Thursday, August 28, 2014

Review: Capital in the Twenty-First Century

Capital in the Twenty-First Century is Thomas Piketty's magnum opus about the future of capitalism and the implications thereof. It is by far and away the best book I've read this year, and I doubt if I'll read a better book in this decade. It's a combination of economics, political economy, history, literature analysis (of Jane Austen and Honore Balzac no less) and big-data analysis that had me getting up early to read it. In my younger days, I would have devoured this book non-stop in a matter of days, ignoring food, sleep, and work. It is more exciting than any combination of science fiction novels, and in many ways fulfills the idea of economics as psychohistory.

The central premise of the book is the inequality r > g. Through human history, while growth rates have usually been around 1%, the return on capital has usually been around 5% (in real terms, not nominal terms). You might question this 5% number as contradicting Bernstein's 2% number. Note that Bernstein's numbers includes major catastrophes, such as the world wars wiping out most assets in Europe. From a personal finance point of view, such events usually mean that you care a lot more about staying alive than your portfolio! The implications on wealth accumulation is fairly straightforward: if you can accumulate capital such that you can live on less than 5% over a long period of time, you can reinvest the remainder of your capital income and grow well above the growth rate of the economy, leaving you not only with increasing assets, but also freeing you and your heirs from ever having to work for an income ever again. In the extreme case (let's say you're Bill Gates), you can live on 0.01% of your income from capital and essentially reinvest all the proceeds, creating dynastic level wealth. The Hiltons, Kennedys, Rockefellers, and Kochs are of course in this category.

Wait a minute, you say, isn't the world GDP growth more than 3%? Isn't China growing at 7-8%? This is where historical data comes in. Piketty provides convincing evidence that these numbers can only occur because of (1) population growth, and (2) catchup with the modern economies. In other words, Europe could only grow at 6-8% a year until it caught up with the USA at the frontier of technology and infrastructure, at which point it devolved down to 1-1.5% growth. The same happened to Japan, and will happen to China. It's reasonable to expect the world to degenerate to that case eventually, but the developed world is already there.

Even more impressively, Piketty has current data. This data in particular, shows that the top 1% in Europe and USA already own more than 70% of the capital assets in their respective economic arenas. Even worse, there's reasonable evidence that because of the existence of tax havens, these estimates are low. Piketty analyzes total capital known to be in existence, and reveals that the world owes more money than exists in developed country accounts. The remainder of the dark capital exists in tax havens and is likely to be around 10% of global wealth.

How bad can things get? Here, Piketty turns to history for data and to literature to make it real. This section of the book is impressive and amazing to read. During the Gilded Age (called Belle Epoque in the book), the wealthy commanded 90% of the capital in their respective countries. Fully half of the population (then and now) owned essentially nothing or had a negative net-worth, and there was no middle class. There was effectively no inflation, which explained why Austen and Balzac would provide numbers in terms of income for the characters in their novels and expect readers to understand what situations each character was in. Worse, there was no way for anyone to get ahead by hard work or education: even judges could at most make 5 to 7 times the average income, compared to the wealthy heirs and heiresses who would have 30 to 60 times the average income from the capital they inherited. Hence, the plots of those novels always involved marrying someone so wealthy that they could provide a dignified existence (meaning that they could hire enough servants to take care of the needs of daily living, given the non-existence of refrigeration, cars, etc).

Lest you think that this state of affairs could only occur because of a stagnant technology, Piketty reminds the reader that automobiles, steam engines, etc. were all invented during this period. It was hardly a period of stagnation. Yet because all new technology required capital, the inventors didn't make off with the lion's share of the profits.

So how did the situation change? Was it the progressive income tax? Was it the introduction of inflation? The answer was that it took 2 world wars to essentially destroy most of the existing capital stock in Europe in order for a more egalitarian post-war generation to exist. This essentially created a middle class that owned about 40% of the wealth and consisted of 40% of the population. 50% of the population continued to own no property, while the top 10% owns 60% of the wealth. In the U.S., punitive taxation levels of 90% kept inequality low, essentially keeping the American middle class from suffering the same fate. Piketty points out that the 90% tax rate was hardly ever paid. Instead, what it did was to keep executives (who essentially set their own pay) from asking for compensation at that level. When those tax rates were dismantled in the 1980s, CEO and other executive compensation sky-rocketed in response.

So how does the world look going forward? It looks grim. We are currently in a situation where in the US and Europe, capital from inheritances and capital from savings through work average about 50%. By 2050, if things don't change, we could easily see a return to inequality levels seen during the Gilded Age: most high net-worth households will be those who are inherited, and once again, your path to success would lie mostly in marrying rich rather than hard work and entrepreneurship. The dystopia of Blade Runner or Elysium never looked more likely than through Piketty's statistics. To balance that out a bit, Piketty points out that the European and US welfare states do cushion the blow somewhat: elderly poverty is down substantially since social security was introduced, and the European safety nets are even more generous. Of course, there's no shortage of the usual suspects wanting to tear that down...

Is there any possibility of change? Piketty proposes a global tax on capital, essentially a wealth tax. This is by far the most disappointing section of the book, not because such an idea wouldn't work, but because the political climate just wouldn't allow it. Furthermore, he works in lots of other issues that have very little with inequality and other topics covered by the book. For instance, he covers ways to pay down the national debts of various countries with a one-time exceptional tax. Since Piketty is French, he spends a lot of time discussing the Euro and the need for Eurozone cooperation and sanctions against tax havens, which is an international problem.

But seriously, that's a small nit on the book. I haven't even covered many of the side-topics that Piketty covers in the book. For instance, there's a huge discussion of slavery in the US in the antebellum South. This was a tour de force, as Piketty shows how much wealth slaveholders had: essentially, the northern US states were poor compared with old Europe, but the southern US states were wealthier, and of course, with a correspondingly higher wealth inequality. There cannot be more impoverishment than the inability to own even your own labor, and Piketty's statistics and graphs show the benefit of being on the other side of that equation in stark relief.

Piketty also discusses the American education system in contrast with the European systems, and how elite American colleges perpetuate the inequality that already exist in society: the majority of their incoming students come from the top quartile of society. He does point out the advantages of charging insanely high tuition, so you do get something for your money. Nevertheless, this goes a long way towards understanding why elite American colleges' acceptance tests seem very similar to the old-school European finishing school, complete with piano-playing and other tests of altruism and "leadership." They essentially have not drifted too far from those original prototypical elite institutions.

Finally, is there anything practical you can learn about personal finance in this economics book? The answer is yes. The first of which is that real-estate is a mug's game. Today's real-estate yields about 3-4%. Why so low when all other capital earns 4-5% real returns? The answer: real-estate is the only capital today subject to Piketty's wealth-tax. That wealth tax seems small: 1-1.5% of property value per year. But since it's levied every year, it imposes a drag on performance that's much higher than the capital gains tax, which are the subject of inter-state competition and hence tends towards zero over the long term. Piketty points out that the higher up the wealth ladder you go, the lower the proportion of real estate owned in the portfolio because of these characteristics. In other words, it's better to be equity-heavy and house poor than equity-light and house rich. The other lessons are fairly obvious: you want to have the lowest costs possible (both in investment costs and living expenses) so that your capital has the highest chance to compound. The bigger your portfolio, the faster the money will grow: Piketty points out that there's no difference in performance between Bill Gate's portfolio and Liliane Bettencourt's portfolio, even though one was a brilliant entrepreneur and the other is the heiress of the L'Oreal fortune. Capital is indifferent as to how you came by it. Furthermore, the largest portfolios grow the fastest. The elite university endowments for instance, grow at 8-10% a year, since once you get past a certain size you can take advantage not only of relatively expensive wealth managers through economies of scale, but you also have the ability to buy illiquid assets that cannot be easily sold and hence command a risk premium.

In the writing of this review, my biggest fear is that I haven't convinced you that you must read this book. Not only does it give you tools with which to analyze the world (and Jane Austen's novels --- you might even be able to avoid having to read them at all, since Piketty does such a great job of picking out the essentials), it also gives you the context of why we are still feeling the effects of world war 2, 70 years after the event.

Highly recommended. Pay whatever price you have to, ignore whatever pressing assignments you have to, read this book. It is that good, and whether or not you disagree with the politics, there's plenty in here for you to exercise your intellectual muscle on. Go to it.
Post a Comment