2014-04-23

Paradigms, Part III - Okay, Fine! I'll Talk About Piketty!

Everyone is talking about Thomas Piketty's new book, Capital. Some on the left have lauded it as a great argument for why the government's welfare safety net system should be expanded. Some on the right think otherwise. I haven't read the book, but I'm deeply skeptical that anything like that book could be used to substantiate a political opinion. This skepticism leads me to conclude two things:

  1. Piketty's most vociferous fans probably think that Piketty has "proven" something that he has not, i.e. they think his work is more revolutionary than it actually is.
  2. The principle benefit of the theory outlined in Piketty's book is that it provides a scientific veneer for an existing set of political priors.
If this doesn't remind us of the perils of paradigms, I don't know what does.

We learn from Piketty that large rates of return on capital imply financial gains for business owners and some displaced employees. This is a good lesson, but not a revolutionary one. Most of us know this without needing to be told. Holding on to this paradigm too long leads us to conclude unlikely things about the world economy; at that point, we're better off letting go of his model, relaxing the constraints, and living in the beautiful, un-model-able nuances of the real world.


Familiarize Yourself
Before you formulate an opinion on Piketty's main idea, you owe it to yourself to find out what he's actually saying. I'm not a reliable source of economic summaries, so do your due diligence. Jonathan Finegold Catalan has already located a free version of the appendix in which Piketty articulates his underlying idea. (Read it, understand it, then come back and finish this blog post of mine. Start on page 36.)

In particular, I think Finegold Catalan does an excellent job of summarizing the key idea when he writes:
The heuristic the book sells to the reader is r > g. That is, if the return on capital is greater than the rate of economic growth, inequality will increase. The concept, explained like that, is somewhat cryptic. It’s an easy heuristic for those who don’t want to get bogged down in the theoretical argument. The theoretical argument is actually not that complicated (theory makes up a very, very small minority of the book). Piketty makes it near the end of the sixth chapter of his book. His argument is that if the elasticity of substitution between capital and labor is > 1, the share of income accruing to capital will grow relative to that of labor.
My Reaction
I'll start with the positive:
Piketty's idea is prima facie correct. If you make more money investing in new machinery than you do by doing "business-as-usual," then this will tend to produce situation-specific income inequality.

Imagine Peter owns a sandwich shop. Peter wants to open a new restaurant: Peter can either choose to hire Roy to make sandwiches in the new shop, or invest in a sandwich-making robot. If Peter makes more money investing in robots than in employees, then Peter - who is wealthy enough to own more than one sandwich shop, unlike Roy - will make an increasing proportion of his income from machines. Roy, who never gets hired, loses in this scenario. You can see how "inequality increases" here because people like Peter earn more money while people like Roy earn less.

Now the so-so:
One objection here is that somebody has to build the robots. Roy may lose out on sandwich-making employment opportunities, but he wins big at the robot-making factory. So there is no reason to merely assume that inequality increases when Peter buys more robots. It might, or it might not. It depends on the particulars of the case.

Piketty makes clear that when he's talking about r and g he means for the whole economy. So he's not just talking about Peter and Roy, he's talking about everyone in the whole world. The claim becomes this: If investing in robots makes more sense for all the people in the economy who make the most money than "business-as-usual," then inequality will increase.

This is a stronger claim, and a more easily disputed one. Suppose we live in a two-good economy where people either make sandwiches or build robots. As sandwich-makers seek to replace employees with robots, robot-builders will need to hire more people to build those robots. The more robots we need, the more we need people to build robots! This will be true, unless the robot-builders also replace robot-builders with robot-building robots...

But doesn't this just kick the can down the road? Who designs and builds the robot-building robots? Somebody has to. The production process has to begin somewhere, and that's where the people will be, if for no other reason than to build the robots that will perform all the other tasks.

Now the negative:
Thus we come to the Achilles' Heel of Piketty's ideas about capital. If capital were a giant, amorphous blob of electrodes produced en masse and then formed like clay into whatever shape required to perform whatever task, then Piketty's claims would be a lot stronger. But capital - especially modern machinery used to produce modern goods and services - is highly diverse and highly specialized.

For example, insulin cannot simply be cranked out by a machine. Recombinant RNA must first be grown in a laboratory (by some combination of humans and machines), and then shipped to a manufacturing facility (by some combination of humans and machines) before the machines at the factory can produce insulin in vats. Synthetic insulin is among the most complicated products in a modern economy, and it requires people to produce it.

On the other hand, assembling automobiles is an almost fully roboticized process.

Modern vehicles and modern medicine are both incredibly important and lucrative and technologically advanced fields. The same macroeconomy that produces the modern automobile produces synthetic insulin.

In short, we can say many superficial things about "manufacturing," but we cannot make specific claims about the "capital" involved in both industries that accurately describe both industries. Different parts of the economy behave differently.

In economic jargon, r and g aggregate up to the macroeconomy, but that includes the summation of a lot of positive and negative numbers, numbers greater than 1 and numbers between 0 and 1. Just like the price of iPads can decrease while the price of gasoline increases, so the price of insulin-making robots and car-making robots can go in opposite directions. Just because the aggregate number is X doesn't mean it's X for every industry in the world.

We can assume-away all the variation in an economy if we want to, but it doesn't provide us with the kind of insight needed to arrive at important policy conclusions.

Conclusion
Piketty's ideas will resonate with leftists who are hungry for a technical justification for implementing leftist policies, such as steep taxation on the rich or on capital itself, and large welfare payments to people who do not own large amounts of capital. It's equally likely that rightists and libertarians will scoff at Piketty's claims and seek to explain why they just cannot be true.

The truth doesn't lie in the middle. The truth lies in the strength of expressing ideas only vaguely, and steering clear of specifics. That is, the truth is that Piketty's ideas are accurate as a shotgun theory and inaccurate otherwise.

Piketty's theory isn't wrong, but it doesn't provide a good justification for leftist social policy, either. Those two facts are bound to disappoint leftists and non-leftists alike, and this is why it's important to take paradigms as learning tools, absorb the knowledge, and then cast the paradigm aside again.

UPDATE: Arnold Kling's view is similar to mine when he says:
The way I see it, Piketty and Solow work with models that incorporate homogeneous workers (with no differences in human capital) and homogeneous capital (with no differences in ex ante risk or ex post returns). The real world is so far removed from those models that I simply cannot buy into the undertaking.
Solow's take, as referenced by Kling, is here