There's an old economic saying: a rising tide lifts all boats. Problem is, most people can't afford a boat.
Most people can't afford a lot of stocks, bonds, or real estate, either. But the few who can afford what economists call capital are racing even further ahead of the many who can't. It's what Nobel prize-winning economist Robert Solow calls the "rich-get-richer" principle, and it's how capitalism usually works.
We know this, because French economist Thomas Piketty has assembled hundreds of years worth of data on wealth and income inequality showing it. His monumental, best-selling new book, "Capital in the Twenty-First Century, makes a startlingly simple argument: if the return on capital, r, is greater than the economy's growth rate, g, as it almost always has been, then inequality will tend to increase. That's because wealth grows faster than wages when r>g, and only the rich have much wealth to begin with.
Now, this dynamic won't make inequality increase forever; it will stop once the ratio of capital to income is the same as the ratio of savings to growth. But in the meantime, the top 1 percent will gobble up more and more wealth—and leave it to their kids.
Here's how we got here, and four things we can to do stop it from getting worse.
The decline and fall - and rise - of the rentiers
Periods of low income inequality, Piketty claims, are just a historical blip. Going back to the 1800s, the rate of return has typically been around 4 to 5 percent, and growth has been far less. Capital-income ratios were high then, so this r>g meant that wealth begat dynastic wealth.
But this, like everything else, changed with World War I. The fighting didn't just destroy a generation. It also destroyed capital—buildings, factories, and government bonds paid back in inflated currency—on a mass scale. Rentiers no longer had the income to support their aristocratic lifestyles, so they started spending down their remaining wealth to do so. Not only that, but countries were forced to resort to steep income taxes to finance their war efforts. Now, governments tried to return to economic normalcy in the 1920s, but the Great Depression and then World War II ended that. There was even more capital destruction. Even more confiscatory taxes. And even more regulation.
It was a bad time to be a rentier even after the war ended: r<g for the first and only time, as rent control, minimum wages, and taxes cut returns and postwar rebuilding boosted growth.
Then the Reagan-Thatcher revolution happened. Tax rates, inflation, and regulations were all cut, raising returns. But this second Gilded Age was different from the first, at least at the start. It wasn't about wealth growing faster than wages. It was about wages at the very top growing so fast that they were wealth. In other words, the owners of capital didn't cause our increasing income inequality. The managers of capital, the MBA class of CEOs and Wall Streeters, did. For now, at least. Today's "supermanagers," as Piketty calls them, will be tomorrow's rentiers. Just wait a generation, and we might be back to a world dominated by inherited wealth.
Or we might not. Piketty has demonstrated that the rate of return has historically been 4 to 5 percent, but he hasn't demonstrated why. Without a theory to explain it, we can't really say if it will continue. Sure, the long-term trend—and it is long—could go on. But it could also be that, in the future, more capital will mean higher wages and lower returns. That the rate of return will fall more than growth.
But that's probably not a gamble we want to take. The IMF, hardly a bastion of populism, has found that high levels of inequality are correlated with slower growth, and redistribution, within reasonable limits, with faster and more durable growth. Income inequality has also been associated with life expectancy inequality, though, again, it's not clear which way the causation runs. And, perhaps most worryingly, concentrated economic power could turn into concentrated political power, entrenching economic power, in what Ezra Klein dubs a "doom loop of oligarchy." Actually, as my colleague Larry Bartels points out, that might already be here: studies show that the rich have 15 times more influence on policy as average people.
So what is to be done? Well, there are four basic strategies: increase growth, decrease pre-tax returns, decrease post-tax returns, or help the 99 percent do better in a r>g world.
1. Increase growth (first, by letting more people live here)
There are easy ways and then there are hard ways to increase growth. The easiest is just to let more people into the country. The calculus is simple: more workers means more GDP (which makes past wealth a smaller piece of the pie). Specifically, the CBO estimates that immigration reform would increase the size of the economy by 5.4 percent in 2033.
The other way to add people, of course, is to try to make life easier for parents, so they can work more and have more kids. That's not as easy, but it is doable—and it comes down to day care. Reihan Salam points out more mothers started working in Quebec after it introduced subsidized child care in 1997. And France, unlike most of its European peers, has pushed its birthrate back up near replacement level in large part because of its system of parental tax breaks and day-care centers (or "crèches").
The hard way to increase growth is to make our workers more productive—that is, to improve education. That could mean adopting Common Core standards. Or charter schools. Or school vouchers. Or vocational training. Or more—and smarter—college aid.
2. Less rent-seeking and more bargaining power for workers. And more houses.
Growth alone, though, won't be enough to save us from a plutocratic future if returns stay around 4 or 5 percent. We'll need to do more, need to cut those returns in some way. And we should start by going after the excessive returns hurting the economy.
Zoning probably isn't the first thing you think about when you think about rent-seeking, but it should be. NIMBY ("not-in-my-backyard") regulations—looking at you, San Francisco—prevent building where there's the most demand for it. The result is a policy-induced housing shortage in our cities that drives up prices and rents, and creates the kind of sprawl that keeps lower-income workers away from job opportunities. Piketty's best data on this comes from France, where things are even worse than they are here: housing rent as a share of national income has almost doubled there the past 30 years. Luckily, though, there's a simple enough way to cut these returns to housing: build more houses where people want them.
Drug and intellectual patents are another source of rent-seeking. Economist Dean Baker points out that these government-granted monopolies make up a sizable chunk of corporate profits, and are almost certainly too generous.
To take one example, Nexium costs $215 in the U.S., and just $23 in the Netherlands. Now, pharmaceutical and tech companies would say they need these temporary monopolies to give them an incentive to invest in R&D, but they might not be temporary enough. Nobel prize-winning economist Joseph Stiglitz thinks our patent laws might actually be hurting innovation by taking ideas out of the usable pool of knowledge for too long. So loosening patent protections wouldn't just make these outsized returns a bit less so; it might speed up growth, too.
Mega-profits aren't just about rent-seeking. They're also about the balance of power between capital and labor—which isn't so much a balance anymore as a war that capital has won. Indeed, the labor share of business income has fallen to a 60-year low during our not-so-great recovery. Part of that is due to big-picture trends like technology and globalization.
But part of it is due to policy. A higher minimum wage, for example, would, according to the CBO, raise aggregate incomes for households making less than $87,000 and lower them for households making more. That's because it would have a cascading effect on wages, raising them for middle-class workers too, which would eat into corporate profits. Making it easier to unionize could do the same.
3. It's time to tax inequality
But crony capitalism isn't causing r>g. Capitalism itself is. Cracking down on rent-seeking can help at the margins, but, if Piketty is right, we're going to have to do more to stop an inequality spiral.
And the absolute least we can do is beefing up the estate tax. France, again, has the best data here, going all the way back to the early 1800s. As you can see below, inheritance is making a slow-motion comeback there, up to 15 percent of national income from a postwar low of 4 percent.
It probably isn't this high in the U.S., because of our population growth—but give it time. Today's supermanagers will have tomorrow's trust-funders, and so on, and so on. Unless we start taxing estates more. That should include getting rid of the step-up basis in capital gains, which saves heirs from taxes that their parents would have had to pay. The Committee for A Responsible Federal Budget estimates that this tax break will cost the government about $50 billion a year in revenue through 2017.
Piketty, of course, wants a global tax on net wealth—that is, subtracting mortgages and any other debts. His admittedly utopian plan would have three tax brackets: 0 percent for households with less than €1 million ($1.39 million) of net wealth, 1 percent for households with between $1.39 million and $6.95 million, and 2 percent for households above that. The virtue of such a system is it would be a tax on idle capital more than invested capital, since it hits both equally. The vice, other than the impracticality of getting governments to cooperate on it, is that it would incentivize going into debt to reduce your tax liability.
More realistically, we could just increase marginal tax rates. Piketty and Nobel prize-winning economist Peter Diamond have said that a top rate as high as 73 percent could be "optimal," because high-earners don't get as much benefit from an extra dollar as low-earners do. The question, though, is how much that would hurt growth. It's possible that high-earners would respond by working less; if not "going Galt," at least going on vacation. But it's also possible that it wouldn't have much effect. So many high-paying jobs have become winner-take-all that there's still a strong incentive to work long hours even if taxes go up.
4. Capital for the rest of us: the 99 percent need to own more stock
If r really is greater than g, now and forever, it's a powerful argument for helping the 99 percent own more stock. Arpit Gupta frames this as an argument for Social Security privatization, in particular, but I don't think that's right. It's not just that transitioning to private accounts would be costly. Or that it would introduce timing risk—of retiring during a market meltdown. It's that we don't know if Piketty is right about the future, so we shouldn't plan our pension system around it. But we should insure against the possibility. That could mean expanding Social Security with a general pool that invests in stocks—basically a sovereign wealth fund—and then makes guaranteed payouts. In fact, Piketty himself proposed something like that in France a few years ago.
Past doesn't have to be prologue. The logic of r>g pushes us towards greater inequality, but we can push back. We don't know how hard we'll have to push, but we should get ready to.
Otherwise, if you want a picture of the future, imagine Paris Hilton's stiletto-heeled boot stamping on a human face—forever.