Piketty's Rickety Economics

Richard Epstein

Richard Epstein

Richard Epstein

The relationship between inequality, whether of income or wealth, and economic growth is perhaps the defining issue of our age. In my previous Defining Ideas column, The Piketty Fallacy, I urged readers to take a critical view of Thomas Piketty’s new book Capital in the Twenty-First Century for two reasons. The first is that we should welcome any increase in wealth to the rich or the poor that does not leave other people worse off, whether that change increases or narrows the gaps in wealth between rich and poor—any such Pareto improvement meets the gold standard of economic welfare. The extra wealth increases the scope of human possibilities no matter where it is lodged. Over time, market and charitable transactions will spread that wealth across society.

Second, this contention is borne out by looking, ironically, not directly at wealth but at individual utility, happiness, or satisfaction. These outcomes are notoriously difficult to measure, which is why all systems of taxation and regulation are keyed to wealth rather than utility. But wealth is just one of several imperfect proxies for personal utility. A far better proxy for utility, however, is overall life expectancy. In the United States that figure has increased by over 30 years per person since 1900, and by over 40 years for African-Americans. A black/white longevity disparity of 15 years in 1900 has shrunk to 4 years today.

Much of that gain comes from overall improvements in public goods, like from better sewage management and vaccinations. Wealth, not utility, funds these advances, so that most of their costs are necessarily borne by the wealthy. But the resulting gains are not concentrated in the top 1 percent. Piketty disregards this massive benevolent and uncontroversial redistribution in his calculations of inequality.

Pitney v. Piketty

In taking this view, Piketty misunderstands the sources of social wealth creation. Thinking that capital accumulation drives social inequality, Piketty favors progressive taxes. Yet he is oddly indifferent to the virtues of competitive markets and the damage that monopolies and cartels can inflict on social welfare.

Piketty may not have made this fatal mistake if he had read the opinion of a great if unappreciated Supreme Court Justice, Mahlon Pitney, who addressed this issue in the 1915 Supreme Court case of Coppage v. Kansas. At issue in Coppage was whether an employer had a constitutional right to insist by contract that his workers not join a union so long as they remain in his employ. Pitney held for the employer: 

A little reflection will show that wherever the right of private property and the right of free contract coexist, each party when contracting is inevitably more or less influenced by the question whether he has much property, or little, or none, for the contract is made to the very end that each may gain something that he needs or desires more urgently than that which he proposes to give in exchange. And since it is self-evident that, unless all things are held in common, some persons must have more property than others, it is from the nature of things impossible to uphold freedom of contract and the right of private property without at the same time recognizing as legitimate those inequalities of fortune that are the necessary result of the exercise of those rights.  

The gist of Pitney’s argument is that any contract between an employer and employee is one for mutual gain: Why else would the worker make it? Indeed the right to contract is, as Pitney stresses, “as essential to the laborer as to the capitalist, to the poor as to the rich, for the vast majority of persons have no other honest way to begin to acquire property save by working for money.” To argue in this case that some level of inequality of bargaining power between the parties is reason enough to block their contract misses the point altogether, for it imposes limitations on the employees’ freedom of choice.

Unionization, of course, will benefit the position of those workers who voluntarily join the union. Yet unionization dims the prospects of excluded workers, and of the suppliers and customers who are put at the mercy of a monopoly union, armed with extra political powers and able to engage in well-timed strikes to the massive inconvenience of everyone else.

Piketty does not address the nitty-gritty of labor market regulation, and thus misses Pitney’s point that gains from trade are necessarily blocked by taxation and regulation. Even if these fall nominally on the employer, both sides are hurt from the contraction of the labor market.

The National Labor Relations Act of 1935 is similarly blockheaded on this point. It contains the outlandish claim that “The inequality of bargaining power between employees . . . and employers . . . tends to aggravate recurrent business depressions, by depressing wage rates and the purchasing power of wage earners in industry and by preventing the stabilization of competitive wage rates and working conditions within and between industries.”

Unfortunately, Piketty’s preoccupation with inequality blinds him to the huge hit to growth that comes from union organization and, more generally, from regulations across the labor, product, and real estate markets that artificially set wages prices, or other terms of trade.
— Richard Epstein

The inequality of bargaining power has little role in well-defined competitive markets, where employers have to meet the going wage. The “purchasing power of wage earners in industry” includes the loss in wages from workers who are excluded from union activities. Business depressions are more likely to arise in rigid labor markets where firms and workers cannot incrementally adjust to changed conditions. Stabilization of wages is an oblique way of referring to how labor cartels force outsiders to bear all the costs of uncertainty from any exogenous shock to labor markets.

Piketty’s Fatalism

Unfortunately, Piketty’s preoccupation with inequality blinds him to the huge hit to growth that comes from union organization and, more generally, from regulations across the labor, product, and real estate markets that artificially set wages, prices, or the terms of trade. Ignoring these mid-level institutions leads Piketty to assert that overall growth rates are constrained by some invisible Malthusian hand so that “there is ample reason to believe that the growth rate will not exceed 1– 1.5 percent in the long run, no matter what economic policies are adopted."

What economic nihilism! Countless systems of direct taxation and regulation reduce gains from trade in countless economic areas. One key way to spark growth is to reduce the repressive income and growth taxes that Piketty favors because, ironically, he thinks that overall growth is not sustainable. It would also do him a world of good to look more closely at current schemes of industry-specific direct regulation that result in the inefficient deployment of capital. He might, for example, consider the adverse impact on pharmaceutical innovation that arises from the unduly risk-averse attitude of the Food and Drug Administration, or the perverse distortions of energy markets from the equally misguided efforts to subsidize wind and solar energy in ways that make it harder to take advantage of the enormous advances in traditional fossil fuel technologies.

Moreover, one of the most persistent threats to growth occurs in Piketty’s home court, the misguided regulation of capital markets. As Tyler Cowen points out, Piketty writes as if all capital falls within a single undifferentiated lump. But in practice, the efficiency of capital markets depends critically on recognizing the distinction between venture capitalists, coupon clippers, and everyone else in between. Capital of course never runs without management and investor expertise; it is essential to match entrepreneurs and investors with the right holdings. It does no good to have retirees take large stakes in risky new ventures, while industry experts hold treasury bills.

Hence, capital must be mobile over the life cycle of new innovation. Most high-risk start-ups fail. But the extraordinary returns from successful ventures more than compensate for the dry holes. But those successful ventures need to find cheap and effective ways to go public so that high-risk players can start new ventures, and risk averse investors can reap solid returns.

Standing athwart this enterprise lies the Securities and Exchange Commission and the multiple agencies under the Dodd-Frank Act whose disclosure and regulatory polices can add unreasonably to the cost of going public. A reliable exit option will increase initial investment levels, which will in turn drive up the demand for labor and with it overall wages. For better or worse, capital and labor are intertwined. It is wrong to think that the infinite array of intermediate institutions and practices do not have a huge impact on overall levels of growth.

In my academic career, I have devoted much time to examining the rise of the regulatory state and the havoc it wreaks on economic growth. The poor growth rates of the last decade are not the unavoidable consequence of natural events or huge impersonal forces. Many of them stem from our boneheaded choices on regulation and taxation. Simplifying the tax code and easing back on regulations could easily bump that growth rate above Piketty’s dire predictions. But so long as policy makers take Piketty’s lead, preoccupying themselves with inequality, our prospects for growth are grim. We will continue to pay a high social price if we place our faith in Piketty’s rickety economic theories.