7/5/21: Record Wealth in the Post-Covid World... for the select few

 Demolishing American middle class... one year at a time

13/6/2020: What Do Money Supply Numbers Tell Us About Social Economics?

What do money supply changes tell us about social economics? A lot. Take two key measures of U.S. money supply:

• M1, which includes funds that are readily accessible for spending, primarily by households and non-financial companies, such as currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; traveler's checks; demand deposits; and other checkable deposits. 

• MZM, which is M2 less small-denomination time deposits plus institutional money funds, or in more simple terms, institutional money and funds available for investment and financial trading.

Here we go, folks:

Does this help explain why Trumpism is not an idiosyncratic phenomena? It does. But it also helps explain why the waves of social unrest and protests are also not idiosyncratic phenomena. More interesting is that this helps to explain why both of these phenomena are tightly linked to each other: one and the other are both co-caused by the same drivers. If you spend a good part of 20 years pumping money into the Wall Street while largely ignoring the Main Street, pitchforks will come out. 

The *will* bit in the sentence above is now here.

8/6/20: 30 years of Financial Markets Manipulation

Students in my course Applied Investment and Trading in TCD would be familiar with the market impact of the differential bid-ask spreads in intraday trading. For those who might have forgotten, and those who did not take my course, here is the reminder: early in the day (at and around market opening times), spreads are wide and depths of the market are thin (liquidity is low); late in the trading day (closer to market close), spreads are narrow and depths are thick (liquidity is higher). Hence, a trading order placed near market open times tends to have stronger impact by moving the securities prices more; in contrast, an equally-sized order placed near market close will have lower impact.

Now, you will also remember that, in general, investment returns arise from two sources: 

1. Round-trip trading gains that arise from buying a security at P(1) and selling it one period later at P(2), net of costs of buy and sell orders execution; and 
2. Mark-to-market capital gains that arise from changes in the market-quoted price for security between times P(1) and P(2+).

The long-running 'Strategy' used by some institutional investors is, therefore as follows: 

Here is the illustration of the 'Strategy' via Bruce Knuteson paper "Celebrating Three Decades of Worldwide Stock Market Manipulation", available here: https://arxiv.org/pdf/1912.01708.pdf.

• Step 1: Accumulate a large long portfolio of assets;
• Step 2: At the start of the day, buy some more assets dominating your portfolio at P(1) - generating larger impact of your buy orders, even if you are carrying a larger cost adverse to your trade;
• Step 3: At the end of the day, sell at P(2) - generating lower impact from your sell orders, again carrying the cost.

On a daily basis, you generate losses in trading account, as you are paying higher costs of buy and sell orders (due to buy-sell asymmetry and intraday bid-ask spreads differences), but you are also generating positive impact of buy trades, net of sell trades, so you are triggering positive mark-to-market gains on your original portfolio at the start of the day.

Knuteson shows that, over the last 30 years, overnight returns in the markets vastly outstrip intraday returns. 

Per author, "The obvious, mechanical explanation of the highly suspicious return patterns shown in Figures 2 and 3 is someone trading in a way that pushes prices up before or at market open, thus causing the blue curve, and then trading in a way that pushes prices down between market open (not including market open) and market close (including market close), thus causing the green curve. The consistency with which this is done points to the actions of a few quantitative trading firms rather than

the uncoordinated, manual trading of millions of people."

Sounds bad? It is. Again, per Knuteson: "The tens of trillions of dollars your use of the Strategy has created out of thin air have mostly gone to the already-wealthy: 

• Company executives and existing shareholders benefi tting directly from rising stock prices; 
• Owners of private companies and other assets, including real estate, whose values tend to rise and fall with the stock market; and 
• Those in the financial industry and elsewhere with opportunities to privatize the gains and socialize the losses."

These gains to capital over the last three decades have contributed directly and signi ficantly to the current level of wealth inequality in the United States and elsewhere. As a general matter, widespread mispricing leads to misallocation of capital and human effort, and widespread inequality negatively a effects our social structure and the perceived social contract."

9/5/20: Some uncomfortable facts on the U.S. wealth distribution since 1989

The distributional effects of COVID19 pandemic impact on the labour markets in the U.S. will likely result in a massive debasement of the national wealth shares of the 'Main Street' segment of American society (the 90 percent) and a further increases in the national wealth share of the top 10 percent. So much is rather clear from the data on the labour markets (e.g.: https://trueeconomics.blogspot.com/2020/05/8520-path-of-tornado-us-labour-force.html).

But this process is not a unique feature of the current 'ideology' prevailing in the White House, nor is it a unique feature of the 'Republican Party ideology'. Historically, both, the Democratic Party Presidencies and the Republican Party Presidencies since the start of the 1990s on have been responsible for the dramatic drops in the share of national net worth accruing to those outside the top 10 percent of the wealth distribution. Here is the data through 4Q 2019:

The last time, the 'Main Street America' enjoyed sustained increases in net worth was during the tenure of George H. W. Bush. Since then, there have been just one short-lived period of increase in net worth, with subsequent declines erasing fully those gains: the Dot.Com bubble during the tail end of the Clinton and the starting part of the George W. Bush administrations.

And the current Presidency is actually somewhat exceptional to the trend: under Trump Administration, American's Main Street witnessed the lowest rates of decline in their share of the national net worth of 'just' 0.13% per annum, of all post-1992 administrations. In fact, the share of the country's net worth accruing to the bottom 50 percent of Americans has risen under the Trump Presidency tenure at the fastest annualized clip since the data series started.

In simple terms, American policies of destroying the prosperity of the majority of the country's population are not reflective of the 'political divide'. Both, Democratic and Republican Presidencies have led to the effective debasement of the wealth of the American Main Street. And, in equally simple terms, the Trump Administration tenure so far has been more benign to the bottom 50 percent of the American wealth distribution than any presidency since 1989.

Like it or not, but the data is quite telling.

2/9/19: One view of Austerity

A picture is worth a thousand words, some say. So here is a picture of austerity we've had (allegedly) in recent decades:

Source: @Soberlook 

The things are savage: debt is up from ca 70% to over 110%. Cost of debt carry is down from just under 4% to under 1.75%. So where are all those fabled public investments? And who has benefited from this massive increase in debt? Virtually all - financialized (a nice euphemism for being absorbed into financial assets valuations). Austerity, after all, is just the old-fashioned transfer of resources from the broader economy to the select few, made more palatable by the superficially low cost of borrowing.

3/5/19: The Rich Get Richer when Central Banks Print Money

The Netherlands Central Bank has just published a fascinating new paper, titled "Monetary policy and the top one percent: Evidence from a century of modern economic history". Authored by Mehdi El Herradi and Aurélien Leroy, (Working Paper No. 632, De Nederlandsche Bank NV: https://www.dnb.nl/en/binaries/Working%20paper%20No.%20632_tcm47-383633.pdf), the paper "examines the distributional implications of monetary policy from a long-run perspective with data spanning a century of modern economic history in 12 advanced economies between 1920 and 2015, ...estimating the dynamic responses of the top 1% income share to a monetary policy shock." The authors "exploit the implications of the macroeconomic policy trilemma to identify exogenous variations in monetary conditions." Note: the macroeconomic policy trilemma "states that a country cannot simultaneously achieve free capital mobility, a fixed exchange rate and independent monetary policy".

Per authors, "The central idea that guided this paper’s argument is that the existing literature considers the distributional effects of monetary policy using data on inequality over a short period of time. However, inequalities tend to vary more in the medium-to-long run. We address this shortcoming by studying how changes in monetary policy stance over a century impacted the income distribution while controlling for the determinants of inequality."

They find that "loose monetary conditions strongly increase the top one percent’s income and vice versa. In fact, following an expansionary monetary policy shock, the share of national income held by the richest 1 percent increases by approximately 1 to 6 percentage points, according to estimates from the Panel VAR and Local Projections (LP). This effect is statistically significant in the medium run and economically considerable. We also demonstrate that the increase in top 1 percent’s share is arguably the result of higher asset prices. The baseline results hold under a battery of robustness checks, which (i) consider an alternative inequality measure, (ii) exclude the U.S. economy from the sample, (iii) specifically focus on the post-WWII period, (iv) remove control variables and (v) test different lag numbers. Furthermore, the regime-switching version of our model indicates that our conclusions are robust, regardless of the state of the economy."

In other words, accommodative monetary policies accommodate primarily those with significant starting wealth, and they do so via asset price inflation. Behold the summary of the last 10 years.

1/4/19: Hollowing out of the American Middle Class: the High Earners, and the 1-percenters

An interesting and insightful 2016 paper from John Komlos of CESIfo, titled "Growth of Income and Welfare in the U.S. 1979-2011" (CESifo Working Paper No. 5880), paints the pretty dire picture of the post-1980s dynamics in the U.S. labor markets, that laid the foundations of the current acceleration and deepening of political populism and opportunism not only in the U.S., but also in Western Europe.

Kolmos estimated growth rates in real incomes in the U.S. from the Congressional Budget Office’s (CBO) post-tax, post-transfer data. Kolmos also adjusts the real income data to improve the accuracy of the measures. The result is striking: "... the major consistent findings include what in the colloquial is referred to as the “hollowing out” of the middle class. According to these estimates, the income of the middle class 2nd and 3rd quintiles increased at a rate of between 0.1% and 0.7% per annum, i.e., barely distinguishable from zero. Even that meager rate was achieved only through substantial transfer payments." Of course, given that we have experienced positive growth in the aggregate economy in excess of these figures and well above the demographic change, this "hollowing out" of the middle class had to be accompanied by the "fattening up" of some other income classes, either the rich or the poor or both. Per Kolmos, it was the former one: "the income of the top 1% grew at an astronomical rate of between 3.4% and 3.9% per annum during the 32-year period, reaching an average annual value of $918,000, up from $281,000 in 1979 (in 2011 dollars)." Predictably, "...the post-tax, post-transfer income of the 1% relative to the 1st quintile increased from a factor of 21 in 1979 to a factor of 51 in 2011."

But what about the poor? Again, per Kolmos, "...income of no other group increased substantially relative to that of the lowest quintile. Oddly, the income of even those in the 96-99 percentiles increased only from a multiple of 8.1 to a multiple of 11.3."

Kolmos id this exercise for 'high' and 'low' ranges of income (depending on specific assumptions that were less and more conservative ratline to the CBO's raw data.

The results of the two calculations are shown in the chart below

Source: Kolmos (2016: 14)

In simple terms, this chart shows two interesting things:
1) The dramatic growth differential between income estimates for all quintiles compared to the top quintile is fully accounted for by the massive growth in income of the top 5% of the populations and especially by the growth in income of the top 1%.
2) The gap between high and low estimates for income growth are massive for the second and third quintiles (the middle class), and are relatively comparable for the first (low income earners) and 4th quintile (upper middle class). The gap becomes much smaller for the 5th quintile (high earners) and turns negligible for top 1%.

Kolmos attempts to convert income into more meaningful 9albeit harder to pin down) measure of well-being. To do this, he estimates the logarithmic utility function for the quintiles (logarithmic utility function preserves the property of the diminishing marginal utility - the idea that as our incomes continue to increase, each percent increase in our income results in progressively smaller gains in satisfaction/utility). Here is what he finds: "A logarithmic utility function yields a growth in welfare for the middle class of roughly 0.01% to 0.07% per annum, which is indistinguishable from zero. With interdependent utility functions only the welfare of the 5th quintile experienced meaningful growth while those of the first four quintiles tend to be either negligible or even negative." Chart below shows these estimates.

Source: Kolmos (2016: 15)

Focusing on the Percentiles section, markers 6-9 disaggregate the last 5th quintile into the ranges of top 81-90%, 91-95%, 96-99% and top 1%. It is quite evident that only top 5% (segments 8 and 9) experienced welfare gains of more than the 4th quantile cohorts.

This strongly implies that, contrary to some left-leaning policymakers' proposals and preferences, the problem of 'hollowing out' of the American middle class is not driven by the incomes of the top 81-90th percentiles, nor even by those in 91st-95th percentiles. The real source of the problem starts somewhere within the 96-99th percentile and most certainly extends to the top 1%.

The same is confirmed by looking at each cohort income relative to that of the top quintile, shown in the chart below

Source: Kolmos (2016:27)

In summary, thus, the problem with the 'hollowing out' of the middle class is not within theta 20% earners, nor within the top 10% earners. It starts much higher than that.

11/1/19: Capital Gains Tax: Human Capital vs Other Forms of Capital

This is exactly the source of policy-induced wealth inequality in the modern advanced economies: the disparity between labor income tax and capital gains tax that (1) incentivises accumulation of capital gains generating assets; (2) increases wealth inequality arising from non-meritocratic transfers (spousal and inheritance); and (3) reduces gains from meritocratic investment in human capital.

Now, factor this into tax-adjusted returns on various forms of capital: Intangible Capital returns are taxed at a corporate tax level at below the Physical Capital returns tax rates, which fall lower than the Capital Gains tax rate. Meanwhile, returns to the [intangible] Human Capital are taxed at the rates of higher margin Income tax rates. Go figure why wealth inequality is rising (as entrepreneurship is shrinking).

30/11/18: The Myth of Social Mobility and Wealth Inequality

Three charts, related topics.

Global wealth inequality has been a much-discussed problem these days, with both longer-term economic and social, not to mention political, impacts being assigned to it across both the Advanced Economies and the Emerging Markets. Setting aside the causes and drivers for this development, here is the latest evidence on the wealth distribution around the world from Credit Suisse:

The 3.211 billion people, accounting for 63.9% of the total estimated world population are holding USD6.2 trillion worth of wealth (1.9% of the world total value of assets). Another 26.6% of population or 1.335 billion people, hold 13.9% of total global wealth. Thus, 90.5% of population hold combined 15.8% of the total global wealth. In the top 10 percent category, those with wealth of USD100K to 1 million account for 8.7% of global population and hold 39.3 percent of total global wealth. The 0.8% of population (42 million people) have combined holdings of wealth around USD142 trillion or 44.8% of total global wealth.

This is striking and it is problematic. Even if most of our own wealth inequality referencing is done across the adjoining class of comparatives, the gap between the top of the pyramid and the bottom is so insurmountably vast, that any idea that there is some sort of meritocratic division of wealth in our global society flies out of the window. The problem is not so much income inequality, but the inequality arising from inherited wealth, which generates income returns from invested assets that cannot be offset or diluted by merit of effort, talent and work, no matter how hard one works. Even stripping out luck effects of self-made millionaires and billionaires, the pyramid above is the evidence to the endurance of inter-generational wealth transfers.

The dynamics of evolution in wealth inequality that got us here are presented in the following charts via Goldman Sachs Research:

These figures are for the U.S. economy and they are frightening, just as much as the wealth pyramid above is frightening. Share of wealth held by the top 1% wealth-holders grew from just above 21% in the late 1970s-early 1980s to closer to 37% in 2014. Since then, it has increased more. Share of wealth held by the remaining top 10 percenters declined from ca 44% in the early 1970s to around 35% from the late 1990s on. But the share of wealth held by middle America collapsed to below 27% since the high of around 36% in mid-1980s. Things were never brilliant for the bottom 50 percent of Americans to begin with, but since the Global Financial Crisis, lower middle of America has had negative net wealth through 2014. even though it might have risen since then somewhat, at no time in modern history have the middle and lower-middle class Americans enjoyed holding more than 2 percent of the total wealth.

This is a double-ugly conclusion, because it simultaneously runs against two key propositions on which the American society rests: the proposition of social cross-class mobility upwards from lower wealth classes to middle class, and the proposition that social progress in the American society is distinct from the ‘basket cases’ dynamics in the larger emerging economies (the likes of India and China). In a way, America replicates the world in terms of both, wealth inequality and its dynamics. And that is not a good thing for a society based on exceptionalism values.

The added dimension to this is that, given the above dynamics and the degree of elites entrenchment / capture within the political establishment, we are facing an impossible task of rebalancing the above wealth inequalities without triggering some serious political discontent. Worse, we have no tools for doing so, other than traditional socialist tools (expropriation via taxation of income), which are not effective in dealing with this problem. One of the reasons why these tools are ineffective is that broad-based income tax measures impact more adversely those who work for living (higher income earners) and do not touch those who experience wealth appreciation through capital gains on inherited wealth (as long as they re-invest their wealth-generated income). Another reason, is that higher income earners, on average, can claim merit as a source of their income more than those who hold inherited wealth. A third reason is that redistribution through taxation is highly inefficient: the funds flow to the politically-empowered, not to merit-deserving, and the losses on tax funds are high due to the cost of Government bureaucracy.

Which leaves us with the unpleasant dilemma: tax inherited wealth (during inheritance transfer in the future, and retro-actively, via tax on existent wealth, in the past). Which in itself is highly problematic for the following reasons: (1) wealth is mobile across borders, and financialized wealth is especially so; (2) a significant tax on wealth is likely to trigger repricing of all assets to the downside (liquidation of wealth to cover tax liabilities), adversely impacting wealth acquired by the first generation of entrepreneurs and investors; and (3) inducing a sizeable decline in the life-cycle expected wealth of the current younger generations, resulting is a large scale re-leveraging of these generations.

Neither of these effects is easy to address.

8/4/18: Talent vs Luck: Differentiating Success from Failure

In their paper, "Talent vs Luck: the role of randomness in success and failure", A. Pluchino. A. E. Biondo, A. Rapisarda (25 Feb 2018: https://arxiv.org/pdf/1802.07068.pdf) tackle the mythology of the "dominant meritocratic paradigm of highly competitive Western cultures... rooted on the belief that success is due mainly, if not exclusively, to personal qualities such as talent, intelligence, skills, efforts or risk taking".

The authors note that, although "sometimes, we are willing to admit that a certain degree of luck could also play a role in achieving significant material success, ...it is rather common to underestimate the importance of external forces in individual successful stories".

Some priors first: "intelligence or talent exhibit a Gaussian distribution among the population, whereas the distribution of wealth - considered a proxy of success - follows typically a power law (Pareto law). Such a discrepancy between a Normal distribution of inputs, suggests that some hidden ingredient is at work behind the scenes."

The authors show evidence that suggests that "such an [missing] ingredient is just randomness". Or, put differently, a chance.

The authors "show that, if it is true that some degree of talent is necessary to be successful in life, almost never the most talented people reach the highest peaks of success, being overtaken by mediocre but sensibly luckier individuals."

Two pictures are worth a 1000 words, each:

Figure 5 taken from the paper shows:

• In panel (a): Total number of lucky events and
• In panel (b): Total number of unlucky events 

Both are shown as "function of the capital/success of the agents"

Overall, "the plot shows the existence of a strong correlation between success and luck: the most successful individuals are also the luckiest ones, while the less successful are also the unluckiest ones."

Figure 7 shows:
In panel (a): Distribution of the final capital/success for a population with different random initial conditions, that follows a power law.
In panel (b): The final capital of the most successful individuals is "reported as function of their talent".

Overall, "people with a medium-high talent result to be, on average, more successful than people with low or medium-low talent, but very often the most successful individual is a moderately gifted agent and only rarely the most talented one.


Main conclusions on the paper are:

• "The model shows the importance, very frequently underestimated, of lucky events in determining the final level of individual success." 
• "Since rewards and resources are usually given to those that have already reached a high level of success, mistakenly considered as a measure of competence/talent, this result is even a more harmful disincentive, causing a lack of opportunities for the most talented ones."

The results are "a warning against the risks of what we call the ”naive meritocracy” which, underestimating the role of randomness among the determinants of success, often fail to give honors and rewards to the most competent people."

31/1/18: What Teachers of Piketty Miss on r vs g

A popular refrain in today’s political and socio-economic analysis has been the need for aggressive Government intervention (via taxation and regulation) to reverse growing wealth inequality. The narrative is supported by the increasing numbers of center and centre-left voters, and is firmly held in the key emerging demographic of the Millennial voters. The same narrative can also be traced to the emergence of some (not all) populist movements and political figures.

Yet, through regulatory restrictions, Governments in the recent past not only attempted to manage risks, but also created a system of superficial scarcity in supply of common goods & services (healthcare, education, housing etc) and skills, as well as access to professional services markets for practitioners. This scarcity de facto redistributes income (& thus, wealth) from the poor to the rich, from those not endowed with assets to those who inherit them or acquire them through other non-productive means, e.g. marriage, corruption, force. Many licensing requirements, touted by the Governments as the means for ensuring consumer protection, delivering social good, addressing markets failures and so on are either too cumbersome (creating a de facto bounds to supply) or outright skewed in favour off the incumbents (e.g. financial services licensing restrictions in trivial areas of sales and marketing). 

The re-distribution takes the form of high rents (paid for basic services that are woefully undersupplied: consider the California ‘water allocations’ and local authorities dumping federal subsidies to military personnel onto private sector renters, or consider the effect of pensions subsidies to police and other public services providers that are paid for by poorer taxpayers who themselves cannot afford a pension). 

This benevolent-malevolent counter-balancing in Government actions has fuelled wealth inequality, not reduced it, and the voters appear to be largely oblivious to this reality.

Crucially, the mechanism of this inequality expansion is not the simple r>g relationship between returns to capital (r) and the growth rate in the economy (g), but a more complex r(k)>r(hh)>r(g)>r(lh) relationship between returns to financial & restricted (r(k)), inc property & water rights in California, etc, high-quality human capital (r(hh)), inc returns to regulated (rationed) professions, the rate of growth in the economy (g), and the returns to low-quality human capital (r(lh)), inc returns to productive productive), but un-rationed professions. 

Why this is crucial? Because the r>g driven inequality, the type that was decried by Mr. Piketty and his supporters is missing a lot of what is happening in the labor markets and in large swathes of organisational structures, from limited partnerships to sole traders. Worse, lazy academia, across a range of second-tier institutions, has adopted Piketty’s narrative unchecked, teaching students the r vs g tale without considering the simple fact that neither r, nor g are well-defined in modern economics and require more nuanced insight. 

Yes, we now know that r>g, and by a fat margin (see https://www.frbsf.org/economic-research/files/wp2017-25.pdf). And, yes, that is a problem. But that is only one half off the problem, because it helps explain, in part, the 1% vs 99% wealth distribution imbalances. But it cannot explain the 10% vs 90% gap. Nor can it explain why we are witnessing the hollowing-out of the middle class, and the upper middle class. A more granular decomposition of r (and a more accurate measurement of g - another topic altogether) can help.

The non-corporate entities and high human capital individual earners can still benefit from the transfers from the poorer and the middle classes, but these benefits are not carried through traditional physical and financial capital returns or corporate rent seeking. (Do not take me wrong: these are also serious problems in the structure of the modern economy). 

Take for example, two professionals. Astrophysicist employed in a research lab and a general medical practitioner. The two possess asymmetric human capital: astrophysicist has more of it than a general medical doctor. Not only in duration of knowledge acquisition (quantity), but also in the degree of originality of knowledge (quality). But, one’s supply of competitors is rationed by the market (astrophysics high barrier to entry is… er… the need to acquire a lot of hard-to-earn human capital, with opportunity costs sky-high), another is rationed by the licensing and education systems. Guess which one earns more? And guess which one has access to transfers from the lower earners that can be, literally, linked to punitive bankruptcy costs? So how much of the earnings of the physician (especially the premium on astrophysicist’s wage) can be explained by a license to asymmetric information (extracting rents from patients) and by restrictions on entry into profession that go beyond assurance of quality? How much of these earnings are compensation for the absurdity of immense tuition bills collected by the medical schools with their own rent-seeking markets for professional education? And so on.

In a way, thus, the Governments have acted as agents for creating & sustaining wealth inequality, at the same time as they claimed to be the agents for alleviating it. 

Yes, consumer protecting regulation is necessary. No question. Yes, licensing is often necessary too (e.g. in the case of a physician as opposed to a physicist). But, no - transfers under Government regulations are not always linked to the delivery of real and tangible benefits of quality assurance. Take, for example, restrictive development practices and excessively costly planning bureaucracies in cities, like, San Francisco. While some regulation and some bureaucracy are necessary, a lot of it is pure transfer from renters and buyers to bureaucrats as well as investors. So, do a simple arithmetic exercise. Take $100 of income earned by a young professional. Roughly 33% of that goes in various taxes and indirect taxes to the Governments. Another 33% goes to to the landlord protected by these same Governments from paying the full cost of bankruptcy (limited liability) and from competition by restrictive new building and development rules. Another 15% goes to pay for various insurance products, again - regulated and/or required by the Governments - health, cars, renters’ etc. What’s left? Less than 20% of income puts gas into the car or pays for transportation, buys food and clothing. What exactly remains to invest in financial and real assets that earn the r(k) and alleviate wealth inequality? Nada. And if you have to pay for debt incurred in earning your r(hh) or even r(lh), you are… well… insolvent. Personal savings averaged close to 6.5-7% of disposable income in 2010-2014. Since then, these collapsed to 2.4% as of December 2017. Remember - the are percentages of the disposable income, not gross income. Is that enough to start investing in physical and/or financial capital? No. And the numbers quoted are averages, so \median savings are even lower than that.

Meanwhile, regulated auto loans debt is now at $4,340 per capita, regulated credit card debt is at $2,930 per capita, and regulated student loans debt is now at $4,920 per capita. Federal regulations on credit cards debt are know n to behaviourally create barriers to consumers paying this debt down and/or using credit cards prudently. Federal regulations make student loans debt exempt from bankruptcy protection, effectively forcing borrowers who run into financial troubles into perpetual vicious cycle of debt spiralling out of control. Auto loans regulations effectively create and encourage sub-prime markets for lending. So who is responsible for the debt-driven part of wealth inequality? Why, the same Government we are begging to solve the problem it helps create.

Now, add a new dimension, ignored by many followers of Mr. Piketty: today’s social & sustainability narratives risk to deliver more of the same outcome by empowering Governments to create more superficial scarcity. This does not mean that all regulations and all restrictions are intrinsically bad, just as noted before. Nor does it mean that social and environmental risks are not important concepts. Quite the opposite, it means that we need to pay more attention to regulations-induced transfers of wealth and income from the lower 90% to the upper 10% and to companies and non-profits across the entire chain of such transfers. If we want to do something about our social and environmental problems (and, yes, we do want) we need to minimise the costs of other regulations. We need to increase r(hh) and even more so, r(lh). And we need to increase the g too. What we do not need to do is increase the r(k) without raising the other returns. We also need to recognise that on the road paved with good (environmental) intentions, we are transferring vast amounts of income (and wealth) from ordinary Joe and Mary to Elon Musk and his lenders and investors. As well as to a litany of other rent-seeking enterprises and entrepreneurs. The subsidies fuel returns to physical and fixed capital, intellectual property (technological capital), financial capital, and to a lesser extent to higher quality human capital. All at the expense of general human capital.

Another aspect of the over-simplified r vs g narrative is that by ignoring the existent tax codes, we are magnifying the difference between various forms of r and the g. Take the differences in tax treatment between physical, financial and human capital. Set aside the issue of tax evasion, but do include the issue of tax avoidance (legal and practiced with greater intensity the higher do your wealth levels reach). I can invest in fixed capital via a corporate structure that allows depreciation tax claws-backs and interest deductions. I can even position my investment in a tax (non-)haven jurisdiction, like, say Michigan or Wisconsin, where - if I am rich and I do invest a lot, I can get local tax breaks. I can even get a citizenship to go along with my investment, as a sweetener. Now, suppose I invest the same amount in technological capital (or, put more cogently, in Intellectual Property). Here, the world is my oyster: I can go to tax advantage nations or stay in the U.S. So my tax on these gains will be even lower than for fixed capital. Investing in financial capital is similar, with tax ranges somewhere between the two other forms of capital. Now, if I decided to invest in my human capital, my investments are not fully tax deductible (I might be able to deduct some tuition, but not living expenses or, in terms of corporate finance, operating expenses and working capital). Nor is there a depreciation claw back. There is not a tax incentive for me to do this. And my returns from this investment will be hit with all income taxes possible - state, and federal. It is almost sure as hell, my tax rate will be higher than for any form of non-human capital investment. Worse: if I borrow to invest in any form of capital other than human capital, and I run into a hard spot, I can clear the slate by declaring bankruptcy. If I did the same to invest in human capital, student loans are not subject to bankruptcy protection.

Not to make a long argument any longer, but to acknowledge the depth of the tax policy problems, take another scenario. I join as a partner a start up and get shares in the company. Until I sell these shares as a co-founder, I face no tax liability. Alternatively, I join the same start up as a key employee, with human capital-related skills that the start up really, really needs to succeed. I get the same shares in the company. Under some jurisdictions rules, I face immediate tax liability, even if I can never sell these shares in the end. Why? Ah, no reason, other than pure stupidity of those writing tax codes. 

The net effect is the same across all of the above points: risk-adjusted after tax returns on investment in human capital are depressed - superficially - by policies. Policies, therefore, are driving wealth inequality. After-tax risk-adjusted returns to human capital are lower than after-tax risk-adjusted returns on physical, financial and technological capital.

Once again, we need to increase returns to human capital without raising returns to other forms of capital. And we need to increase real rates of economic growth (what that means in the real world - as opposed to what it means in the world of Piketty-following academia is a different subject all together). And we need to get Government and regulators out of the business of transferring our income and potential wealth from us to the 1%-ers and the 10%-ers. 

How do we achieve this? A big question that I do not have a perfect answer to, and as far as I am aware, no one does. 

One thing we must consider is systemically reducing rents obtained through inheritance, rent seeking and other unproductive forms of capital acquisition. 

Another thing we must have is more broadly-spread allocation of financial assets linked to the productive economy (equity). In a way, we need to dramatically broaden share holding in real companies’ assets, among the 90%. Incidentally, this will go some ways in addressing the threat to the social fabric poised by automation and robotisation: making people the owners of companies puts robots at work for people. 

Third thing is what we do not need: we do not need is a penal system of taxation that reduces r(hh) and r(lh). Progressive income taxation delivers exactly that outcome. 

Fourth thing: we need to recognize that some assets derive their productivity from externalities. The best example is land, which derives most of its value from socio-economic investments made by others around the site. These externalities-related returns must be taxed as a form of unearned income/wealth. A land value tax or a site value tax can do the job.

As I noted above, I do not claim to hold a solution to the problem. I do claim to hold a blue print for a systemic approach to devising such a solution. Here it is: we need sceptical, independent  & continuous impact analysis of every piece of regulation, of every restriction, of every socially and environmentally impactful (positive or negative) measure. But above all, we need to be sceptical about the role of the Government, just as we have become sceptical about the capacity of the markets. Scepticism is healthy. Cheerleading is cancerous. Stop cheering, start thinking deeper about the key issues around inequality. And stop begging for Government action. Government is not quite the panacea we imagine it to be. Often enough, it is a problem we beg it to solve. 

18/4/16: Taxing 1%?.. Make My Day...

An interesting paper on the dynamics of income inequality from Xavier Gabaix, Jean-Michel Lasry, Pierre-Louis Lions and Benjamin Moll (December 2015, CEPR Discussion Paper No. DP11028: http://ssrn.com/abstract=2714268).

Take in the abstract alone for key conclusion:

“The past forty years have seen a rapid rise in top income inequality in the United States. While there is a large number of existing theories of the Pareto tail of the long-run income distributions, almost none of these address the fast rise in top inequality observed in the data. We show that standard theories, which build on a random growth mechanism, generate transition dynamics that are an order of magnitude too slow relative to those observed in the data. We then suggest two parsimonious deviations from the canonical model that can explain such changes: "scale dependence" that may arise from changes in skill prices, and "type dependence," i.e. the presence of some "high-growth types." These deviations are consistent with theories in which the increase in top income inequality is driven by the rise of "superstar" entrepreneurs or managers.”

So the key to alleviating inequality increases (if the key were to be found in income / wealth tax territory so frequently inhabited by socialstas) is not to tax all high earners, but to tax the very left tail of the high earners’ distribution, or so-called “"superstar" entrepreneurs or managers”. It’s not a 1% tax, nor a tax on wealth (capital), nor a tax on “anyone earning more than EUR100,000” (the latter being commonly bandied around the countries like Ireland), that is a panacea. It is, rather, a tax on Zuckerbergs and Bloombergs, Bezoses and Ellisons et al.

Which, sort of, means taxing exactly those who create own wealth, rather than inherit it from mommy or daddy… Perverse? If it is the “high-growth types” that are the baddies, not the Rothschilds or the Kochs who inherited wealth, at fault, then the entrepreneurs should be taken out and fiscally shot.

And if you do, here’s what you will be fiscally shooting at: innovation (see http://www.nber.org/papers/w21247). The linked paper conclusion: “our findings vindicate the Schumpeterian view whereby the rise in top income shares is partly related to innovation-led growth, where innovation itself fosters social mobility at the top through creative destruction”.

Dust out that ‘tax the 1%’ argument, again… please.

14/3/2016: Inheritance-Rich Social Disasters?

Using microdata from the Household Finance and Consumption Survey (HFCS), a recent research paper from the ECB examined “the role of inheritance, income and welfare state policies in explaining differences in household net wealth within and between euro area countries.”

Top of the line findings:

1) “About one third of the households in the 13 European countries we study report having received an inheritance, and these households have considerably higher net wealth than those which did not inherit.” Which is sort of material: in a democracy 1/3 of voters making their decisions based on inherited wealth can and (I would argue) does impose a cost on those who do not stand (do not expect) to inherit wealth. Examples of such mis-allocations? Take Ireland, where everything - from retirement to housing markets to childcare provision to education hours is predicated on transfers of income and / or wealth within the family. While those who stand to gain through this system cope well, those who stand to not gain through this familial wealth and income transfers system, stand to lose. Guess who the latter are? Of course: the poor (or those from the poor background, even if they are higher earners today) and the foreign-born.

2) “Regression analyses on households' relative wealth position show that, on average, having received an inheritance lifts a household by about 14 net wealth percentiles. At the same time, each additional percentile in the income distribution is associated with about 0.4 net wealth percentiles. These results are consistent across countries.” Which, in basic terms means that you have to work 2.5 times harder to achieve the same impact as inheritance for every point increase in inherited wealth. Merit, you say? Of course not: daddy’s money vastly outperforms, as far as financial returns go, own education, effort, aptitude etc… Though, of course, here’s a pesky bit: for all those pursuing equality and other nice social objectives, higher income taxes, of course, make it even less feasible for income (work) to catch up with inherited wealth. Which might explain why well-heeled (and often inept) folks of Dublin South are so much in favour of the ideas of raising income taxes, but are not exactly enthused about hiking inheritance taxes.

3) “Multilevel cross-country regressions show that the degree of welfare state spending across countries is negatively correlated with household net wealth.” Which, basically, says the utterly unsurprising: wealthy households don’t rely on social welfare. Doh, you’d say. But not quite. The “findings suggest that social services provided by the state are substitutes for private wealth accumulation and partly explain observed differences in levels of household net wealth across European countries. In particular, the effect of substitution relative to net wealth decreases with growing wealth levels. This implies that an increase in welfare state spending goes along with an increase -- rather than a decrease -- of observed wealth inequality.”

In other words, inheritance induces higher inequality in wealth. It compounds this effect by allocating inheritance without any sense of merit and at an indirect (policy) cost to those households that are not standing to inherit wealth. Which means that more inheritance-based is the given society, more wealth inequality you will get in it, and less merit in wealth allocation will result. Which, in turn implies you gonna pay for this with higher taxes (everyone will, except, of course, the really wealthy).

Next time you driving through, say Monkstown, check them out: the *daddy’s money* wandering around… they cost you, in tax, in higher charges for policy-related services, and in merit-less society.


Full paper here: Fessler, Pirmin and Schuerz, Martin, Private Wealth Across European Countries: The Role of Income, Inheritance and the Welfare State (September 22, 2015). ECB Working Paper No. 1847: http://ssrn.com/abstract=2664150

26/11/15: Ireland on Inequality Heat Map

Much has been said about inequality in Ireland. On TV off TV and elsewhere. Much of it is, sadly put, locked out factoids.

You see, inequality is a tough thing to measure. So we have loads of various metrics to go by and none are ‘perfect’.

Here is a slightly more comprehensive view via @Jim_Edwards

What the above shows is that across comparable economies, Ireland is mid-range in terms of inequality. Right next to Canada and Austria - two societies that few would consider to be viciously unfair to their residents. Not that there is no room for improvement, mind.

That said, the chart does miss some relevant data for Ireland - the wealth distribution. Which we are, arguably, not a shining example of.

I am not going to repeat my arguments about the relationship between tax system and wealth inequality (you can read them here: http://trueeconomics.blogspot.ie/2014/08/2182014-thomas-piketty-powerful.html), but it is worth noting that we rank well in terms of real wages growth and gender pay gap, as well as health status. We rank average in terms of all other metrics, save for involuntary part-time employment, which - by the way - is improving. I am not too keen on including arbitrary metric of ‘Digital Access’ in the scoring, however.

As an aside, the above table also fails to measure underemployment (you can read on this here: http://trueeconomics.blogspot.ie/2015/11/241115-over-skilled-under-employed.html).

21/8/2014: Capital v Labour Taxes: Time to Scratch that Cabbage Head, Mr. Politico

Ireland, like majority of other small open economies, runs a tax regime that is punitive to highly skilled workers and benign to capital owners. This, as I explain in part here (http://trueeconomics.blogspot.ie/2014/08/2182014-thomas-piketty-powerful.html), spells bad news for wealth distribution. It is simply a tax transfer from one form of capital (human capital) to other forms of capital (financial, IP and physical capital). Still, majority of small economies around the world continue to argue in favour of skinning alive their human capital and subsidising (in either relative or absolute terms) other forms of capital, based on a simple argument: in modern world, financial, IP and technological forms of capital are highly mobile (tax them and they will run for the border, goes the argument), even physical capital is mobile over the long run (tax it and investment will flow somewhere else), while labour is tied to its chair by the chains of visas, work permits etc (tax workers and they have nowhere to go).

Of course, in the real world, labour is mobile and highly skilled labour is highly mobile. That is something our outdated, outsmarted and out-of-touch political classes do not comprehend. But some academics do. Here's an example: Aghion, Philippe and Akcigit, Ufuk and Fernández-Villaverde, Jesús, paper, titled "Optimal Capital Versus Labor Taxation with Innovation-Led Growth" (May 31, 2013. PIER Working Paper No. 13-025. http://ssrn.com/abstract=2272651) shows that in presence of mobile labour force, capital subsidies are suboptimal from the revenue point off view. And worse, the more innovation-driven is your growth (the more reliant it is on human capital and the more mobile that human capital is), the lower is efficiency of capital supports.

"Chamley (1986) and Judd (1985) showed that, in a standard neoclassical growth model with capital accumulation and infinitely lived agents, either taxing or subsidizing capital cannot be optimal in the steady state. In this paper, we introduce innovation-led growth into the Chamley-Judd framework, using a Schumpeterian growth model where productivity-enhancing innovations result from pro.t-motivated R&D investment."

Enough of mumbo-jumbo. "Our main result is that, for a given required trend of public expenditure, a zero tax/subsidy on capital becomes suboptimal. In particular, the higher the level of public expenditure and the income elasticity of labor supply, the less should capital income be subsidized and the more it should be taxed. Not taxing capital implies that labor must be taxed at a higher rate. This in turn has a detrimental effect on labor supply and therefore on the market size for innovation. At the same time, for a given labor supply, taxing capital also reduces innovation incentives, so that for low levels of public expenditure and/or labor supply elasticity it becomes optimal to subsidize capital income."

Of course, labour supply is even more income elastic when it is related to high quality human capital (that can be marketed internationally), and worse, when it is related to innovation (the one that is sought after by dozens of advanced economies bidding over each other to attract the right talent in).

Now, give it a thought:
* Irish tax system literally destroys returns to human capital through punitive levels of taxation of returns on high skills;
* Irish labour markets are open to migration (including emigration of highly skilled);
* Irish economy competes for high skills with scores of other similar economies; and
* Irish state is subsidising in relative terms returns to physical and financial capital, while our tax codes also subsidise IP returns.

Time to scratch that cabbage head, Mr. Politico?

21/8/2014: Thomas Piketty: Powerful Questions, Questionable Answers

This is an unedited version of my article for the Village magazine, August-September 2014


Thomas Piketty's "Capital in the Twenty First Century" (Harvard University Press, 2014) has ignited both public and professional debates around economic theory of income and wealth distribution not seen since the days of the Interwar period a century ago when applied Marxism collided with the laissez faire economics.

To give the credit due to the author and his book, this attention is deserved.

Like Marx's opus, Pikkety's volume is sizeable enough to provoke an instantaneous submission of the readers to its perceived academic (meticulously factual and theoretically all-encompassing) virtues. Like "Das Kapital", "Capital in the Twenty First Century" is impenetrable to anyone unequipped with an advanced degree in political economy and understanding of economic theory. Like Marx's tome, Piketty's work is an attempted herald of a New Revolution; the one that, in the end, boils down to exactly the same Revolution that Marx foresaw: the dis-endowed against the endowed. Like Marxist debates of the 1930s, Piketty’s thesis comes at the time of a major upheaval and crisis.

Thus, Piketty's work is destined to stay with us for a long, long time. Looming at the horizon line, its thesis of the coming age of chaos rising from the chain reactions of growing wealth inequality will be fuelling activists' imagination for decades into the future.

Yet, perhaps to the surprise of the majority of non-specialists, the book has, within a month of its publication, faded into the background in the world of economics. The reason for this is the book’s comprehensive ambition at creating a unified theory of future economic development renders it an easy target for criticism, challenge and, ultimately, negation.

Before diving deeper into Piketty's work, let me state three facts.

Firstly, I admire Piketty for his audacity to challenge the orthodoxy of macroeconomics and tackle a broad-ranging set of targets. 99.9 percent of economics literature explores the minutiae of some empirical or theoretical cul-de-sac in a specific sub-division of a sub-field of economics. Piketty falls into the 0.1 percent of economists who pursue the big picture.

Secondly, witness to the vitriol with which Piketty’s book was greeted in the economic policy circles, I have defended his work in the media and on my blog.

Lastly, having read Piketty's academic publications and working papers in the past, I found his book to be inferior to his academic publications. "Capital in the Twenty First Century" is too long and stylistically un-engaging to be worth returning to it in the future.

The last fact means that you should read Piketty's thesis and be aware of his core evidence, as well as the growing evidence of its shortcomings.  The best means for acquiring this information is by reading Piketty's articles and interviews, as well as taking in the debates surrounding his book. But you should not buy "Capital in the Twenty First Century", unless you are endowed with a desperate propensity to impress your image of a couch intellectual onto the receptive minds of your friends and colleagues. In the latter case you should avail of Flann O'Brien's gentlemanly service that can get the tome thumbed, marked and annotated for you with scientifically-sounding marginalia.


Core Theses

Piketty's core thesis is based on what he defines to be the 'fundamental laws' of Capitalism. Both of these laws stem directly from his view that the economic inputs can be grouped into only two categories: capital (something that can be bought and sold, and thus accumulated without a bound) and labour (something that cannot be sold, although it does collect wage returns, and cannot be accumulated without bounds). Incidentally, beyond undergraduate economics, this division remains valid only in the literature pre-dating the 1980s.

Piketty’s First Law states that capital's share of income is a ratio of income from capital (or return to capital times the quantum or stock of capital) divided by the national income (for example, GDP).

As anyone with a basic knowledge of economics would know, this is not a law, but an accounting identity. Furthermore, any undergraduate student of economics would spot a glaring problem with the above definition: it applies to all forms of capital, including the ones that Piketty omits.

This brings us to the first major problem with Piketty's core thesis: capital itself is neither homogeneous, nor yields a deterministic and singular rate of return. Instead, capital takes various forms. There is financial capital - the one to which the rate of return is measured in form of equity returns, bond returns, financial portfolio returns and so on. There is also intellectual capital that can be traded. This generates financial returns to the holders/investors, but also yields productivity gains to its users, including workers. There is human capital - which generates (alongside other inputs into production) returns to labour (wages and performance-related bonuses), but also returns to entrepreneurship, creativity of employees and so on. There is managerial and technological know-how that can be invested in and transferred or sold, albeit imperfectly, in so far as it often attaches to labour and skills.

To measure income share of all of these forms of capital, one simply needs to divide income from the specific form of capital by total income. Ditto for labour's share and for any other input share. This is neither Piketty's discovery, nor a law of Capitalism.

The problem is that in many cases we cannot easily measure returns to the more complex forms of capital. And a further problem is that returns to one form of capital are linked to returns to other forms of capital. A good example here is urban land. Return to this form of capital is strongly determined by the returns to human capital that can be deployed on this land, as well as by know-how and technology that attaches to economic activity that can take place on it.

Piketty's second fundamental law is a theoretical proposition derived from the mainstream macroeconomic theory. The author claims that the ratio of the stock of capital to income will be equal to the ratio of the savings rate to the sum of growth the growth rates in technology and population. Together with the first law this implies that income share of capital equals to the ratio of the product of the return on capital and savings rate to the combined growth rate in technology and population.

Piketty's main thesis is that over time, as growth rates in technology and population fall, capital's share of income will rise resulting is a sharp rise in inequality.

The core corollary of this is Piketty's call for a global tax on capital (or wealth) coupled with a massive rise in the income tax on super-earners. These measures, in his view, can ameliorate the increase in the income share of capital triggered by slower growth.


Mythology of the Piketty’s ‘Laws’

There are numerous and significant problems with Piketty's analysis and even more problems with conjectures he draws out of data.

Although Piketty presents numerous factual arguments describing the rise and fall and the rise again in income and wealth inequalities, his factual arguments are tangential to his theoretical proposition. Per Krusell (Stockholm University) and Tony Smith (Yale University) pointed out that "Piketty’s forecast does not rest primarily on an extrapolation of recent trends that he has uncovered in the data..."

Krussell and Smith go on to show that Piketty’s second 'fundamental law' relies not on data, but on an assumption that the ‘net’ saving rate is constant and positive over time. This means that capital stock rises by an amount that is a constant fraction of national income.

Now, suppose that Piketty is correct. And suppose that the growth rates in population and technological progress fall to near-zero. Piketty’s assumption then implies that ever greater share of economy’s output will have to be used to maintain capital stock. This will crowd out investments in education, health or new technologies. Eventually capital formation will have to consume the entire GDP. This has never been observed in the past and cannot be true in the future.

Now, personally, I do believe we are staring into the prospect of diminished rates of growth in the advanced economies. But I also believe that savings follow growth over the long run, implying that, the gross investment - investment including replacement of capital depreciation and amortisation - is relatively constant as a ratio to national income. At times of structurally slow growth, therefore, savings are also low.

This belief is supported by historical evidence and contradicts Piketty's conjecture. Furthermore, this evidence is supported by data from individual consumers’ behaviour. In cyclical recessions, households do engage in increased savings, known as precautionary savings. But this phenomena is short-lived and does not contribute to increased investment. Over time, slower growth in income equals lower rates of savings.


Piketty’s Tax Fallacy

Aside from the above, Piketty's suggestion that a wealth tax can stem the rise of inequality is illogical.

Wealth taxes tend to decrease the quantity of capital, thus raising the scarcity and the quality of it. The result - higher returns to capital in the long run that will at least in part neuter the wealth tax effects on stock of capital. More scarce goods tend to command higher prices.

The problem with wealth inequality rests with the distortionary nature of taxation, not with tax levels per se.

To see this, take three forms of capital: financial assets, intellectual property and human capital.

Tax rates on financial assets normally run close to zero, due to availability of various off-shore schemes for tax optimisation for those well-off enough to afford legal and financial engineering services required to attain such rates. Each 1 percentage point in return to financial assets held by a wealthy Irish owner attracts a tax of under 10 percent (inclusive of costs of tax optimisation). For the mere mortals, capital gains rates run also well below income tax rates. In Ireland today, the headline rate is 30%. Intellectual property is facing an effectively near-zero tax rate.

Whereby professional or institutional investors in traditional capital collect roughly 85-90 cents on each euro of gains, intellectual property investors collect closer to 90 cents and retail investors pocket around 70 cents. On the other hand, human capital returns are taxed at an upper marginal tax. Thus a professional consultant will collect around 45 cents on each euro returned to her from added investment in education and skills upgrading.

The result of this asymmetric treatment of returns from various forms of capital is that households simply have no surplus income left to invest and accumulate wealth. Instead, wealth accumulates in the hands of those who can afford living off rents and start their lives with inherited capital.

To make things worse, Peketty also calls for raising dramatically upper marginal tax rate - to hit the high earners. This too is directly contradictory to the objectives he claims to pursue.

Upper marginal income tax rate hits those who live off the wealth of the businesses they built and skills they acquired. Capital gains tax hits those who either dispose of the businesses they built or sell capital they accumulated or inherited. Two of these groups of earners are collecting on value added they created. One is collecting on what others created for them. Treating them all with one brush will simply reduce future rates of growth and/or reduce rates of return on non-capital income. In other words, Piketty's income tax policy proposal will lead to higher wealth and income inequality in the long run under his own model.

The solution to this dilemma is not to tax all capital more, but to equalise the rates of taxation on all capital: physical, financial, technological and human. And focus on what Jacob Hacker of Yale University calls 'pre-distribution' of labour income. The latter requires simultaneously addressing three determinants of market wages: education and skills (increasing skills of the low income segments of population), focused enterprise policy (supporting demand for these skills) and improved mobility and efficiency of the labour markets (increasing returns to skills and human capital).


The Economic ‘Bad’ of Inequality

Piketty's work deserves huge credit for bringing to the fore of the economics debate legitimate concerns with inequality. However, here too the book is open to criticism for being based on occasionally thin evidence.

"Capital in the Twenty First Century" is premised on the assumption that wealth inequality is tearing societies apart, leading to violent conflicts and breakdowns of the civic and state institutions. There is very little evidence to support this assertion amongst the advanced economies. Extreme inequality, measured in absolute terms, can be exceptionally dangerous. So much is true. But relative inequality to-date has not been a major flashing point for revolutions whenever such inequality is anchored in some meritocratic foundations for wealth distribution. All of the recent disturbances in the advanced economies have referenced income and wealth inequality if one were to listen to activists involved in these events. But all have been linked to either public policies relating to income and opportunities available to the less well-off groups or to diminished growth rates in the local economies.

More importantly, current research shows that individual perceptions of relative income and wealth inequality strongly depend on which reference group one selects for benchmarking against.

For example, Daniel Sacks, Betsey Stevenson and Justin Wolfers paper "The New Stylized Facts About Income and Subjective Well-Being (published by CESIfo in 2013) find that there is little evidence to support theories of relative income. In simple terms, if you are concerned with inequality, you should focus on increasing the rates of growth in the economy, not depressing the rates of return on capital.

Another study, by Maria Dahlin, Arie Kapteyn and Caroline Tassot, titled "Who are the Joneses?" (CESR, June 2014) shows that individuals are "much more likely to compare their income to the incomes of their family and friends, their coworkers and people their age than to people living in the same street, town, …or in the world." We reference our own wellbeing against wellbeing of those close to us socially. In this case, Piketty's policy prescription should call for taxing rich people with greater familial networks at a higher rate than those with fewer familial ties. Which, of course, is absurd.


The World is Non-Marxian

Perhaps the greatest error in Piketty's logic is the failure to account for other forms of capital – an error exactly identical to that committed by Marx.

I named these forms of capital above in the discussion of Piketty’s two Fundamental Laws. Ricardo Hausmann from Harvard ("Piketty’s Missing Knowhow", Project Syndicate) shows that Piketty's argument completely falls apart at the national accounts level in the case of advanced and emerging economies. Furthermore, his argument dovetails with my view that hiking upper marginal tax rates to combat income and wealth inequality is simply counterproductive.

Piketty's assumption that the rate of return to capital is following a historically constant trend of 4-5 percent per annum is also questionable. Dani Rodrik of Princeton University reminds us that the return to capital is likely to decline if the economy becomes too rich in capital relative to labor and other resources and the rate of innovation slows down. So if innovation were to fall, as Piketty assumes, rate of return to capital is likely to decline in line with diminished economic growth. This decline is going to be further accelerated by the rise in the quantum of capital accumulated prior to the economic slowdown.

Lastly, since capital is non-homogenous, even constant average return can conceal wide variations in returns to various forms of capital. For example: agricultural land vs industrial property, private equity vs listed shares and so on – all command different and over-time varying returns. Imposing a uniform tax on all wealth will raise cost of investing in more productive and less certain (thus 'pricier') capital associated with new technologies and new industries. In turn, this will only reduce mobility of wealth in the society, increasing, not lowering long-run wealth inequality and supporting currently endowed elites at the expense of any challengers.

Truth is, Marxian world of the epic confrontation between labour and capital has been surpassed by reality. Today, we live in a highly complex, more dynamic and less homogenous economy. This does not mean that the burdens of rising income and wealth inequality should be ignored. But it does mean that policy responses to these challenges must be based on more complex, behaviourally and macroeconomically-anchored analysis.

Piketty’s "Capital in the Twenty First Century", spectacularly succeeded in raising to prominence the debate about income and wealth distributions. But it also failed in delivering both the analytical frameworks and policy responses to these twin challenges.

Tax and reallocation measures - whether through aid or charity, force of compulsion or financial repression - are neither sufficient to restore balance between returns to physical capital, technology and human capital, nor conducive to delivering continued growth of human-centric economic systems. Instead, there is a dire need for direct, markets-based repricing of the sources of value added in the society. This repricing must recognise the simple fact of nature: people add value to capital, not the other way around, and people with skills and productive attitudes to work do so more than those without both or either.

There is a need for closing tax incentives that favour physical capital over human capital, and there is a need for rebalancing our tax system to allow for greater rewards to flow to those creating new value in the economy. But there is also a need for the state systems to stop treating workers as captives for tax purposes, whilst capital remains highly mobile and tax efficient.