French economist Thomas Piketty’s Capital in the Twenty-First Century has been making waves over the past few weeks for its excellent analysis of the historical evolution of wealth inequality.
The crux of the book’s analysis rests on one expression: r – g > 0, where r stands for interest rates and g for growth rates. When r exceeds g, Piketty argues that the society will experience worsening levels of wealth inequality.
Piketty argues that r will remain higher than g for the near future in developed countries based on their historical trends (which he uses to recommend a global wealth tax). There are many reasons to doubt that his argument: Returns to capital could fall along with growth rates (as they have in Japan, for instance). Meanwhile, high r does not mechanically result in persistent wealth inequality across generations. Many of the richest families have given away a large chunk or even the vast majority of their fortunes (Gates, Buffett), or seen wealth levels dissipate with generations (the Pritzkers and the Waltons). Piketty takes as given that wealthier individuals save more, but as Paul Krugman has pointed out, it’s not clear whether richer individuals save more systemically or just sock away windfall gains in years when they shoot up the income distribution.
But suppose Piketty’s argument about growth and interest rates were true. The most natural policy takeaway would be to push for policies that build wealth for the working and middle class, such as Social Security privatization and sovereign wealth funds. (This would apply in other nations’ social-security systems as well, but let’s stick to America’s pension system.)
Piketty actually does discuss moving away from a PAYGO system of pensions, where contributions are pooled into a defined-benefit plan (like Social Security and private pensions) to one of individual accounts (like 401(k)s or Chile’s pension system), but rejects it for a couple reasons.
All signs are that the return of capital in the twenty-first century will be significantly higher than the growth rate of the economy (4-5 percent for former, barely 1.5 percent for the latter).
Under these conditions, it is tempting to conclude that the PAYGO system should be replaced as quickly as possible by a capitalized system, in which contributions by active workers are invested rather than paid out immediately to retirees. These investments can then grow at 4 percent a year in order to finance the pensions of today’s workers when they retire several decades from now. There are several major flaws in this argument, however. First, even if we assume that a capitalized system is indeed preferable to a PAYGO system, the transition from PAYGO to capitalized benefits raises a fundamental problem: an entire generation of retirees is left with nothing. The generation that is about to retire, who paid for the pensions of the previous generation with their contributions, would take a rather dim view of the fact that the contributions of today’s workers, which current retirees had expected to pay their rent and buy their food during the remaining years of their lives, would in fact be invested in assets around the world. There is no simple solution to this transition problem, and this alone makes such a reform totally unthinkable, at least in such an extreme form.
Is the transition as prohibitive as Piketty says? Not really.
Several countries actually have transitioned away from a system of PAYGO to one of individual accounts. That process has involved sizable but manageable transition costs to fund the liabilities of current retirees (around 5 percent of GDP a year, at the most, for Chile), who have certainly not been left with nothing. It is important to keep in mind that obligations to current retirees remain national liabilities regardless of the system we have for paying them – simply switching from a PAYGO system to a special temporary tax does not yield additional liabilities in a fundamental sense (Social Security’s current unfunded liabilities are massive, this would just be made more obvious). Certainly, financing these transitional costs may prove difficult and may otherwise discourage us from adopting a system of personal accounts. But if Piketty is right about the fundamental long-term trajectory of growth and interest rates, it’s difficult to see why these one-time costs should prevent us from taking advantage of such windfall prospects in asset markets.
Second, in comparing the merits of the two pension systems, one must bear in mind that the return on capital is in practice extremely volatile. It would be quite risky to invest all retirement contributions in global financial markets. The fact that r > g on average does not mean that it is true for each individual investment. For a person of sufficient means who can wait ten or twenty years before taking her profits, the return on capital is indeed quite attractive. But when it comes to paying for the basic necessities of an entire generation, it would be quite irrational to bet everything on a roll of the dice. The primary justification of the PAYGO system is that it is the best way to guarantee that pension benefits will be paid in a reliable and predictable manner: the rate of wage growth may be less than the rate of return on capital, but the former is 5-10 times less volatile than the latter.
The real question is not whether personal accounts are perfectly secure or not, but whether a PAYGO system is more or less secure than personal accounts, given long-term trends in demographics, stagnating wage growth, rising longevity, and a forecast of future Social Security insolvency. Piketty ignores that basic asset-management techniques, such as diversification and saving over the decades of a person’s working life, could improve the reliability of investment income. The Center for American Progress has proposed a “SAFE Retirement Plan” that would smooth individual account balances across years of high and low returns, solving one of Piketty’s concerns at relatively little cost.
While there are other reasons to oppose Social Security privatization, a view of the future in which asset returns are such fundamentally higher than growth rates leads straightforwardly into an agenda of ensuring greater and more widespread ownership of capital.
Thus, Piketty’s broader conclusions would also support establishing an American sovereign wealth fund, as Miles Kimball advocated. Making the large gains from asset markets more widely shared would do much to ensure that living standards for average citizens would remain high in the future, and would mitigate the issues associated with rising wealth inequality.
At the same time, greater public investment would push against the basic r – g imbalance in the first place. With much higher public savings, interest rates would presumably fall and growth rates might rise as higher investments fuel investments in infrastructure and basic capital goods (Kevin Hassett’s critique of Piketty has touched on the first part of this issue).
The best arguments against Social Security privatization and sovereign wealth funds are actually that Piketty is wrong and future asset returns will not match recent historical trends. The case of housing markets is an instructive example: Policymakers pushed homeownership in part as a way to ensure that more households could enjoy housing capital gains, but this only made households more exposed to future drops in housing wealth, and may have pushed them into a low-return asset class.
If Piketty is right about the long-run trends of interest rates and growth, the best policy response is to support Social Security privatization. If he is wrong, the case for Social Security privatization is weaker; but the concern over wealth inequality is also probably overblown.
Addenum: Tyler Cowen also mentions Social Security privatization in the context of Piketty’s analysis.