Piketty’s (unintended) advice for investors
In macroeconomics, this has indisputably been the year of Thomas Piketty. Rarely, if ever, has a single book so profoundly influenced the public discourse on a central topic, the inequality of wealth and income in the developed economies over many centuries. In an age of tweets and sound bites, the fact that a Herculean intellectual work can have such influence is surely uplifting [1].
The financial markets, however, have largely ignored the book, seeing it as outside the realm of their direct interests. This is a mistake since, whatever one might think of Prof Piketty’s policy recommendations, he has written a major treatise on the economic process that generates wealth in our societies, and that is exactly what most investors are trying to understand.
On Friday last week I was on a platform with Prof Piketty at the London Business School, and the slides from my presentation are attached here. The LBS does not plan to upload the video of the presentations on the web until early next year, so this blog contains my main points.
Parts of this are inevitably a bit technical. Skip to the final section for the bottom line. Much of this is still very controversial; debate is welcome.
Prof Piketty’s work is frequently said to have “dismal” implications for the future of capitalism, and he does indeed conclude that inequality will increase inexorably, given the current tax code. But the other side of the same coin is that Prof Piketty’s analysis has bullish implications for long-run returns on asset classes. Abstracting from distributional issues, which may need to be handled through the tax system, that surely does not constitute a “dismal outlook” for capitalism. High returns on assets can, in principle, make everyone better off.
Actually, Prof Piketty’s prediction on the future path for what he calls “capital” (ie, the market capitalisation of household financial wealth plus housing) is a good deal more optimistic for asset returns than some asset pricing models would imply. These models suggest that asset markets today are “expensive”, so future returns are predicted to be below average. Prof Piketty disagrees.
The generation of wealth in Prof Piketty’s framework follows the steady state path in Robert Solow’s classic 1956 growth model. You cannot get much more conventional than that, especially since Prof Solow himself says that “Piketty is right”. As Prof Solow explains in simple English, the steady state wealth/income ratio in Piketty’s model is equal to s/g (where s is the net savings ratio and g is real growth in national income). Prof Piketty shows that this simple relationship appears to explain both the rise in global wealth since 1980, and the pecking order among major countries, rather well.
Crucially, he sees the rise in wealth in recent decades as a return to normal after capital was destroyed by the wars in the middle of the last century. Rather than being an aberration that has taken capital to unsustainably high levels, he views it as part of a fundamental process that is deeply embedded within capitalism.
He also thinks that this process is likely to continue well into the future. His explanation centres on the future path for g, which he predicts will fall as population growth and productivity growth slow [2]. Since g is in the denominator of the Solow equation, a drop in g results in a higher wealth/income ratio in steady state.
A key question for investors is whether this rise in the wealth/income ratio would impact total returns on financial assets. Prof Piketty addresses this somewhat obliquely. His relationship does not track total wealth or real wealth, only wealth/income. If income growth slows, the ratio may rise without total wealth rising. Also, his definition of wealth, quite rightly, includes housing, which he sees as particularly important in recent decades.
This can lead to many short-term distortions. As a broad generalisation, though, it seems likely that, if Prof Piketty is right about the future of “capital”, then returns on financial assets in general, and risk assets in particular, will probably be very attractive for investors.
So is he right? The most serious criticism of his theory comes from Per Krusell and Tony Smith, who have made waves in academia by suggesting that the correct expression for the wealth/income ratio should include depreciation on the capital stock (d). Therefore the expression should be s/(g+d), not s/g. This increases the denominator, and therefore reduces the wealth/income ratio in steady state [3].
The Krusell/Smith criticism seems justified [4] but it could still be consistent with a large rise in the wealth/income ratio from here, especially if Prof Piketty is right about the variable that is really central to his entire case, the rate of return on capital (r). He argues that the real pre-tax rate of return has been about 4 per cent since the dawn of time, and he thinks that this is likely to continue into the future, even if g slows sharply.
So the key, in his mind, is whether we can expect r to be significantly greater than g indefinitely.
The bottom line….
Assume for the sake of argument that the real rate of return on capital, r, is close to 4 per cent, as Prof Piketty predicts, and further assume (realistically) that financial assets and housing wealth are similar in scale, and that both produce the same real returns. If half of financial assets are bonds and the rest are equities, and (as now) the real return on bonds is zero, then the real return on equities would need to be as high as 8 per cent, despite today’s high stock market valuations.
That is all very back-of-the-envelope, and is not taken directly from Prof Piketty’s work, but it is why I am making the shorthand claim that “Piketty is bullish”. In fact, if he is not bullish about asset returns, then some of his pessimism about the future of wealth inequality probably falls away.
Finally, though, let us circle back to the real rate of return on capital. Can it really stay indefinitely about 4 per cent, as Prof Piketty suggests, at a time when central banks are setting interest rates at zero, and when the growth rate, g, is slowing down? Boiled right down, he himself says that this is his central claim. But in modern textbook economic models, while the rate of return on capital can remain higher than g in the long term, it is likely to decline when g declines.
Prof Piketty denies that this will be the case, and it is on that claim that his conclusions — whether they should be described as “optimistic” or “pessimistic” — largely rest.
Thomas Piketty has produced an empirical tour de force, but his underlying theory is more controversial [5]. Furthermore, as I have argued previously, there is a different explanation for the empirical facts of recent decades, combining secular stagnation, monetary expansion and some traces of Austrian economics. Prof Piketty’s “inexorable” rise in wealth is less inexorable in these alternative models.