Fri, May 30, 2014 - Page 9 News List

Capital not the only factor in creating wealth and disparity

By Ricardo Hausmann

Theoretical frameworks are great because they allow us to understand fundamental aspects of a complex world in much simpler terms, just as maps do. However, like maps, they are useful only up to a point. Road maps, for example, do not tell you current traffic conditions or provide updates on highway repairs.

A useful way to understand the world’s economy is the elegant framework presented by Thomas Piketty in his celebrated book Capital in the Twenty-First Century.

Piketty splits the world into two fundamental substances — capital and labor. Both are used in production and share in the proceeds.

The main distinction between the two is that capital is something you can buy, own, sell and, in principle, accumulate without limit, as the super-rich have done.

Labor is the use of an individual capacity that can be remunerated but not owned by others, because slavery has ended.

Capital has two interesting features. First, its price is determined by how much future income it will bring in. If one piece of land generates twice as much output in terms of bushels of wheat or commercial rent as another, it should naturally be worth double. Otherwise, the owner of one parcel would sell it to buy the other.

This no-arbitrage condition implies that, in equilibrium, all capital yields the same risk-adjusted return, which Piketty estimates historically at 4 to 5 percent per year.

The other interesting feature of capital is that it is accumulated through savings. A person or country that saves 100 units of income should be able to have a yearly income, in perpetuity, of 4 to 5 units.

UNEQUAL GROWTH

From here, it is easy to see that if capital were fully reinvested and the economy grew at less than 4 percent to 5 percent, capital and its share of income would become larger relative to the economy.

Piketty argues that, because the world’s rich countries are growing at less than 4 percent to 5 percent, they are becoming more unequal.

This can be discerned in the data, though in the US a large part of the increase in inequality is due not to this logic, but to the rise of what Piketty calls “super-managers,” who earn extremely high salaries (though he does not tell us why).

So let us apply this theory to the world to see how well it fits.

In the 30 years from 1983 to last year, the US borrowed from the rest of the world in net terms more than US$13.3 trillion, or about 80 percent of one year’s GDP.

Back in 1982, before this period started, it was earning some US$36 billion from the rest of the world in net financial income, a product of the capital that it had previously invested abroad.

If we assume that the return on this capital was 4 percent, this would be equivalent to owning US$900 billion in foreign capital. So, if we do the accounting, the US today must owe the rest of the world roughly US$12.4 trillion (13.3 minus 0.9).

At 4 percent, this should represent an annual payment of US$480 billion. Right?

‘SHOULD’ VERSUS REALITY

Wrong — and by a long shot.

The US pays nothing in net terms to the rest of the world for its debt. Instead, it earned about US$230 billion last year. Assuming a 4 percent yield, this would be equivalent to owning US$5.7 trillion in foreign capital.

The difference between what the US “should” be paying if the Piketty calculation was right is about US$710 billion in annual income, or US$17.7 trillion in capital — the equivalent of its yearly GDP.

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