A Little More Math - On further review of Piketty's book, Capital in the Twenty-First Century, I have found several key assumptions underlying Piketty's calculations that are, at best, dubious and this requires some additions to the analysis in Part 1 of this series.
First of all, in his wealth distribution calculation, Piketty includes assets that have been transferred to private foundations (like the Gates Foundation) as assets of the transferor. Thus, Bill Gates's wealth includes the amount he has donated to his own foundation on the theory that he still has control over it. In reality, there are strict limitations on funds transferred to private charitable foundations (at least in the United States) and while Gates can decide to donate the money to malaria research rather than inner city education, his control is limited to the pursuit of charitable objectives. I think it is misleading and incorrect to include these amounts as part of the wealth of the individual transferor. I am not sure how much this decision impacted the results but in the case of certain of the super-rich the impact may be substantial.
Secondly, Piketty's income distribution calculations are pre-tax and pre-transfer payment. That means, that if you calculate the income people actually get after taxes are paid and after transfer payments (social security, unemployment compensation, food stamps, housing subsidies, disability payments, etc.), the distribution of net income is much less regressive.
Thirdly, an argument can be made that the wealth of each individual should include the present value of the expected future pension and social security benefits he or she is entitled to receive. Again, this would reduce the concentration of wealth by creating a new asset held by a very large number of individuals.
Finally, a striking disparity in the nature of capital in various countries jumps out from Figures 3-1, 3-2, 4-1 and 4-6. In Germany and the United States, the capital falling into the "housing" category appears to be equal to roughly twice national income. On the other hand, in France the capital devoted to housing appears to be nearly four times national income and in Britain it appears to be roughly three times national income. We will return to this issue in the third part. Suffice it to say, that I would love to see a calculation of the proportion of the British and French housing capital which is in London and Paris - cities which could be replicated in America only if we moved the national capital, Harvard University and the New York State capital into New York City and tried to concentrate as much of the new activity in Manhattan as possible.
Piketty's World of Too Much Capital - Piketty conjures up a world in which, as the ratio between capital and national income increases, the inheritance of wealth becomes more and more important. He seems fixated on "Vautrin's Lesson" (pp.238-40) citing Balzac's Pere Goriot (set in Restoration Era France) in which a "shady character" (Vautrin) spells out his "Lesson" to the protagonist. The Lesson is that, even making generous assumptions, a lifetime of hard and excellent work for a young lawyer cannot possibly yield anything close to the financial returns achievable by marrying money. He also provides other literary references including Jane Austen and Henry James in order to remind the reader of the horrors of the 19th Century and a world in which the capital/national income ratio got too high. Piketty feels that we are on the path back to this situation because we are rapidly nearing the same ratio of capital to annual income that prevailed in Balzac's time.
Piketty is correct that this is a depressing spectacle. It is the world of Woody Allen's Match Point, in which the protagonist can escape his modest London flat (having been reminded by the agent that "this is London" when surprised at the rent) only by marrying up and is therefore motivated to commit a tragic crime. It is a world dominated by people like Clarence Emerson Wincester III in Mash, like John Wayne's rich in-laws in In Harm's Way, like the rich, pompous fuddy-duddies who populate Marx Brothers movies, like the very worst characters in Titanic, like Kevin Spacey's mother-in-law in The Ref, and like Potter in It's a Wonderful Life. It's actually a world in which those people we all like to make fun of because of their pomposity, arrogance and stupidity wind up in the driver's seat. The more I think about it, Piketty is not really imagining a World, he is imagining a Hell. Young men and women are not motivated to work hard, hone their skills or invest wisely; instead, they are forced into a process of steely-eyed and ruthless pursuit of a remunerative marriage. The game of life will be over before it starts; the most relevant fact about a person will be his or her parent's balance sheet. Most of us will live in a pit of despair with very few ladders out - all of which will be crowded with climbers trying to secure the right marriage.
The Real World of Too Much Capital - Is this really what the world will be like if there is too much capital sloshing around? One big difference between 21st Century France (and the United States) and Restoration Era France is that, even if the income distribution is not more egalitarian today, the overall increase in income and wealth means that the quality of life for those outside the top 10 per cent is vastly improved. This means that one can "opt out" of the "marrying up" derby and still live a very comfortable and rewarding life. As Paul Fussell pointed out quite a while ago in his excellent and hilarious book, Class, a new class has been emerging of Americans less traditionally status conscious, more hip, and more inclined to reject arbitrary norms about status markers.
But the real reason Piketty is wrong is that the world of too much capital is not a world of constipated coupon-clippers who keep to themselves. A reasonably free and workably efficient market will generate a constant search for return on the part of the holders of capital. This will not create a world dominated by inherited wealth and vested privilege. Instead, it will create a world in which entrepreneurs with new ideas will be able to get those ideas funded. It will also unfortunately be a world replete with scams and frauds. It will involve relatively volatile financial markets as capital flees at the hint of trouble. Even now, many of the largest fortunes are truly first generation fortunes rather than fortunes based on inherited wealth. The spirit of our age will be defined by Tom Wolfe's The Bonfire of the Vanities, by The Wolf of Wall Street, and by the meteoric rise of Facebook portrayed in The Social Network. If you want to watch the world of too much capital in a television series, don't look at Downton Abbey, just tune in to Silicon Valley.
The reason for this is that capital aggressively (and sometimes blindly) keeps seeking higher returns and, if there is too much capital, the entrepreneurs who promise those returns wind up in a very attractive bargaining position. This also goes for financial engineers who create investment vehicles attractive to capital owners and who find, in a world of too much capital, a receptive market for their latest creations. The aggressive capital deployers and financial engineers will be the real winners as holders of capital desperately seek higher yield. The entrepreneurs and financial engineers are frequently the first generation in their family to be truly wealthy (and in some cases are the first generation to live in the United States) and will create a world very different from Restoration France.
Of course, I have been talking about the United States and, I suspect, even in the 19th and early 20th Century, the United States really wasn't accurately described in Vautrin's Lesson. Indeed, Vautrin's Lesson may have been a factor driving many energetic Europeans to hop on a boat and cross the Atlantic because in the United States immigrants and their sons and daughters were starting the oil industry, setting up investment banks, and making many of the movies cited above.
In the United States, at least, Piketty doesn't really capture the spirit of the age we are entering. It will not be the stratified world of early 19th century France or even of Belle Epoque France in the late 19th and early 20th Century. We shouldn't have to worry about our children and grandchildren lacking possible avenues of advancement nor is it likely that the heirs of huge family fortunes will dominate the business and political worlds. Indeed, the accumulation of huge amounts of capital will put a premium on the skills of those adept at deploying the capital to maximize return. It will also create (with a periodic "risk on, risk off" dynamic) an atmosphere in which new ventures can obtain funding on reasonable terms.
In France with such a high proportion of capital tied up in housing (likely heavily in Paris), things may be different. It may be true that the only way to get a really great apartment in Paris will be to marry into a family that owns one (the same may become true in London). I will deal with this issue a bit in the third part of this series. As a general matter, to the extent that it is a legitimate issue, Piketty's concern about the rising importance of inheritance can be addressed by estate taxes and does not constitute an indictment of capitalism nor does it justify the unworkable capital tax he proposes.
Investment Implications - Piketty's calculations do support the thesis that there has been a trend in the direction of higher amounts of income concentrated at the top in the United States and that there has been a wealth concentration. He may misrepresent the extent of the phenomenon for some of the reasons stated in this review, but the trend appears to be an accurate assessment of the situation. It is unclear whether this trend will continue, but even if it stabilizes, it means that there will be a large number of multi-millionaire households in the United States. They will probably be concentrated along the Coasts and heavily concentrated in New York, the Bay Area, Washington, Boston and Los Angeles.
Looking at things from 35,000 feet in the air and trying to discern long run trends, this situation creates a tailwind that will favor certain equities. Some names that will continue to benefit from this situation are: 1. Equity Residential (NYSE:EQR) - I have written here about its very attractive apartment buildings in prime locations in the top markets; 2. Tesla (NASDAQ:TSLA) - this is the only car which lets its owner make the "statement" that "I am a rich guy but I also care about the environment"; 3. Asset Managers including Blackstone (NYSE:BX) and Kohlberg, Kravis, Roberts (NYSE:KKR) providing investment alternatives for wealthy individuals and pension funds; 4. Tiffany (NYSE:TIF) - still a well-established luxury brand; and 5. BMW (BMW.F) - a solid aspirational luxury brand and also the owner of Rolls Royce.
As I said in part 1, Piketty has compiled interesting data and it should set off a spirited debate. I do not think that he has established an inherent "flaw" in capitalism and it is certainly not new news that developed countries have to set aside funds to establish an adequate safety net. Part 3 of the review will deal with his policy prescriptions and some alternative ideas.
Disclosure: I am long BX, KKR, TIF, EQR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.