There are two reasons I expect inequality to increase in the absence of policy intervention. First, the rate of return on existing wealth is higher than the rate of growth, which means that income from inherited wealth will matter more than income from labor in the coming decades. Second, higher initial amounts of wealth lead to higher returns on that wealth.
The second point has been overlooked in many discussions about inequality. Spurred by Thomas Piketty’s landmark Capital in the Twenty-First Century a lot of digital ink has been spilled discussing the complicated relationship between labor income and capital income, a point I will take up in a minute. First, however, I want to look at the more straightforward and more neglected topic of how starting with higher concentrations of wealth (capital) leads to higher rates of return on that wealth.
Buried in the midst of Piketty’s economic tome (p. 447) is an examination of university endowments in the U.S. University endowments publicly report their status. If larger endowments get higher rates of return, then inequality will continue to grow. If the Harvard’s, Yale’s and Princeton’s of the world not only started with more money, but are able to accumulate money more rapidly, then no one else will ever catch up. The other key point is the direction in which this relationship works – it is precisely because Harvard started with more that it is able to accumulate more rapidly. This is precisely what we see in the data, where there is a straightforward relationship between endowment size and the real average annual rate of return.
|The return on the capital endowments of US universities, 1980-2010|
|Endowment size in dollars (number of universities in that size range)||Average real annual rate of return (%)|
|Greater than 1 billion (60)||8.8|
|Between 500 million and 1 billion (66)||7.8|
|Between 100 and 500 million (226)||7.1|
|Less than 100 million (498)||6.2|
|All universities (850)||8.2|
If you start with more than 15 billion dollars (Harvard-Yale-Princeton), then not only do you have a head start on everyone else, you also will be able to run more quickly precisely because of that head start. Perhaps a fair analogy can be made to poker. Even if the cards are fair, if people start with unequal amounts, then there are different bets that are available to them. Over a large enough number of hands, most of the time the people who started with the most chips should be able to leverage that to their advantage.
The implications here extend well beyond academia. Piketty looked at University endowments because that data is available, while data from business is not. We do see that hedge funds with high minimum buy-ins that make them available only to extremely wealth investors are able to generate higher than average rates of return, suggesting that this pattern of higher levels of initial wealth allowing for faster accumulation of future wealth holds true for most types of investors, not just universities.
Let’s turn now to the more complicated relationship between capital income and labor income. At the core of Piketty’s book is a historical account of the rate of return on capital (r) and the rate of economic growth (g). If the economy is growing rapidly, so g>r, then inherited wealth doesn’t matter very much. Even if your grandparents were relatively wealthy and invested well, as long as economic growth (g) is greater than the rate of return on your grandparents investment (r), then the amount you earn in wages will be a lot more than what you can inherit from your grandparents. This is simply because in this scenario we’ve assumed that wage growth is faster than growth from money in the bank.
But what if r>g, such that capital has a higher rate of return than the rate of economic growth? In this scenario, inherited wealth starts to matter a lot more. If your grandparents put aside some money that generated a rate of return of 4-5% per year, while the economy only grew at 1% per year – suddenly that inheritance money is significantly more than you could earn from wage labor, since wages have been increasing at a much lower rate than the inherited wealth.
So is r>g? Piketty suggests that for most of history r>g, and so inequality increased, with the notable exception of the years between 1914 and the mid 1970s. The two world wars wiped out a lot of capital, and thus we had the post-WWII years where inheritance mattered very little and the economic benefits of growth were broadly shared (well, broadly shared relative to most of the rest of history).
There’s often a comparison made between the post-WWII years where wages and productivity rose together so that middle and lower-class incomes increased, and the 1980s-2010s where wages at the bottom of the economy have stagnated. While there certainly where important economic and policy changes in the late 1970s and early 1980s, Piketty has done the debate an invaluable service by broadening the time horizon. A large chunk of economic theory developed during those post-WWII years when it really was sensible to suggest that the benefits of economic growth would be broadly shared. Historical context suggests that those years may have been an exception to the general trend throughout history of r>g and growing inequality.
To recap briefly, if capital grows faster than wages (r>g), and larger amounts of capital grow faster than smaller amounts of capital (as we saw with university endowments), then the people who start with small amounts of capital will increase their wealth more than those who start with no capital, and the people who start with large amounts will increase their wealth even faster than those with small. As long as the pace of wealth accumulation is positively correlated with the amount of wealth one currently has, we will see increases in inequality.