Inequality and the future rate of savings

Thomas Piketty’s second “fundamental law of capitalism” in his book “Capital in the 21st Century” is generating some intriguing attention of late. This law argues that in the long run the ratio of wealth to income will rise to a level equal to the savings rate divided by the growth rate of the economy. This ratio is important for economists and policymakers to understand because if this is indeed a fundamental law then our economy would become increasingly dominated by the accumulating capital of the wealthy.

Recently there’s been a discussion about whether the variables underlying Piketty’s second law would actually lead to a rising wealth-to-income ratio. In particular, how much will the savings rate increase at all in the future? Economists Per Krusell of Stockholm University and Tony Smith of Yale University, for example, argue that there is a positive relationship between growth and the saving rate leading to a declining savings rate as growth declines. This means that the ratio of savings to growth, and therefore the wealth-to-income ratio, would not increase as much as Piketty predicts.

There’s also the issue of net savings versus gross savings. In order for savings to create new capital, the rate of savings has to be higher than the rate of decline in old capital, known as depreciation. If savings just keeps up with the depreciation, then old capital is just being replaced and nothing new is created. Piketty acknowledges this in the book, but only briefly and moves right along. The distinction, however, is important. As S.H. at the Economist notes, the net savings rate has been on the decline in recent decades. In the long turn, rising income inequality could be the source of the rise in the savings rate. As S.H. points out, rising inequality could come from other sources such as skill-based technological change. But that rise could itself feed into Piketty’s second law.

Then there’s this consideration—as more and more income flows to those at top, the consumption and savings decisions of top earners would have a larger effect on the overall savings rate. We know that high-income individuals have a higher savings rate than the rest of the population, as detailed in research by economist Karen Dynan at the Federal Reserve Board, Dartmouth College’s Jonathan Skinner, and Stephen Zeldes of Columbia University. Shifting income toward those at the top could increase the gross savings rate of the economy, increasing the savings rate and potentially increase the wealth-to-income ratio.

Of course, the net savings rate depends not only the gross savings rate but also the depreciation rate. Depreciation in the future could accelerate and counteract the rise in net savings. It could also decrease or stay constant and the net savings rate would increase.

As quantum physicists and baseball players know, predictions are difficult. Especially those about the future. According to Piketty’s second fundamental law, the wealth-to-income ratio depends upon the future path of savings, depreciation, and the total growth of the economy. Making solid predictions about any of these variables is a difficult task. But inequality could play an important role in the future rate of savings.


June 5, 2014


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