Starting with Thomas Piketty and moving to more moderate positions, such as those held by the OECD, a growing chorus of alarmist voices decries the rising economic inequality in the Western world and especially in the United States.[1] Surprisingly enough, the same mainstream analysts complain about the anaemic growth of labour productivity without seeing the correct link between the two.
Data shows a strong correlation between labour productivity and economic inequality in the U.S. (the two charts below). From the end of Second World War until the mid-1970s, labour productivity grew at a robust rate of almost 3% p.a. while income inequality declined. Afterwards both trends reversed – labour productivity slowed to below 2% growth p.a. on average and almost stagnated since the Great Recession while both wealth and income inequality expanded steadily.[2]
What common factor could explain the two divergent trends that the mainstream analysts seem to overlook? In the 1940s Mises[3] was impressed by the ”miraculous” rise in the standards of living of American wage earners which had been going on for more than two centuries. Employees were receiving a rising share out of a growing supply of goods due to the fact that capital equipment was multiplied much in excess of the growth in population. For him the answer was straightforward: capital accumulation is the driving force behind both labour productivity and the convergence of standards of living in a capitalistic society. Building on Mises’ work, Rothbard[4] explained in detail what capital accumulation requires: (i) new capital investment that lengthens the structure of production and (ii) technological progress that overcomes the diminishing returns accompanying the increase in capital goods’ supply.
Since "capitalism" has fallen into disrepute with the political establishment, mainstream analysts have conspicuously shifted their focus away from capital accumulation to more immaterial concepts such as technology, innovation and business models. They also look more inclined to investigate the negative impact of inequality on long-term economic growth rather than vice-versa.[5] However this means ignoring Mises’s warning that a depletion of the capital stock would hamper capital accumulation and labour productivity.[6] Unfortunately, the United States seems to have forgotten this valuable lesson.
In terms of technological progress, the U.S. has maintained its world leadership during past decades. It ranks second in the world to Switzerland in terms of both innovation and business sophistication[7], spends more for Research & Innovation than the OECD or EU on average relative to GDP[8] and makes up for the majority of the top 25 universities in the world.[9] Moreover it has issued the same amount of patents over the last three decades compared with the previous 150 years, being surpassed only by China recently (see chart below).[10]
In terms of capital stock, the picture is completely different. According to estimates of the Bureau of Economic Analysis (BEA) [11], the stock of private non-residential assets per worker has increased in real terms at about 1% p.a. from 1947 to 2009 and stagnated since the Great Recession (left chart below). However, BEA’s alleged sustained pace of capital growth hardly seems to reconcile with the falling of private investment and savings since the mid-1970s (right chart below).
In addition, the BEA methodology presents some serious shortcomings. Except for cars, BEA uses the “perpetual inventory method” to estimate fixed assets.[12] According to it, the value of the capital stock is indirectly estimated as the sum of past investment flows minus the estimated depreciation. It means that all past investments are considered sound by default which is certainly not the case nowadays when recurrent boom and busts cause significant volumes of malinvestment.[13] Other question marks relate to the accurate estimation of depreciation rates in the face of rapid technological progress and the use of GDP deflators[14] while their accuracy is unreliable especially as regards real estate investment.
All these considerations have led not only us, but also the Federal Reserve Board (FRB) to suspect that BEA’s estimates of the U.S. capital stock are overvalued.[15] It is intriguing that the FRB adjusts the BEA estimates downwards, especially as regards real estate assets – "structures" in BEA’s jargon –, when it uses them as input for the calculation of the capital stock in manufacturing. As a result, there is a substantial difference between BEA and FRB estimates of the evolution of the volume of manufacturing capital stock from 1952 to 2016, in particular for the real estate component (left chart below). [16] Therefore, we tried to recalculate the BEA estimate of the total stock of private non-residential capital per employee by extrapolating the difference between the two manufacturing indices coming from BEA and FRB (right chart below).
The new results suggest that the real stock of capital per worker has grown in a clear and sustained manner only until the end-1970s and fell afterwards until the trough of the Great Recession. The recalculated capital stock is both more consistent with the observed declines in investment and productivity since the mid-1970s and confirms Mises’ prediction that wrong policies would lead to capital consumption.
For the United States, the failed economic policy is the exponential growth of government intervention in the economy in the 20th century, which stifled entrepreneurship and capital accumulation. This is obvious in the rise of both government spending that redistributes away economic resources from their originators (left chart below) and the amount of regulatory burden (right chart below).
Another key factor taking a toll on capital endowment is inflation, which gained traction since the de-facto abolishment of the gold standard in 1971. As a hidden tax on savings, inflation favours consumption over thrift and investment. As a distorting element of entrepreneurial calculation, it leads to overestimation of profits and underestimation of costs to replace worn-out equipment. Most importantly, inflationary policies trigger boom-bust cycles via the artificial lowering of interest rates below their free market level. Inflation may lead to “forced savings” at the beginning of the boom if businesses can raise prices before wages start growing. However, as the boom progresses and salaries catch-up, inflation is more likely to lead to capital consumption than accumulation. [17]
Salerno emphasizes that, "overconsumption" and "malinvestment" are the two salient marks of the boom and not "overinvestment" as wrongly understood by some mainstream critics.[18] Credit expansion induces not only businesses but also households to overestimate their income and net worth, increasing consumption. It also diverts factors of production to the industries of consumer goods, reducing the supply of capital goods which is needed to finalize investments in the middle stages of the structure of production. Many of the new investments cannot be completed while some of the misdirected factors of production cannot be converted into productive capital goods in the recovery phase. Therefore it is no surprise that the capital stock per worker dropped during the business cycles that occurred regularly since the 1970s and culminated in the Great Recession.
The illusion of richness in the boom fuels not only capital consumption but also the polarisation of wealth and incomes in the society. The fiduciary credit expansion fuels an increase in asset prices, most commonly on stock exchanges and in real estate (charts below). Although based on a limited number of transactions financed by credit, all owners calculate their net worth with the newly inflated asset prices, boosting the value of household assets in excess of liabilities. As a result, the rich appear to get even richer in an economy on steroids.
This multiplication of net wealth on account of an artificial expansion of credit explains why both the U.S. national wealth has grown much faster than national income since the end-1970s (left chart below) and the number of wealthy people increased significantly. For example, Capgemini Financial Services estimate that the number of U.S. High Net-Worth Individuals (HNWI) and their wealth have more than doubled in less than a decade of ultra-low interest rates (right chart below).[19]
In conclusion, all stylized facts point into one direction: the rising inequality since the 1970s has been fuelled by both the decline in labour productivity and the monetary expansion inflating asset prices. Both are perverse effects of government interventionist policies, which led to a gradual erosion of the U.S. capital stock per employee. This is the correct link between inequality and productivity as explained by Mises and other Austrian School economists.
People have different skills and preferences, so the free market does not lead to a complete equalisation of incomes and wealth. Nevertheless, it does ensure the proper allocation of capital to increase labour productivity and satisfy the most urgent needs of consumers. As a result, the gap between the well off and the poor is not only gradually diminishing, but also gets less significant in terms of consumption. Eventually the disadvantage of wealth inequality becomes mostly a psychological one.[20] As long as the capitalist consumes only a fraction of his wealth and invests the rest into productive businesses, the real beneficiary of the increase in labour productivity is the poorer part of the society. Regrettably the virtuous cycle of capital accumulation and rising living standards which is deep-rooted in free markets went into reverse in the U.S. in the 1970s.
[A shorter version of this article has been published on mises.org.]
[1] See George Reisman’s devastating critique of Thomas Piketty’s Capital in the Twenty-First Century (2014) at http://georgereismansblog.blogspot.com/2014/07/pikettys-capital-wrong_28.html, or the OECD at http://www.oecd.org/social/in-it-together-why-less-inequality-benefits-all-9789264235120-en.htm.
[2] In addition to the share of total income and wealth gained by the top 1% rich, the share of both the bottom 50% and especially the middle 40% went down since the 1980s, reflecting the "hollowing-out" of the middle class.
[3] See Ludwig von Mises, Human Action ([1949] 1998), pp. 611-612.
[4] See Murray N. Rothbard, Man, Economy, and State with Power and Market, ([1962]2009) pp.537-543.
[5] See the OECD at https://read.oecd-ilibrary.org/employment/in-it-together-why-less-inequality-benefits-all/summary/english_bc9f5d0b-en#page1.
[6] See Ludwig von Mises, Human Action ([1949] 1998), pp. 844.
[7] See the Global Competitiveness Index 2017-2018 at https://www.weforum.org/reports/the-global-competitiveness-report-2017-2018.
[8] See the OECD data at https://data.oecd.org/rd/gross-domestic-spending-on-r-d.htm .
[9] See rankings at https://www.topuniversities.com/ .
[10] See data from the US Patent and Trademark Office at https://www.uspto.gov/web/offices/ac/ido/oeip/taf/h_counts.htm .
[11] The most authoritative U.S statistics of capital stocks are provided by BEA who estimates long term series of the net stocks of fixed assets for the US economy. See BEA data that I used at: https://apps.bea.gov/iTable/iTable.cfm?reqid=10&step=1&isuri=1#reqid=10&step=1&isuri=1 under section 4: Section 4 – Nonresidential Fixed Assets (Table 4.2)
[12] See the BEA methodology at https://apps.bea.gov/national/pdf/Fixed_Assets_1925_97.pdf at M-6.
[13] The Austrian Theory of the Business Cycle pioneered by Mises, Hayek and Rothbard explains how malinvestments create significant distortions in the structure of production and reduce directly the capital stock in the economy during the boom.
[14] See https://apps.bea.gov/national/pdf/Fixed_Assets_1925_97.pdf at M-8.
[15] See https://www.federalreserve.gov/releases/g17/CapitalStockDocLatest.pdf, pages 5 and 6.
[16] See BEA data at: https://apps.bea.gov/iTable/iTable.cfm?reqid=10&step=1&isuri=1#reqid=10&step=1&isuri=1 under section 3: Section 3 – Private Fixed Assets by Industry (Tables 3.2ESI, 3.2E and 3.2S ) and FRB estimates at https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/annual-data-on-investment-and-capital-stocks-20160302.html and FRB data in Table G.17 at https://www.federalreserve.gov/releases/g17/download.htm#capstock.
[17] See Ludwig von Mises, Human Action ([1949] 1998), pp. 547.
[18] See Joseph Salerno.2012. "A Reformulation of Business Cycle Theory in Light of the Financial Crisis", Quarterly Journal of Austrian Economics, Vol 15/No1/3-44 at https://mises.org/library/reformulation-austrian-business-cycle-theory-light-financial-crisis-0.
[19] Capgemini Financial Services define HNWIs as those who have investable assets of more than USD 1 million, excluding primary residences, collectibles and consumer durables. It estimate that the number and wealth of U.S. HNWIs more than doubled in less than a decade of ultra-low interest rates; see report at https://www.worldwealthreport.com/reports/population.
[20] George Reisman.2014. "Piketty’s Capital: Wrong Theory/Destructive Program", pp. 25.
