Thomas Piketty’s Capital in the Twenty-First Century is beginning to receive book of the year awards, but has it changed anything within economics? There are two ways in which is has, one involving how economists approach questions about the distribution of income and wealth, and the other involving the use of historical narrative as a means of evaluating economic models.
The study of distribution of income has waxed and waned over time. To explain why, let’s begin with Adam Smith.
When Adam Smith wrote The Wealth of Nations in 1776, the major question was about production, not distribution. Europe had been stuck in the Malthusian trap for centuries, the industrial revolution was in its infancy, and the question of the day was how to produce enough to lift the vast majority of the population above subsistence living. Hence, Smith’s focus on the division of labor in his famous pin factory example, and his focus on how the price system moves resources to their most productive uses.
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To explain how the price system worked, Smith needed a theory of how prices are set. There were two choices, a theory where prices are based upon the value of labor used to produce a good or service, and a theory where value is determined by usefulness, what economists call utility.
Smith rejected the utility theory of value based upon his famous water-diamond paradox. What could be more valuable to people than water, Smith asked, certainly it has more value than diamonds? Which would you rather go without? Yet water sells for far less than diamonds, so usefulness – utility – cannot be the source of value. Thus, he settled on the labor theory of value to explain prices.
“If among a nation of hunters … it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer.”
He argued, for example, that in a primitive society, “If among a nation of hunters … it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer.” However, in a capitalist society this would no longer hold due to the presence of capital and profit, and he was never able to fully explain prices with the labor theory of value. Nevertheless, the labor theory of value, which leads naturally to questions about the distribution of income, persisted.
By the time David Ricardo began writing in the early 1800s, the focus had turned from production to distribution. The industrial revolution made it possible for there to be a surplus of production over and above what was needed for subsistence, but the distribution of the surplus was very unequal. Landlords were living lavishly, but the majority of the population was still suck at subsistence. Why was distribution so unequal, Ricardo wondered? To answer this question he developed his theory of rent.
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Ricardo argued that as economies grow, existing land would be farmed more intensively, and more land would be brought into production. However, the new land would be less and less productive (and working existing land more intensively would also produce less and less), so prices would have to increase to cover the higher costs of production on the less fertile land. For example, if 100 units of corn could be produced for $100 on the best land, a price of $1 is sufficient to cover costs.
If it takes $150 to produce 100 units of corn on the second, less productive piece of land, the price would have to go up to $1.50 per unit. But the price wouldn’t just increase on corn produced on new land, it would increase overall, meaning that the owner of the most productive land would earn $.50 in rent per unit produced (the difference between the $1.50 price, and the $1.00 needed to cover costs of production).
According to Ricardo, these rents were the source of the high incomes of landlords, and he advocated a tax on land – the main source of wealth at that time – as a solution to this problem. Piketty’s global wealth tax – his proposed solution to the problem of growing wealth inequality – has echoes in the past.
Piketty’s global wealth tax – his proposed solution to the problem of growing wealth inequality – has echoes in the past.
That’s not the only way in which today’s debate over the distribution of income resembles debates in Ricardo’s time. Ricardo and Thomas Malthus had a famous debate over whether general gluts – their term for recessions/depressions – could exist, and if so what could be done about them. Ricardo argued for Say’s law, i.e. that an excess supply of goods in one sector (think of the excess supply of housing, i.e. the glut of houses, in the housing crisis) would always be matched by excess demand in another sector.
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There could be temporary mismatches, excess supply in one sector and excess demand in another, but these would quickly resolve themselves. Malthus disagreed and proposed a theory of underconsumption, a theory that is very much like the arguments Robert Reich and others have been making today. Malthus believed that landlords with very high incomes, would consume all they wanted, and still have money left over.
Piketty’s global wealth tax – his proposed solution to the problem of growing wealth inequality – has echoes in the past.
Imagine, for example, gold piling up in their “cookie jars” at home. All of that unspent income would represent deficient demand. Goods and services would be produced generating income of equal value, but not all of the income would be spent leading to a “glut” of goods. The solution for Malthus was to encourage lavish spending by landlords on goods, servants, whatever it took to spend the idle income (the trickle down theory of his time).
Robert Reich and others would rather see redistribution that moves the idle income of the rich to the middle and lower classes where it will be spent, but the focus of the analysis on the distribution of income as the underlying cause of recessions and stagnation is very similar.
David Ricardo also tried to fix the problems Adam Smith had encountered when trying to use the labor theory of value to explain prices in a capitalist economy, Ricardo viewed capital as stored up labor that was released as the capital was used and depreciated, but in the end he too was unsuccessful. Still, the labor theory of value persisted, and it was the basis of Karl Marx’s theory of exploitation. If labor was the source of all value, and capitalists reap income merely from ownership, then they must be expropriating income they have not earned from the laboring class.
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The counterpoint to the distributional issues that come with the labor theory of value came with the rise of the marginalists in the late 1800s, William Stanley Jevons and Carl Menger in particular, and the solution to Smith’s water-diamond paradox. The problem was that Smith had confused total and marginal utility. It’s true that the total utility of water is higher than the total utility of diamonds – water is far more useful. But water is abundant for now, and the value of one more units, its marginal value, was very low and hence it sold for a low price. Diamonds on the other hand were scarce, and hence the marginal value of one more diamonds was very high leading to a high price. Thus, it is marginal utility that explains prices, not total utility.
The Marxists scoffed at this notion, how much sacrifice is required from the wealthy who can consume all they want and still have saving left over? They viewed it as an apologetic for the unequal distribution of income.
Marginalism and the utility theory of value, the theory that is still in use today, provided an alternative to the class-based labor theory of value that had lead economists to focus on distributional issues. According to the marginalists, each factor of production, which included land, labor, capital, and (for some) the entrepreneur, was paid an income – rent, wages, interest, etc. – equal to the value of their marginal product, i.e. the contribution of each factor to the value of the good or service produced. What could be fairer than a system that rewards each person precisely according to their contribution to the value of production?
But what about the argument that capitalists earn an income purely through ownership? Nassau Senior and others argued that capitalists did earn their incomes. In order to accumulate capital, they must save, i.e. they must sacrifice present consumption, and they deserved to be rewarded for their abstinence (a morally charged term). The Marxists scoffed at this notion, how much sacrifice is required from the wealthy who can consume all they want and still have saving left over?
They viewed it as an apologetic for the unequal distribution of income.
The utility theory of value and the corresponding idea that interest and other income was the just reward for an individual’s contribution to final output gradually took hold. It is used today, for example, to argue that CEOs deserve the incomes they get. Whether or not this is true is another matter, but the utility theory of value provides a basis for saying that we should not be concerned with unequal distributions of income and wealth and research into this question began to wane.
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Another reason the study of the distributional issues fell out of favor among economists is the distinction between positive and normative economics that began with Nassau Senior among others (this distinction is featured in the introductory chapter of almost all principles and intermediate level textbooks). According to this view, economists should not make value judgments about the distribution of income and other issues, they have no business saying what the distribution of income ought to be. They should take this is a given, and then analyze what happens in a positive, scientific way that simply states facts.
If, for example, there are two people endowed with two goods, call them apples and oranges (this can easily be extended to more people and more goods), economists should take the initial distribution of apples and oranges as given no matter how unequal it might be. Then, if the two individuals engage in voluntary trade, it must make everyone better off (nobody would make a trade that makes them worse off).
Thus, the utility theory of value combined with notions of positive and normative economics leads to a harmonious view where everyone receives a just income and everyone is made better off rather than the class conflict that emerges from the labor theory of value.
What Piketty has done in his book is revive the study of the distribution of wealth without violating the positive and normative distinction that economists hold so dear.
Critics of the capitalist system such as Karl Marx believed that this avoided the essential question, how the distribution of income and wealth is determined and evolved over time, power relationships between classes, and so on, but with the rise of the marginalists these questions were largely shunted into the background of inquiry.
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What Piketty has done in his book is revive the study of the distribution of wealth without violating the positive and normative distinction that economists hold so dear. It’s fine to leave questions about the distribution (or redistribution) of wealth to the political arena, but how can politicians make good decisions if economists cannot tell them about the laws of motion that determine the evolution of wealth and income distributions? Whether or not Piketty is correct about the fundamental determinants of these distributions remains to be seen, but he deserves much credit for reviving these questions and bringing them to the forefront of economic research.
Another thing Piketty deserves credit for is the revival of the historical, narrative methodology as a means of evaluating theoretical models. I was taught that economists should follow a “scientific” methodology. One first writes down a mathematical model, derives hypotheses from it, and then takes those hypotheses to the data to be evaluated through formal statistical tests.
Piketty shows us an alternative where historical narratives rather than formal statistical tests can be used to draw important conclusions about the ability of particular models to explain the world. Economists, to a large degree, have lost the historical methods and perspective – knowledge of history would have served us well during the financial crisis – and Piketty deserves a lot of credit for reviving this important way of understanding the world.
In his 1919 presidential address to the American Economic Association, Irving Fisher said, “The real scientific study of the distribution of wealth has, we must confess, scarcely begun as yet.” Nearly a hundred years later that, along with a revival of historical methods and perspective, may finally be changing.
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