If Capital Grows This Fast, How Come Fortunes Disappear?

18th Century Aristocracy

Michel Barthelemy Olivier, "Thé a l'Anglaise" via Getty Images

The great aristocratic fortunes of the 21st century rival those of Louis XV. And beheading is rarer.

Just how fast do fortunes grow? Andrew Carnegie started from essentially nothing to become the second-richest man in the United States by the time he’d reached the modern retirement age of 65. John Pierpont Morgan got to the top spot even faster, though he had the advantage of being born into wealth. In our own century, Bill Gates beat them both, becoming the richest man in the world before the age of 40.

If the descendants of Carnegie and Morgan and Gates (who has promised to give most of his wealth away) and Carlos Slim bank their fortunes and let it accumulate over the generations, just how much of the world will they own?

The question comes up now because of one book that has seized the attention of the world of economists and those who interpret them: Thomas Piketty’s “Capital in the 21st Century.” The grand summation of the worldwide problem of inequality has gotten a reception that the New York Times’s Jennifer Schuessler describes as “rapturous.”

Together with his frequent collaborator Emmanuel Saez, Piketty has probably done as much as anyone to map wealth and income in the world today. So the encomia are understandable, but as Bloomberg View’s Clive Crook argues, many folks have seem to overlook the leaps from Piketty’s careful scholarship to his big claims. Some of those claims, like Piketty’s accounting of how fast capital expands, seem downright strange.

Which brings us back to that question about how fast fortunes grow. The central claim of Piketty’s book is that the period of diminishing inequality that we saw in the 20th century is a historical aberration, and we are entering a period in which capitalism returns to its natural state of affairs: an increasing concentration of wealth in fewer and fewer hands. That contention is based on a formula that’s fast becoming famous: When the rate of return on capital is greater than the overall growth of the economy — when r>g, in Piketty’s formula — wealth becomes progressively more concentrated.

Piketty believes this was the the case through most of history. To illustrate this, he starts off the book with a long, erudite, and charming discussion of Honoré de Balzac and Jane Austen, demonstrating how for many years it was an accepted rule of thumb that owners of land or bonds would see their capital appreciate at a rate of about 5 percent a year.

For Piketty, that 5 percent rate of growth routinely cited by Balzac and Austen is quite close to the mark; his own calculations yield a number somewhere in the 4 or 5 percent range for the period in which they worked. And that, unfortunately, is a lot faster than most economies grow. Some of that capital, of course, gets spent to maintain the lifestyles of the rentiers. But the rest gets reinvested. If the holders of capital manage to reinvest, say, three-fifths of their money (a number that Piketty takes as reasonable assumption), they will see their fortunes grow 3 percent a year. That’s much faster than economies expanded through most of history. Actually, it’s faster than just about any economy expands except during short and anomalous bursts (like China today or Europe in the period 1950-1980) — and faster than U.S. and European economies are likely to expand in the next century.

The 5 percent returns on capital that Piketty sees as the historic norm have to come from somewhere. And if the income of the 1% (or really 0.1%) is not coming from economic growth, it has to be coming out of squeezing the share of the 99%. That’s a neat and powerful argument you don’t need to be a professional economist to understand. It hinges, though, on that rate of return on capital, a number that frankly seems hard to support.

On Balzac, let’s defer to Thomas Piketty. But it’s not totally clear that on this subject French novels are more authoritative than Russian plays, in which the position of the rentier is more precarious. Not every landowner could sit back and collect a 5 percent risk-free return on the value of an estate; if that was the case, Anton Chekhov’s Anya and Varya would still be sitting pretty in their cherry orchard.

In addition to the 19th century literary canon, some actual bond returns are relevant. Great Britain forms a very good example here. In the 18th century the British government began issuing bonds that paid interest in perpetuity at the rate of 3.5 percent of face value (Barry Ritholtz has a useful discussion of that). Britain issued more of those “consols” through the 19th century, mostly paying interest of 3 percent and eventually 2.5 percent.

That’s already lower than Piketty’s assumed return, but still very nice for what were perceived as pretty much risk-free bonds (the U.S. Treasuries of their time). The caveat is that after 1913 the return on those bonds would have been seriously clobbered by World War I-era inflation. So if you’d bought the bonds in the mid-1800s you would get a good half century of 3 percent returns, but then see your principle clobbered by inflation.

There were many bonds that offered higher returns than the British consols, but they came with correspondingly higher risk. Coupons on U.S. railroad bonds in the late 18th century hovered around 5 percent (earlier in the century they were somewhat higher). This, though, is by no means a risk-free return. Most of those railroads went bust and eventually defaulted. In the 1870s, railroad bond default rates averaged 6 percent a year — see this paper — which would essentially have wiped out any gains for railroad bond holders.

To some folks that must sound like nit-picking. “Capital in the 21st Century” is a heavyweight, so it’s tempting to say, “Hey, look at the big picture here and don’t dawdle over decimal points.”

Maybe it is nit-picking; TMN has been going through Piketty’s book more ploddingly than some other journalists. A lot, however, hinges on these percentages. If you think that the historical rate of return on capital was as high as Piketty estimates, then you’re likely to accept Piketty’s r>g formula and see the concentration of wealth as essentially inevitable. In that case, if like Piketty you see that as a problem (as most folks probably do, but certainly not all) then you’re going to focus solutions on redistributing money at the back end, with taxes on wealth, inheritance and capital distributions or other ways of transferring money to those who weren’t born into the rentier class.

If, on the other hand, the long-term risk-free return on capital is lower than Piketty says, then the dynastic accumulation of wealth becomes less of an issue. That’s especially the case if you’re inclined to think that the second- and third-generation wealth tends to develop a propensity for spending (“rags to riches to rags…”) that does much to dissipate those returns on capital.

Without doubt Piketty’s work on measuring income is important. Everybody who thinks about income and inequality seriously — whether or not they think inequality is a problem — has to credit Piketty and Emmanuel Saez with describing the facts on the ground. That makes the omission of actual historical data on investment returns in Piketty’s book especially strange.

On the face of it, Piketty’s account of wealth accumulation seems to make assumptions that, from the capitalist’s viewpoint, are awfully optimistic. Without more good historical information it’s impossible to be sure of how fast capital is built up. I’m skeptical that it is quite as easy to get the risk-free returns on capital that Piketty imagines. There are plenty of heirs who believe, as Piketty does, that they can comfortably live forever from the interest on their fortunes. A fair number of them wind up broke.


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