Piketty ignores the great convergence

Published in The National Business Review (Auckland), 6 June 2014 (PDF)

This year’s global publishing sensation has been Capital in the 21st Century, a tome on the alleged rise of inequality in developed countries.

Written by French economist Thomas Piketty, it argues that over long periods of time, capitalist societies had become more polarised. He claims the cause of this growing gap between the rich and the poor is the rate of return on capital exceeding the rate of economic growth. To correct this development, Piketty then proposes targeted state intervention of a redistributionist nature.

After an initially glowing international reception of the book, led by economists such as Paul Krugman and Joseph Stiglitz, a Financial Times investigation into Piketty’s data sources revealed some serious flaws in his argument.

Chris Giles, the FT’s economics editor, concluded Piketty’s spreadsheets were riddled with “transcription errors from the original sources and incorrect formulas. It also appears that some of the data are cherrypicked or constructed without an original source.” Having corrected for these errors, Giles concluded, Piketty’s central thesis of rising wealth inequality collapses.

The FT was not the first publication to point out the data issues in Piketty’s work. Last September, economist and historian Nicolas Baverez already pointed out in Le Point magazine there were serious doubts about the data used in the original French edition of Capital.

It remains to be seen how problematic Piketty’s data-picking is. There have been other economics books in recent times containing factual mistakes (think of Reinhart and Rogoff’s This Time is Different) that nevertheless did not discredit their main claims.

Regardless of these methodological questions, there are a few things that are odd about Piketty’s approach. His analysis of a widening gap between rich and poor in developed, capitalist countries (if it holds) may be interesting but it ignores a much more important development.

While there may be growing inequality within countries, on a global scale we are observing the very opposite between countries.

To understand this development, it is instructive to consider a few figures. In 1980, China’s per capita GDP was 1.5% of US per capita GDP. By 2012, this had risen to 10.5%.

The increase in South Korea was even stronger over the same period: from 13.2% in 1980 to 39.1% in 2012. Meanwhile, Malaysia made the journey from 14.3% to 20.1%; Peru from 9.5% to 13.1% and Botswana from 8.4% to 14.0%.

All these countries not only became richer in absolute terms but also narrowed the relative gap between themselves and the US, the world’s leading economy.

By embracing globalisation, these formerly less developed countries have thus played catch-up with the developed West. The more economically liberal they have become, the faster and stronger was their convergence.

Sadly, the same cannot be said for other countries, mostly in Africa, that did not make the transition toward liberal, open economies and have remained poor as a result. However, the convergence – especially of Asian countries – is a remarkable success story.

It is instructive to consider Piketty’s claims in this context. Even if he were right about economic polarisation happening within developed nations, he would have to concede that globally inequality is diminishing between those countries adopting the capitalist model.

As countries move toward a free market system, their productivity improves, their incomes shoot up and incidentally they also improve on most other measures such as education, health and life expectancy. On this global scale, the spread of free market capitalism is a gigantic development programme. It produces results that decades of government aid could not deliver. And it is closing the gap between the world’s rich and poor.

There is, however, a rather unpleasant side-effect of this generally positive development. As these developing economies embrace capitalism, they add to the global workforce. These people may not be as productive as their counterparts in the industrial countries yet but they are rapidly improving and their labour costs are much lower than in the old industrialised world.

As a result, workers in developed countries are subjected to increased competition. The competition is obviously greater for less productive and lower-skill jobs because these jobs are the first to migrate to newly industrialising economies.

If Piketty wanted to lament the pressures on the less affluent segments of Western society, he should not put the blame on the West’s rich or on capitalism as such but on developing nations’ eager workforces. It is their competition that is making it harder for low-skilled workers in developed countries to improve their incomes.

Once seen from this angle, Piketty’s policy recommendations of increased income and wealth redistribution in developed countries no longer make sense. The problems of the West’s unskilled workers cannot be solved by taxing the rich more.

They can only be solved by making sure that everyone in developed societies has the skills needed to participate in the changing global economy. Premium wages can only be justified by premium productivity. There are serious doubts about Piketty’s record of past inequality. There are fewer doubts about the prospects for future inequality.

The global convergence of productivity and incomes means there are no realistic chances that lower skilled workers in developed nations will be able to move up the wealth ladder. This means they will either have to become more skilled or they will become poorer in relative terms, and possibly also in absolute terms.

As developing countries become more free market, developed countries’ response cannot be to become more regulated and redistributionist. Yet this is what Piketty recommends.

If implemented, such policies would only render developed nations less competitive against their newly developed challengers. This in turn would exacerbate the problem he seeks to address.

Whoever cares about (global) inequality should support capitalism, not fight it.

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