said, there is a corporate governance problem of long standing in determining whether any particular CEO is a future Jobs or a future Scully. But Krugman and Piketty don’t offer a solution to that problem, Krugman just points out that some CEOs are not worth the money and Piketty evidently believes that none of them are (or perhaps it doesn’t matter whether they are or not). As to this issue, Krugman is surely right and Piketty wrong. So far, however, I don’t see that moves us forward very much.

19 Brett April 10, 2014 at 12:44 am

The problem with the “cozy board” hypothesis is that you’d expect CEOs on the inside to get better pay than those on the outside when hired, but that’s not the case. It’s the opposite – as the article I linked to points out, CEO candidates from outside of a company typically get a sizeable premium more than those promoted from within.

That seems less like coziness to me, and more like the board is terrified of getting a crappy CEO and so they set the hiring pay very high in comparison to other companies in the hopes that high pay will get them quality. If the CEO is even halfway competent they’ll jack up his pay later.

20 prior_approval April 10, 2014 at 1:48 am

Though this is accurate, as the link shows, you neglected to point out that board member promotion can also be a valid model –

‘“One noteworthy twist on the decision to hire external talent is the selection of a director from the company’s own board as CEO,” adds Jason Schloetzer, a report co-author and assistant professor at the McDonough School of Business at Georgetown University. “The director-turned-CEO succession model provides companies with a chief executive who is familiar with corporate strategy and key stakeholders, thereby reducing leadership transition risk.”

Whether a board member counts as ‘internal’ is an interesting perspective, as board members are considered in a different category than ’employee,’ in part because of their supposedly independent role in providing oversight. And the fact that broadly speaking, board members are already employed by another organization.

21 Thomas April 11, 2014 at 12:40 am

Another problem with the “cozy board” hypothesis is that it doesn’t fit most public company boards anymore. There was a time when most compensation committees were picked by the CEO, but that time ended for most public companies more than a decade ago.

22 Jim Tobias April 10, 2014 at 7:57 am

I think you’re misreading Krugman’s comment. He’s not saying what you think he’s saying. He said that “willingness to engage in morally dubious wheeling and dealing” is encouraged by low marginal tax rates, and that “willingness to flout pay norms” is also “encouraged by low marginal tax rates”, but he says nothing about the moral dubiousness of flouting pay norms.

23 bmcburney April 10, 2014 at 1:29 pm

Jim Tobias,

I think you’re wrong. In fact, flouting pay norms is clearly given as an example of the “morally dubious” behaviour to which Krugman is opposed (note the word “like” immediately preceeding “willingness to flout pay norms”). Indeed, it is the only example he offers us and, if you think about it, it is one of the very few examples Krugman can give in this context.

24 seanB April 11, 2014 at 12:30 am


I think you interpret the “like” wrong.

For example: “willingness to engage in morally dubious wheeling and dealing is, like willingness to flout pay norms, encouraged by low marginal tax rates”

25 bmcburney April 11, 2014 at 4:18 pm


I see what you mean, but that would imply that Krugman thinks public policy should aim at surpressing “morally dubious” behavior in the economy by reducing economic incentives across the board. Wouldn’t a Nobel Prize winning economist recognize that high marginal tax rates would discourage positive economic behavior as well as negative behaviour? Wouldn’t a Nobel Prize winner recognize that positive economic behaviour is actually more likely to be surpressed, relative to negative behaviour, since a “morally dubious” actor would be encouraged to evade taxes (as per Jim Glass below)?

26 Jim Glass April 11, 2014 at 3:27 am

“He said that ‘willingness to engage in morally dubious wheeling and dealing” is encouraged by low marginal tax rates'”

Which is flat wrong — as one who was a young tax professional back in the last days of the those old-fashioned high marginal rates for which PK and and left so long, I can tell you first hand.

Nobody in the business world engages in such morally dubious wheeling and dealing as does the tax shelter industry and those who employ it to hide their income from taxes — the great bulk of which was wiped out by the genuinely bipartisan 1986 TRA’s dropping the top marginal tax rate to 28%. How quickly people forget! The Democrats supported that for a reason.

You want to see morally dubious wheeling and dealing en masse? Push top tax rates back up to 70%, then watch what happens so that in the end nobody pays anything like that rate any more than they did back in the old days.

Incentives drive behavior. Create situation where masses of people can slash heir tax bills in half with morally dubious wheeling and dealing — which going back to those rates would absolutely do, as surely as it did last time — and the flood tide of it will return. PK and those who dream of going back to the old world of high tax rates should beware what they ask for lest they get it.

27 ww April 10, 2014 at 9:55 am

Above and below.

What Krugman get’s paid has nothing to do with his airtight arguments.

28 GF April 10, 2014 at 11:16 am

What do you think is the definition of “morally dubious wheeling and dealing”? Does Krugman decide? Do you?

29 TMC April 10, 2014 at 12:50 pm

” nothing to do with his airtight arguments”

Lucky for him.

30 bmcburney April 9, 2014 at 10:43 pm

I note that the last actual data point on “Figure 1” (as quoted by Krugman) must be for 1950-2012. If one were to block out the “speculative” portions of that graph, one receives a somewhat different impression of our present condition than is conveyed by the original figure.

I have not yet read the Piketty book itself so perhaps this is explained in the text.

31 Steve Sailer April 9, 2014 at 10:51 pm

Krugman writes:

“Before this revolution, most discussions of economic disparity more or less ignored the very rich.”

It’s interesting why economists have paid so little attention to the annual Forbes 400 lists. I’ve always found them fascinating, of course. Here’s one recent paper on the Forbes 400 over time, but it includes references to only a handful of other papers on the Forbes 400:

32 Steve Sailer April 10, 2014 at 1:32 am

I suspect the lack of enthusiasm economists have shown toward mining the data trove that has been the Forbes 400 since 1982 reflects:

A. Worry that research might offend a member of the Forbes 400 who might otherwise fund a project.

B. Worry that research might turn out to be deemed politically incorrect regarding the demographics of the Forbes 400

33 Dan Weber April 10, 2014 at 9:05 am

Demographics of the Fortune 500? What are you . . .

. . . Oh, I get it. Jews.

34 josh April 11, 2014 at 7:55 am

Well, yeah.

35 Rahul April 10, 2014 at 3:05 am

Steve, since you have analysed these lists for so long can you educate us about your findings?

36 Millian April 10, 2014 at 4:44 am

People who are like Steve Sailer GOOD. Tiny minorities who can’t threaten Steve Sailer BETTER in principle. Big minorities Steve Sailer doesn’t like BAD.

Cowen and the company he keeps.

37 Careless April 10, 2014 at 9:57 am

Cowen and the company he keeps.

writes the guy who chooses to hang out with Steve Sailer, complaining about Tyler not banning Steve Sailer

38 josh April 11, 2014 at 7:56 am

Can you cite anything to back up this silly pejorative.

39 Ricardo April 10, 2014 at 6:12 am

“I’m roughly guessing that Jews make up about 1/7th of the billionaires on earth, despite being only about 1/500th of the population.”

That’s not a very illuminating comparison considering that most rich Jews and rich gentiles are white and most of the countries rich enough to have billionaires living in them are also majority white.

Waiving away the problem of intermarriage in counting or defining who is or is not Jewish isn’t very convincing either. If we are going to carefully comb through the family histories of rich, famous people (at least as represented on Wikipedia) to determine whether they have Jewish roots, we have a biased comparison if we don’t use the same methodology to measure the “Jewish” population of the U.S. Intermarriage was low before the 1960s in the U.S. but it was higher in Germany and possibly other European countries that sent immigrants to the U.S., some of whom might have wanted to downplay or conceal the fact that they had Jewish parents or grandparents.

40 Steve Sailer April 10, 2014 at 6:21 am

Here the U.S. Forbes 400 by ethnicity:

You can leave corrections in the comments.

41 Steve Sailer April 10, 2014 at 6:27 am

Here’s n/a Forbes’ global billionaire’s list by ethnicity:

The ethnic breakdown I come up with for the March 2013 update of Forbes’ “The World’s Billionaires” list:

No. %
Northwestern European 413 28.96
Asian or Pacific Islander 313 21.95
Jewish 252 17.67 [more than 1 out 6]
Middle Eastern or Central Asian 120 8.42
Eastern European 95 6.66
Southern European 84 5.89
(New World) Hispanic or Brazilian 74 5.19
South Asian 69 4.84
Black 6 0.42
total 1426 100

Particularly for Eastern Europe, individual classifications may be less accurate than my classifications of US billionaires, but the overall breakdown should be reasonably close to reality. I may have incorrectly included a few people in the Jewish list, but if anything probably incorrectly left off a larger number — my Jewish category should be more accurate/comprehensive than Forbes Israel’s “Richest Jews” list in any case. Note that I’ve arbitrarily chosen to include Tatars in the Middle Eastern category, along with Armenians, Azerbaijanis, etc.

42 Steve Sailer April 10, 2014 at 7:31 am

Last time seems to have disappeared, but let’s try it again. Ricardo objects:

“If we are going to carefully comb through the family histories of rich, famous people (at least as represented on Wikipedia) to determine whether they have Jewish roots …”

No, you seem to be assuming that these strikingly high figures for the Jewish percentage of the Forbes 400 are derived from close antiquarian researching combing genealogical archives for traces of Jewish roots. After all, somebody would have mentioned these numbers to you before if they aren’t derived from a very contrived methodology, right?

But as Orwell said, “To see what is in front of one’s nose needs a constant struggle.” You aren’t supposed to think about this gigantic fact of the modern world, so most people do what they are supposed to do … even though you can go look up the ethnic ancestry of the vast majority of the names on n/a’s list right on their Wikipedia page.

Try it.

43 seanB April 11, 2014 at 12:32 am

Piketty explains that he and many other economists are skeptical of the quality of the data in the Forbes 400 list and lists like it.

44 Steve Sailer May 5, 2014 at 10:42 pm

And does Piketty have better data on the richest of the rich?

45 Michael G. Heller April 9, 2014 at 11:33 pm

So, all of today’s leading North American leftwing economists and entertainers are once again worshipping at the shrine of a left-bank French intellectual crusading for égalité who finds solace in Marx rather than in Smith or Schumpeter. It’s bizarre that leftists suddenly again place inequality of wealth at the top of their priority list at precisely the moment when all of the sand the very same leftists have heaped into the cogs of the capitalist engine of wealth (though taxes, regulations, and excessive aggrandisement of the public sector) is finally causing that capitalist engine to grind to a halt. Really, c’est un scandale … the motor and the vehicle safety devices all urgently need major servicing, yet the Piketteers are requesting fancy new seat covers and in-car entertainment systems. Because at the same time they are helping to prevent a thorough Schumpeterian overhaul and lubrication of the capitalist engine, the wellspring of wealth will soon be thoroughly dried-up and cemented over. Soon there may be no more wealth to distribute. Anyone who thinks that inequality of wealth must be reversed and reengineered as Numéro Uno priority during a major crisis which is preventing forward movement of the engine of wealth needs their head examined.

The remedy for extreme inequality is more market freedom that creates opportunities and creative destructions of the monopolies and privileges (like those enjoyed by the cosseted rent-seeking elite of modern financiers). Capitalism’s destruction is in any case much more likely to result from Piketteering intellectual hostility and taxation than from immiserisation. It’s basic really. Pikettering value judgements do not always follow from the historical facts. Though we have capitalism to thank for the personal freedoms, rising living standards, institutionalised pacifism and altruism in politics, a welfare state, modern medicine, mass education, and consumer products such as the medical scanners, iPods, drones, and microwaves that enable happier and healthier lives, it cannot be taken for granted that people will feel better off. Likely as not, they hate capitalism’s utilitarianism. As Joseph Schumpeter famously wrote, people tend to resent a system that leaves them ‘to their own devices, free to make a mess of their lives’. The free-enterprise system automatises progress, but then it becomes easy from one generation to the next to forget the reasons for that progress. Understanding of the long-term benefits of capitalism could never be made simple enough to communicate to people who look only at the short-run picture of wealth distribution inefficiencies and at the continual instability of the economy. Capitalism produces almost everything, but not the human feeling or classroom learning that could guarantee its own survival. Continual improvement plus forgetfulness about the reasons produces social unrest. The Piketteers follow a romantic left-bank coffee ‘n’ cigarettes tradition called Le Ressentiment. Feels good, but ain’t healthy for the system.

46 GiT April 10, 2014 at 12:19 am

Of course, Marx found some solace in Smith, and Schumpeter in Marx. But “ooooh, Marx, be afraid!”

47 Michael G. Heller April 10, 2014 at 1:04 am

Not at all, Git. At my English universities we read Marx (we even had a quaint Das Kapital Reading Class taught by a smart Ethiopian marxist professor) plus we read French marxists (Althusser), English marxists, Greek marxists (Poulantzas), and countless Latin American marxists. Never once felt scared. However I do confess to being a wee bit fearful that a new retro-love fest of USA Keynesian equalitarian public intellectuals discovering Marx for the first time with assistance from French égalitérians bodes badly for the future of intelligent policy discourse in the leading capitalist nation and displays exactly the problem Schumpeter pointed out in his criticism of Marx — forgetfulness, failing to learn from history.

48 Brett April 10, 2014 at 12:46 am

If the ultra-high marginal rates of the 1950s and 1960s didn’t cause “the capitalist engine” to grind to a halt, then the incredibly lenient regulatory and tax burden of the present isn’t going to do that.

49 Michael G. Heller April 10, 2014 at 1:12 am

I don’t think this makes much sense, Brett. The capitalist engine starts spluttering badly when the regulatory and tax regime is over-indulgent. I guess you are saying in the USA you’d like another few thousand discretionary regulations and a French level of corporate and income tax. Bye bye America.

50 Alexei Sadeski April 10, 2014 at 5:49 am

Corporate tax is higher in CA than France.

Income tax is arguably higher in CA than France as well.

51 Alexei Sadeski April 10, 2014 at 5:47 am

Effective rates are far higher today.

52 chuck martel April 10, 2014 at 2:04 am

So the world is an automobile and the driver is a hedge fund manager and if he doesn’t get to fill the trunk with his compensation package nobody will get to the supermarket and back.
“…we have capitalism to thank for the personal freedoms, rising living standards, institutionalised pacifism and altruism in politics, a welfare state, modern medicine, mass education, and consumer products such as the medical scanners, iPods, drones, and microwaves that enable happier and healthier lives,” We hear this same crap over and over again, that the rising living standards, brought about by technological advances, are making everyone happier. Does that mean that at some time in the past everyone was unhappy? That hitching up Dobbin to the shay for that trip down to the general store brought tears to Dad’s eyes? That when the flying wing or the jet pack becomes commonplace, we’ll be even happier than we are now but still not as happy as we’ll be when medical advances make a 120 year lifespan normal? And that none of this will possible if Lloyd Blankfein doesn’t get $19.9 million this year for whatever it is that he does? OK.

53 Michael G. Heller April 10, 2014 at 3:38 am

I’m truly shocked, Chuck. That shay was cast iron, and Dobbin had tears in his eyes. Now happy Dobbin can enjoy leisure in the pasture on the hobby farm which Dad was able to buy by assiduously saving up many middle class tax credit subsidies.

54 Ricardo April 10, 2014 at 5:47 am

“Though we have capitalism to thank for the personal freedoms, rising living standards, institutionalised pacifism and altruism in politics, a welfare state, modern medicine, mass education, and consumer products such as the medical scanners, iPods, drones, and microwaves that enable happier and healthier lives, it cannot be taken for granted that people will feel better off.”

Most of which came about during a time when inequality was less than it is now. Piketty isn’t anti-capitalist — I think he wants capitalism to exist within a mixed economy (e.g. government-funded military and civilian R&D that led to some of the innovations you highlight) and a commitment to redistribution.

55 Alexei Sadeski April 10, 2014 at 5:49 am


56 Brandon April 10, 2014 at 10:15 am

excellent retort

57 ed April 10, 2014 at 1:18 am

If you want to have any hope at all of understanding Piketty’s actual model (such as it is), with r>g and all that, you might want to look at these lecture notes, recommended by commenter david over at Scott Sumner’s site.

58 Matt Rognlie April 10, 2014 at 2:45 am

Krugman correctly highlights the importance of the elasticity of substitution between capital and labor, but like everyone else (including, apparently, Piketty himself) he misses a subtle but absolutely crucial point.

When economists discuss this elasticity, they generally do so in the context of a gross production function (*not* net of depreciation). In this setting, the elasticity of substitution gives the relationship between the capital-output ratio K/Y and the user cost of capital, which is r+delta, the sum of the relevant real rate of return and the depreciation rate. For instance, if this elasticity is 1.5 and r+delta decreases by a factor of 2, then (moving along the demand curve) K/Y will increase by a factor of 2^(1.5) = 2.8.

Piketty, on the other hand, uses only net concepts, as they are relevant for understanding net income. When he talks about the critical importance of an elasticity of substitution greater than one, he means an elasticity of substitution in the *net* production function. This is a very different concept. In particular, this elasticity gives us the relationship between the capital-output ratio K/Y and the real rate of return r, rather than the full user cost r+delta. This elasticity is lower, by a fraction of r/(r+delta), than the relevant elasticity in the gross production function.

This is no mere quibble. For the US capital stock, the average depreciation rate is a little above delta=5%. Suppose that we take Piketty’s starting point of r=5%. Then r/(r+delta) = 1/2, and the net production function elasticities that matter to Piketty’s argument are only 1/2 of the corresponding elasticities for the gross production function!

Piketty notes in his book that Cobb-Douglas, with an elasticity of one, is the usual benchmark – and then he tries to argue that the actual elasticity is somewhat higher than this benchmark. But the benchmark elasticity of one, as generally understood, is a benchmark for the elasticity in the gross production function – translating into Piketty’s units instead, that’s only 0.5, making Piketty’s proposed >1 elasticity a much more dramatic departure from the benchmark. (Keep in mind that a Cobb-Douglas *net* production function would be a very strange choice of functional form – implying, for instance, that no matter how much capital is used, its gross marginal product is always higher than the depreciation rate. I’ve never seen anyone use it, for good reason.)

Indeed, with this point in mind, the sources cited in support of high elasticities do not necessarily support Piketty’s argument. For instance, in their closely related forthcoming QJE paper, Piketty and Zucman cite Karabarbounis and Neiman (2014) as an example of a paper with an elasticity above 1. But K&N estimate an elasticity in standard units, and their baseline estimate is 1.25! In Piketty’s units, this is just 0.625.

59 Steve Sailer April 10, 2014 at 6:00 am

“For the US capital stock, the average depreciation rate is a little above delta=5%.”

Interesting. Let’s take the kind of example Piketty likes from history and literature: the great houses of England, such as fictionalized in Downton Abbey.

For example, consider the history of the real Blenheim Palace. Winston Churchill’s ancestor, the first Duke of Marlborough, built gigantic Blenheim Palace in Oxfordshire in the early 18th Century. But by the end of the 19th Century, Blenheim Palace was falling apart. Despite peace, prosperity, and favorably tax policies, Churchill’s cousin, the 9th Duke, couldn’t afford to fix it out of his own capital. It had depreciated too much. So, the Duke contracted a notoriously loveless marriage with the American railroad heiress Consuelo Vanderbilt in 1895 to get the money to rebuild Blenheim.

There were something like 9 marriages in 1895 alone between titled Brits and rich American heiresses to inject enough money to overcome the depreciation of the great country houses. (Downton Abbey depicts a happy trans-Atlantic marriage between the Earl of Grantham and Cora Levinson.)

Here’s Wikipedia’s extensive list of American heiresses who married European titles:

60 Steve Sailer April 10, 2014 at 7:13 am

That raises an important point regarding Piketty’s thesis: what role did corruption play in the gigantic inequality of the past? Is rapidly growing inequality inevitable under capitalism, or do Piketty’s literary examples of giant estates in Britain largely come from what people from Victorian times onward have considered corruption? (“Behind every great fortune lies a great crime?”) For example, Dwight Eisenhower was roughly as successful of a general and politician as John Churchill, but here’s what the farm Eisenhower bought himself at Gettysburg looks like:

In other words, not like Blenheim Palace:

Late Victorian Britain was enormously successful, but its great country houses needed a lot of American heiresses to fix them up because Victorian noblemen weren’t allowed to be as crooked as their ancestors who built them. For example, Winston Churchill’s ancestor John Churchill could afford to build Blenheim Palace because, in part, he had a secret agreement with Queen Anne (who was best friends with John’s wife) that he could skim 2.5% of the government’s pay to British soldiers during the almost decade long War of the Spanish Succession into his own pocket.

Winston Churchill, in contrast, went broke maintaining a much smaller establishment (a staff of merely 25) and had to be bailed out by anti-Nazi supporters of his in the late 1930s because more recent British statesmen weren’t allowed to be so piratical.

That’s an important distinction between the workings of honest and dishonest accumulation that I haven’t seen discussed much in coverage of Piketty’s book.

61 chuck martel April 10, 2014 at 11:45 am

Marlborough was also getting paid by the French not to wreck the place. And wasn’t Blenheim Palace also built with a substantial stipend of government money as thanks for all that Churchill had done? Queen Anne and Sarah Churchill became more and more distant as time went by. John Churchill was very much respected by William I, however.

62 Matt Rognlie April 10, 2014 at 2:47 am

What does this all mean for the Piketty’s central points – that total capital income rK/Y will increase, and that r-g will grow? His model imposes a constant, exogenous net savings rate ‘s’, which brings him to the “second fundamental law of capitalism”, which is that asymptotically K/Y = s/g. The worry is that as g decreases due to demographics and (possibly) slower per capita growth, this will lead to a very large increase in K/Y. But, of course, this only means an increase in net capital income rK/Y if Piketty’s elasticity of substitution is above 1, or if equivalently the usual elasticity of substitution is above 2. This is already a very high value, and frankly one to be treated with skepticism.

Meanwhile, it is even harder to get growth in r-g, which most readers take to be Piketty’s central point. Suppose that in recent decades, r has been roughly 5% while g has been 2.5%, and suppose that g will ultimately fall to around 1%. In Piketty’s framework, this implies an increase in steady-state K/Y of 2.5. If there is an elasticity of 1 (in Piketty’s units), this implies a decrease in r from 5% to 2%, and thus a *decrease* in the gap r-g from 2.5% to 1%. The point is that with this unit demand elasticity and the exogenous net savings assumption, it is the ratio r/g rather than the difference r-g that is constant, which means that a decline in g leads to a proportionate decline in r-g. (Note that Krugman’s review is ambiguous about this distinction.)

What would we need to obtain even a tiny increase in r-g in this setting – say, of half a percentage point? We would need r to fall from 5% to only 4% while g fell from 2.5% to 1%, increasing r-g from 2.5% to 3%. But given the 2.5-fold increase in K/Y, a decline in r by a factor of only 1/5th implies an elasticity of substitution (in Piketty’s sense) of nearly 4. This implies an elasticity of substitution in the *usual* gross production function sense of nearly 8, not plausible by any stretch of the imagination.

Unless I’m missing something, the formal apparatus in Piketty’s book simply is not capable of generating the results he touts. There are two very simple issues that break it quantitatively – first, the distinction between elasticities of substitution in the gross and net production functions; and second, the fact that as g falls, an extraordinarily high elasticity of substitution is necessary to prevent r from falling along with it and actually compressing the arithmetic gap between r and g. Perhaps there are modifications to the framework that can redeem it, but as it currently stands I’m baffled.

63 Donald Pretari April 10, 2014 at 3:12 am

Thank you, Matt. I haven’t finished the book, but your points sound interesting, even if a bit of rough going in my case.

64 Greg April 10, 2014 at 10:40 am

Is this Solow model or what? Need to refresh, but not sure what to google …

65 Donald Pretari April 10, 2014 at 2:51 am

These comments are interesting. The first comment points out that Krugman makes good money, meaning, what? He can still be willing to pay more taxes. What’s the point of the question? In order to discuss inequality you need be an anchorite? Then, Steve Sailer claims he’s willing to tell it like it is, while seemingly being unable to get to the bottom line of what he’s suggesting. I’m not sure what he’s claiming. Then Michael G. Heller, right after telling us we need to learn from history, seems to say that he’s done learning from history, and so he can’t learn anything from books that veer from his ideological preference. Instead, he’s afraid that, if we read books not sanctioned by him, we will want to overthrow the market system, even though all I’m hearing being argued for by the people he’s terrified of are increases in taxes. He hears the word “capital”, I guess, and lurches headlong into a fear of Bolshevism returning. Has he even read the book? Take a breathe.

66 Donald Pretari April 10, 2014 at 2:55 am

“breath.” But I did refrain from my annoying capitalizations.

67 rayward April 10, 2014 at 7:15 am

It’s unfortunate James Tobin isn’t around to provide the insight that’s so lacking. R > g is Piketty’s warning for a rapidly escalating level of inequality that will undermine social cohesion. Maybe. What Piketty mostly ignores is the financial and economic instability that correlates with high levels of inequality. It isn’t as though the last financial crisis occurred in 1929; it occurred in 2008! Short memories. Tobin emphasized instability as the price of excessive inequality, and he too proposed a tax, a world-wide tax on financial transactions, to mitigate inequality (and to discourage the continued growth in finance). Tobin’s been dead 12 years, but he understood the potential for bubbles when income and wealth is concentrated, as owners of capital seek ever higher returns through speculation rather than investment in productive assets. What would Tobin think of the amounts being paid today for start-up tech firms with little or no income or assets? What would he think of the hedge and equity funds that rely on complex mathematical formulas to squeeze a dollar from currency and other commodity markets? The path to economic collapse is right in front of us and we debate whether r > g will lead us back to the 19th century. Good grief! Piketty all but ignores the financial and economic instability of excessive inequality. Why? Because he assumes that governments and central bankers will respond to each financial crisis the way they responded in 2008-09. He says so in his new book. I suggest that Piketty’s perspective is a European perspective, in which the corrective to the excessive level of inequality in Europe before WWI was the physical destruction of capital that occurred in the two world wars. In the U.S., by comparison, the corrective to the excessive level of inequality in 1927-28 wasn’t the physical destruction of capital, it was the destruction in the value of capital resulting from the financial collapse in 1929. How many more times will voters accept public bail-outs of the financial sector? Piketty believes an endless number because the owners of capital control the levers of government. Maybe. But would President Rand Paul bail out the financial sector?

68 rayward April 10, 2014 at 8:04 am

For those who haven’t read Piketty’s book, he doesn’t spare the rod when it comes to marginalists: he ends the book with highly critical remarks about marginalists and their emphasis on mathematics. Krugman alludes to this in his review, but he doesn’t make clear just how critical Piketty is of marginalists. I mention this because I would expect Cowen to return fire in his review.

69 Willitts April 10, 2014 at 10:41 am

If you have to rely on a character from fiction to make your point, you have no point.

Increasing the marginal tax rate might reduce the incentive to “wheel and deal,” but it increases the incentive for outright criminal behavior. A normal person would shun that, but a liberal sees that as an increased oppotunity to put (the right) people in prison.

70 Glenn Schafer April 10, 2014 at 11:52 am

Just to be clear most of the income extracted from hedge fund operations is ordinary income to the managers. Carried interest results when the managers of private equity funds share in the profits when they sell a company they have usually held for several years.

71 Robert McGregor April 10, 2014 at 11:07 pm

@Michael G Heller: When you say, “Though we have capitalism to thank for the personal freedoms, rising living standards, institutionalised pacifism and altruism in politics, a welfare state, modern medicine, mass education, and consumer products such as the medical scanners, iPods, drones, and microwaves that enable happier and healthier lives, it cannot be taken for granted that people will feel better off,” it is little different than saying “we owe all good things in life to our loving Jesus Christ.” Whether you are an atheist or a fundamentalist Christian or Muslim, it is the same kind of vague, absolutist thinking. You say, “We have capitalism to thank for the personal freedoms . . . ” Hmm. Is that the “capitalism” of the 18th century European Enlightenment, or the “capitalism” of the 19th century American “Gilded Age?” How about the “capitalism” of the the Eisenhower, Nixon, Reagan, or Clinton years? I assume you prefer the current US brand of capitalism to the capitalism in Canada, England, France, Germany, and Northern Europe. But if you do prefer the US brand of capitalism, and that capitalism brings all these wonderful things, then why are the medical and educational systems superior in the other countries. If you’ve missed the articles and charts about this, I can send you the links. And since Russia’s socialist system is the furthest from your economic wet dream, why did Nicholas Taleb say in his book, “The Black Swan,” that he preferred to hire Russian Math and Science students–that the commie, Russian public schools have better math and science programs than the US public school system?

72 TallDave April 10, 2014 at 11:35 pm

“but the Gordon Gekkos out there are clearly good at something”

Yeah, they’re good at duping people into paying them enormous fees in exchange for market returns. Okay, sure, they do some political corruption too, but that’s only because the one group that really can average above-market returns are those legally permitted to engage in insider trading: U.S. congresspersons. But I try to never blame people for responding rationally to the economic incentives they are presented with, that would be like claiming Communism failed because North Koreans are just lazier than South Koreans — the problem is the incentive, not the actors.

But for the honest hedge funds — hey, more power to them, separating fools from their money is a valuable economic service.

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