Bob Rowthorn questions two of Piketty’s central assumptions

26 Jun, 2014 at 17:38 | Posted in Economics | 5 Comments

Piketty uses the terms “capital” and “wealth” interchangeably to denote the total monetary value of shares, housing and other assets. “Income” is measured in money terms. We shall reserve the term “capital” for the totality of productive assets evaluated at constant prices. The term “output” is used to denote the totality of net output (value-added) measured at constant prices. Piketty uses the symbol β to denote the ratio of “wealth” to “income” and he denotes the share of wealth-owners in total income by α. In his theoretical analysis this share is equated to the share of profits in total output. Piketty documents how α and β have both risen by a considerable amount in recent decades. He argues that this is not mere correlation, but reflects a causal link. It is the rise in β which is responsible for the rise in α. To reach this conclusion, he first assumes that β is equal to the capital-output ratio K/Y, as conventionally understood. From his empirical finding that β has risen, he concludes that K/Y has also risen by a similar amount. According to the neoclassical theory of factor shares, an increase in K/Y will only lead to an increase in α when the elasticity of substitution between capital and labour σ is greater than unity. Piketty asserts that this is the case. Indeed, based on movements α and β, he estimates that σ is between 1.3 and 1.6 (page 221).

Thus, Piketty’s argument rests on two crucial assumptions: β = K/Y and σ > 1. Once these assumptions are granted, the neoclassical theory of factor shares ensures that an increase in β will lead to an increase in α. In fact, neither of these assumptions is supported by the empirical evidence which is surveyed briefly in the appendix. This evidence implies that the large observed rise in β in recent decades is not the result of a big rise in K/Y but is primarily a valuation effect …

Piketty argues that the higher income share of wealth-owners is due to an increase in the capital-output ratio resulting from a high rate of capital accumulation. The evidence suggests just the contrary. The capital-output ratio, as conventionally measured has either fallen or been constant in recent decades. The apparent increase in the capital-output ratio identified by Piketty is a valuation effect reflecting a disproportionate increase in the market value of certain real assets. A more plausible explanation for the increased income share of wealth-owners is an unduly low rate of investment in real capital.

Robert Rowthorn

It seems to me that Rowthorn is closing in on the nodal point in Piketty’s picture of the long-term trends in income distribution in advanced economies. As I wrote the other day:

Being able to show that you can get the Piketty results using one or another of the available standard neoclassical growth models is of course — from a realist point of view — of limited value. As usual — the really interesting thing is how in accord with reality are the assumptions you make and the numerical values you put into the model specification.

(h/t Erik Hegelund)