The Hourly Piketty: Paul Krugman, “Gattopardo Economics”, and Economic Modelling

*Paul Krugman: On Gattopardo Economics: “Thomas Palley… raises an interesting point…

…disappointed that Piketty’s book relies mainly on conventional, mainstream economics… labor and capital… paid their marginal product… True, when discussing the rise of “supermanagers” Piketty talks about imperfect competition and rents, but that’s not the core of his work…. Palley and others are disappointed…. The thing to bear in mind, however, is that you really don’t need to reject standard economics either to explain high inequality or to consider it a bad thing…. You can be perfectly conventional in your economics–or, my own attitude and what I think is Piketty’s, willing to use conventional models when they’re convenient and seem useful without treating them as irrefutable truth–while still taking inequality very seriously.

I think Thomas Palley has a stronger point than Krugman does. As I wrote, well, last night:

Brad DeLong: The Daily Piketty: Thursday Focus: April 24, 2014: “I had not fully realized just how heavy a lift Piketty has in trying to persuade the American neoclassical growth-economics community within economics departments. Their–our–default view of the world is–very strongly–that it is characterized by a Cobb-Douglas aggregate production function, in which the rate of profit moves inversely with the L ratio and in which as a result the capital income share of total income is constant.

You may say: “But if you have a model in which you assume the capital income share is constant, you then have no chance of ever explaining fluctuations in income distribution. How can you use a model in which fluctuations in income distribution do not happen to criticize anyone trying to explain why they do?” And this is a more than fair cop. But that the habit of thought is not rational doesn’t keep American neoclassical growth-economists in economics departments from doing it: their–our–first reaction to Piketty is: “That can’t be right, because in our model the capital-income share of total income is invariant to shifts in the wealth-income ratio.” And they–we–typically do not take the second step in the argument and say: “wait a minute: in our model nothing causes shifts in income distribution, so we need a different model”.

And, as I have also said before, I think Suresh Naidu gets this point right:

Suresh Naidu: The Slack Wire: Notes from Capital in the 21st Century Panel: “I think there is a ‘domesticated’ version of the argument…

that economists and people that love economists will take away. Then there is a less domesticated one, one that is more challenging to economics as it is currently done. I’m curious which one Thomas believes more. I worry that the impact of the book will be blunted because it becomes a “Bastard Piketty-ism” and allows macroeconomics to continue in its modelling conventions, which are particularly ill-suited to questions of inequality.

The domesticated version is a story about technology and the world market making capital and labor more and more substitutable over time, and this is why r does not fall very much as wealth accumulates. It is fundamentally a story about market forces, technology and trade making the demand for capital extremely elastic. We continue to understand r as the marginal contribution of capital to the production of the economy. I think this is story that is told to academic economists, and it is plausible, at least on the surface. 

There is another story about this, one that goes back to Keynes. And the idea here is that the rate of return on capital is set much more by institutions, norms and expectations than by supply and demand of the capital market. Keynes writes that “But the most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners.” Keynes footnotes it with the 19th century saying that “John Bull can stand many things, but he cannot stand 2 percent.”

The book doesn’t quite take a stand on whether it is brute market forces and a production function with a high elasticity of substitution or instead relatively rigid organization of firms and financial institutions that lies behind the stability of r.  

I think the production approach is less plausible, partly because housing plays such a large role in the data, partly because average wages would have increased along with K/Y, partly because the required elasticity of substitution is too big for net quantities, and partly because of the differences between book and market capital. The (really great) sections from the book on corporate governance actually suggest something quite different, that there is a gap between cash-flow rights and control rights, and this is why Germany has lower market relative to book values. This political dimension of capital, the difference between the valuation written down in the balance sheet and the real power to dispose of the asset, is something that the institutional view of capital can capture better than the marginal product view. This is, I think, also a fruitful interpretation of what was at stake behind the old capital controversies.

The policy stakes from this are also potentially large, because if it is just a very high substitutability, a variety of labor market reforms are taken off the table, as firms just replace workers with machines if you try to raise the wage.

Second, what is gained by producing long-run data? Why do economic historians do what we do? And why is it important that the series go before 1960? Part of the answer is that we discipline the modelling with useful analogies to a past. History gives us a library of options for understanding the present….

The Gilded Age U.S. North was riven with labor conflict and the South was an apartheid state. U.S. military forces were deployed on U.S. territory more times in the late 19th century than any other period, solely for breaking up strikes and repressing labor conflict. And this points us towards one of the costs of inequality, which is a large amount of social conflict. But note that… you could have a peaceful high inequality society by spending a lot on security guards and gated enclaves (or hired economists to tell people it is all efficient and for the best), but that is still costly, in that social resources are getting unnecessarily spent to repress, persuade, and manage social conflict. We see the same thing in unequal societies like India, South Africa or the gulf countries.

There is a place where the analogy breaks down, however. We live in a world where much more of everyday life occurs on markets…. From health care to schooling to philanthropy to politicians, we have put up everything for sale. Inequality in this world is potentially much more menacing than inequality in a less commodified world, simply because money buys so much more. This nasty complementarity of market society and income inequality maybe means that the social power of rich people is higher today than in the 1920s, and one response to increasing inequality of market income is to take more things off the market and allocate them by other means.

Finally, let me suggest that if we’re aiming for politically hopeless ideas, open migration is as least as good as the global wealth tax in the short run, and perhaps complementary…