Capital in the 21st Century — Income & Output’s Delicate Dance

Overview & Thoughts on Chapter 1 of Capital in the Twenty-First Century

Background

In 2013 Thomas Piketty released a weighty volume called Capital in the Twenty-First Century, which examines the past ~300 years of capital in mostly the United States, Brittan, & France, and the lessons we can draw from it’s evolution, dynamics & affecting forces, effects on society, and response to regulations. This book sent immediate shock-waves throughout the economic world, serving as one of the first in-depth studies of capital’s evolution & accumulation patterns on a broad scale since Simon Kuznets’ publishings in the 1950s. The core question that this book attempts to address is whether capital naturally pools into fewer hands over time as Karl Marx argued, or if it naturally redistributes itself over time as innovation & technological advancement progress, as was the belief of Kuznets.

In this series I’ll highlight some of my main takeaways from & thoughts on each chapter. Please note that I am an amateur economist in both Google-provided definitions of the term (someone who engages unpaid in a pursuit, and someone who’s inept relative to professionals). I make software for a living. Economics is simply something I’m interested in (based off of one college class & working at a financial company), and much of this writing is meant to help me clarify my own thoughts on the subject, rather than convince anyone else of their correctness. Use this more as a jumping-off point for your own thoughts & research, rather than something that should be taken as completely true.

What is Capital?

Although economics typically define the three factors of production as land, labor, and capital, Piketty lumps labor into the capital domain, and gives capital a broader definition of anything owned that can be traded for a certain market value. This simplifies the factors into capital & labor, which is useful for understanding the balance between capital income/returns & wages income.

Capital is a required part of any functioning economy, regardless of the shape it takes or ideology it follows. In traditional industries there always had to be some form of raw material to work on, land & buildings to perform the work in, tools to perform the work with, and vessels with which to transport the finished product. Even seemingly non-capital dependent industries like software still require computers to create the software on, other computers/servers to run the software (even the cloud’s just someone else’s computers), and networking infrastructure to transport the software to consumers. National wealth (note that according to Piketty’s definitions capital & wealth can be used interchangeably, so no need to split hairs over wording here) is defined as the sum of all private capital owned by all citizens, and all state capital owned by the government. So even a fully-communist country with no private ownership still contains capital, it’s just all owned by the state (as opposed to most capitalist countries where the vast majority of wealth is privately owned).

The Capital to Income Ratio

Critical to the core study in this book is the capital to income ratio, which is simply the total capital (public & private) existent in a country divided by the national income (domestic output + net income from abroad). In developed countries this result is almost always greater than 1 (and often anywhere between 3–7), so the result’s expressed as “total capital is worth x years of income”.

Old-school economics tended to peg this ratio as relatively stable over time. Piketty’s research shows just how inaccurate that belief is.

When applied to the formula α = r X β (share of national income coming from capital = the capital to income ratio (β) times capital’s rate of return (r)) we can get a rough picture of how capital-heavy a nation’s income is. Capital-dependent societies often have higher rates of income inequality (though this isn’t perfect correlation, there are other factors at play), since income from capital’s mostly based on starting capital (assuming roughly the same rate of return across the board). So the rich (who own more of the starting capital) make more than the poor when a large amount of the country’s income is capital-based and the rate of return on capital outstrips income growth (more on the last point in future chapters).

The Evolution of Global Production Distribution — The Catchup Effect, and Why it Feels Like Asia’s Eating our Lunch

For the past few years, besides COVID and Wall Street Bets, it feels like economic news has been dominated by reports on how Asia (and specifically China)’s becoming more and more powerful on the global stage. Indeed it looks as though America & Europe’s centuries of economic dominance may be waning, but this may not be due to anything specific that we’re doing (or not doing), and instead be the result of the catchup effect on global output.

Piketty includes two excellent charts on page 78 of this book’s paperback edition, showcasing both the distribution in population across continents, and the distribution in output from 1700 to 2012. While Asia has consistently made up the majority of the world’s population (anywhere from 70% in ~1820 to ~60% today), it quickly fell behind in total output between 1820 & 1950, producing as little as ~25% of the globe’s output in 1950. Now to be fair the early 20th centuries contained two world wars in Europe (with America getting involved in both), and as we know three of the most prominent things produced by wars (besides all the death) are patriotism, Kurt Vonnegut novels, & upticks in economic output as the involved countries ramp up their supply & demand, but Asia’s declining role in global output started well before both wars. It wasn’t until after the 1950s that Asia started to claw back global output share, a trend that has slightly accelerated since the turn of the 21st century.

In terms of output per head, America (including North & South America) & Europe punched well above their weight throughout the 20th century, generating 70–80% of global output from 1900 to 1980, while making up only 20–30% of global population. that’s 2 to 4 times the output per head of the “average” continent and roughly 4 to 8 times the output per head in Asia. But various factors such as infrastructure & upskilling investments, along with rapid future-oriented industry knowledge transfer partially resulting from globalization, have allowed China, South Korea, Japan, and other Asian countries to increase their output per head dramatically over the past 50 years. The population advantage Asia has means that, barring massive increases in productivity in the west, they’ll eventually catch up in output per head & lead the world in global output.

While technological advancement could allow America to continue its dominance (like it has up until now), there are two challenges that I personally see facing it in the 21st century.

The first is an argument put forth by Robert J. Gordon in The Rise and Fall of American Growth is that modern technological innovations like A.I., quantum computing, machine learning, and social media, although impressive, don’t quite stack up to the 19th & 20th century innovations of electricity, the internal combustion engine, aviation, and computing in terms of overall impact. Whether it’s possible to identify & execute on innovations that make this same impact is up in the air, but it’s going to be harder to create that same level of change as more stuff gets invented. Personally I don’t consider this to be a decrease in our collective ability to innovate (for proof of the world’s innovation might look at the number of unique COVID-19 vaccines developed in under a year), but it instead points to the challenge in identifying new areas that would cause massive positive society-changing impacts while living within scientific & technical possibility (sorry teleportation), and the spike in difficulty associated with the next massive problems on our list (see: curing cancer).

The second deterrent to sustained high-output growth is simple diminishing returns. Although there’s certainly room to grow in terms of education & infrastructure (especially the latter if you’ve ever driven on a Michigan road), relatively speaking America’s a well educated place with (mostly) paved roads. According to the National Center for Education Statistics ~39% of Americans 25 & older hold at least a bachelor’s degree (as of 2019), and 94% hold a high school or equivalent degree. While we could see more Americans w/ bachelor’s degrees or higher, the amount to which those would impact productivity is a good question (see the overplayed engineering school joke about the English major working at Starbucks). And although potholes are annoying & our infrastructure could use a refresh, according to the Bureau of Transportation Statistics more than 70% of our roads are paved, a single but significant indicator of our infrastructure development.

In terms of Asian countries’ ultimate share of global output, the best answers we have are educated guesses. Time will tell whether they’ll fully catch up with the western world in output per head. There are too many political & technical factors at play to say anything for sure, but the odds are in their favor if they use them correctly.

Global Income Inequality vs. Global Output Inequality, a (Possible) Case Study in Africa

Although they seem similar, income & output are two very different measurements, and according to Piketty when applied & compared at a continental scale may provide a clue for many African countries’ slower economic development compared to the rest of the world.

At it’s simplest terms, output is the measure of how much a country produces that can be bought or consumed, while income is the amount of money or goods that all citizens make. These two values are correlated, but when assets are used in one country but owned by residents of another country they become unequal (the country in which the assets exist now has greater output than income, and vice-versa for the country in which the owners reside). For the most part foreign ownership is relatively equal across continents, and for most countries foreign-based income only makes up a couple percentage points of national income (~1–2% of GDP in the US). Africa’s the one exception to this, where ~20% of African capital is foreign-owned (as of 2012).

A theory exists that high amounts of foreign ownership of a developing country’s assets is a positive for said developing country, since jobs are being created & investment is flowing into the country. While these benefits do technically exist (most developing countries don’t assign citizens to jobs, instead people choose to work in the foreign-owned mines or sweatshops for reasons like better pay over the other, also not-great options available to them like subsistence farming), Piketty describes a couple flaws he sees in the argument that foreign ownership leads to the country economically “catching up” w/ the world in terms of income per capita & quality of life. His arguments are summarized as follows:

First, while foreign investment does typically lead to increased output, most of the resulting income increase goes to the foreign ownership, as opposed to the local workers. This leads to increased income gaps between rich & poor countries and reduces the ripple-effect that this increased output has on the local economy. Furthermore, there’s a potential correlation between high levels of foreign ownership and political instability. Citizens, upset about the high levels of foreign ownership and slow pace of income growth, begin forming & supporting political groups that oppose foreign ownership (proposing policies that vary in their true economic benefits & feasibility). Often these groups succeed in replacing the existing, foreign ownership-friendly government, but struggle to deliver on the promises that got them to power, and are either replaced with more capitalist governments (leading to a cyclical approach to foreign investment) or devolve into authoritarian regimes frequently at war with their own citizens.

Second, while foreign owners are happy to invest in machinery and other physical capital, they’re not typically focused on the development of “human capital”, a.k.a. building future-focused skills within the local workforce, or infrastructure that extends beyond what’s needed for the job at hand. Instead most local workers learn & execute on simpler, labor-intensive skills that don’t aid the maturity of the economy, and the country’s overall infrastructure isn’t developed as quickly as it could be.

While I can see merits behind Piketty’s arguments (and he’s certainly better-studied on this topic than I), every research paper I could find indicates mostly positive effects of FDI (Foreign Direct Investment) on the local economy’s development & and the recipient country’s political stability, so for me personally the jury’s out on this one.