Is Piketty's R>G Inequality Discovery Really Just A PE Ratio?

by: Nick Gogerty

Summary

Is Piketty's R>G inequality discovery really just a PE ratio?

The relationship of inequality, growth and capital pricing need to be understood clearly.

Capital Growth reflects future expectations of value delivery.

Misunderstanding economics may lead to bad solutions for problems of social inequity.

Thinking about value shows why Piketty's inequality R>G must be.

In his new book Capital in the 21st Century, Thomas Piketty discovers that Returns on Capital (R) are greater than the gains of economic growth (G) leading which may cause inequality. Piketty hints this inequality may be true for many economic periods.

This discovery isn't really very new. Thinking about Capital using an economic value perspective shows why this should logically occur. Basically R>G because capital is priced on expected yield.

Understanding why R>G is easily understood by thinking about PE Price:earnings ratios. Piketty presents the inequality of R>G as a discovered new "law" of economic capitalism. A little thinking about how economic value and asset pricing work shows why this outcome is both obvious and desired. Piketty and Marx misunderstand Capital, believing it to be a fixed thing. This leads to many logical flaws. Capital is actually a process which gets assigned a value based on its expected future yields.

Let's take a look at why the inequality R>G should logically hold true. Returns on Capital growth reflect an expected value over time. Innovation applied grows value in a given year. If an organization grew profits by $100 last year that is economic growth. If the organization is expected to maintain that profit increase for the foreseeable future, someone may be willing to pay an extra $1,000 for the organization's shares or Capital. This equates to an investor pursuing a 10% yield on capital or 10:1 price to earnings (E) ratio.

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Looking at the nature of how value is created and capital is priced by the market makes the relationship obvious. Increased corporate income typically reflects economic growth. Capital assets are priced based on the expectations of that increased growth delivered into the future. The diagram above may help.

R will grow as a reciprocal of G subject to operating profit margins and expected future yield on risk capital demanded by the market. Capital assets are priced relative to expected yield. So yes, the capital asset owner sees evolution's innovations grow his or her piece of wealth faster than the whole economy due to expectations of future maintained earnings growth. G is based on years of expected value creation, R is based on last year's improved growth.

Piketty's and Marx's treatment of capital fail to consider the nature of how value is created and capital assets are priced based on future expectations. Capital is a process not a thing.

Marx failed to understand the value of evolution's use of innovative competition and death. Marx and Piketty's failure to understand the nature of the capitalist process is fairly common. The chart below shows a cohort of millions of US firms dying over time.

Evolution's destruction of ineffective capital allowing for re-allocation of resources gets little attention in Piketty's book. Please note the US and global economy in aggregate grew significantly during this period delivering many incredible innovations enhancing billions of lives.

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Evolution's competitive economic forces mean even large companies that survive will struggle to maintain earnings growth over time. The chart below showing earnings growth for US companies during one of the strongest periods for US equities in the 20th century.

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Piketty's book Capital in the 21st Century never really understands capital, claiming at one point that stock markets return on average 8% annually. 8% equity returns while desirable aren't the norm for equity capital returns. Such returns haven't been seen in any major economy in the 20th century as a whole. Even in Piketty's France, equities yielded just under 3% between 1900-2011. Real sustained 8% equity returns haven't been seen in any economy over the 20th century. See chart below of major 20th century equity indexes.

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Piketty's work on measuring inequality is somewhat useful, but not deeply revelatory. The work of development economists like Esther Duflo or Amartya Sen or Hernando de Soto Polar are far more interesting to framing the economic development and equity impacts debate. Sustained high levels of income inequality and overly concentrated economic and political power can retard societies' human development for both rich and poor.

Here is some interesting work on those impacts:
Richard Wilkinson from Children North East

The TED Talk is pretty good as well.

The danger of Piketty's logical flaws is that failure to understanding capital and economic growth coupled with a rush to resolve social inequity with flawed solutions could be disastrous leading to destroying economic capital, innovative growth and value flow. Let's hope the debate on social equity becomes a thoughtful one led by parties who truly understand the nature of how innovation and capital work as a process to create value, opportunity and growth based prosperity for everyone.

For those interested in understanding how innovation and capital create value, The Nature of Value by Nick Gogerty may provide an interesting read, even without Jane Austen or Balzac swooning around to help things along.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.