Capital in the Twenty-First Century (10 page)

The fact that national income in the wealthy countries of the world in 2010 was on
the order of 30,000 euros per capita per annum (or 2,500 euros per month) obviously
does not mean that everyone earns that amount. Like all averages, this average income
figure hides enormous disparities. In practice, many people earn much less than 2,500
euros a month, while others earn dozens of times that much. Income disparities are
partly the result of unequal pay for work and partly of much larger inequalities in
income from capital, which are themselves a consequence of the extreme concentration
of wealth. The average national income per capita is simply the amount that one could
distribute to each individual if it were possible to equalize the income distribution
without altering total output or national income.
¹¹

Similarly, private per capita wealth on the order of 180,000 euros, or six years of
national income, does not mean that everyone owns that much capital. Many people have
much less, while some own millions or tens of millions of euros’ worth of capital
assets. Much of the population has very little accumulated wealth—significantly less
than one year’s income: a few thousand euros in a bank account, the equivalent of
a few weeks’ or months’ worth of wages. Some people even have negative wealth: in
other words, the goods they own are worth less than the debts they owe. By contrast,
others have considerable fortunes, ranging from ten to twenty times their annual income
or even more. The capital/income ratio for the country as a whole tells us nothing
about inequalities within the country. But
β
does measure the overall importance of capital in a society, so analyzing this ratio
is a necessary first step in the study of inequality. The main purpose of
Part Two
is to understand how and why the capital/income ratio varies from country to country,
and how it has evolved over time.

To appreciate the concrete form that wealth takes in today’s world, it is useful to
note that the capital stock in the developed countries currently consists of two roughly
equal shares: residential capital and professional capital used by firms and government.
To sum up, each citizen of one of the wealthy countries earned an average of 30,000
euros per year in 2010, owned approximately 180,000 euros of capital, 90,000 in the
form of a dwelling and another 90,000 in stocks, bonds, savings, or other investments.
¹²
There are interesting variations across countries, which I will analyze in
Chapter 2
. For now, the fact that capital can be divided into two roughly equal shares will
be useful to keep in mind.

I can now present the first fundamental law of capitalism, which links the capital
stock to the flow of income from capital. The capital/income ratio
β
is related in a simple way to the share of income from capital in national income,
denoted
α
. The formula is

α
=
r
×
β

where
r
is
the rate of return on capital.

For example, if
β
=
600% and
r
=
5%, then
α
=
r
×
β
=
30%.
¹³

In other words, if national wealth represents the equivalent of six years of national
income, and if the rate of return on capital is 5 percent per year, then capital’s
share in national income is 30 percent.

The formula
α
=
r
×
β
is a pure accounting identity. It can be applied to all societies in all periods
of history, by definition. Though tautological, it should nevertheless be regarded
as the first fundamental law of capitalism, because it expresses a simple, transparent
relationship among the three most important concepts for analyzing the capitalist
system: the capital/income ratio, the share of capital in income, and the rate of
return on capital.

The rate of return on capital is a central concept in many economic theories. In particular,
Marxist analysis emphasizes the falling rate of profit—a historical prediction that
turned out to be quite wrong, although it does contain an interesting intuition. The
concept of the rate of return on capital also plays a central role in many other theories.
In any case, the rate of return on capital measures the yield on capital over the
course of a year regardless of its legal form (profits, rents, dividends, interest,
royalties, capital gains, etc.), expressed as a percentage of the value of capital
invested. It is therefore a broader notion than the “rate of profit,”
¹⁴
and much broader than the “rate of interest,”
¹⁵
while incorporating both.

Obviously, the rate of return can vary widely, depending on the type of investment.
Some firms generate rates of return greater than 10 percent per year; others make
losses (negative rate of return). The average long-run rate of return on stocks is
7–8 percent in many countries. Investments in real estate and bonds frequently return
3–4 percent, while the real rate of interest on public debt is sometimes much lower.
The formula
α
=
r
×
β
tells us nothing about these subtleties, but it does tell us how to relate these
three quantities, which can be useful for framing discussion.

For example, in the wealthy countries around 2010, income from capital (profits, interests,
dividends, rents, etc.) generally hovered around 30 percent of national income. With
a capital/income ratio on the order of 600 percent, this meant that the rate of return
on capital was around 5 percent.

Concretely, this means that the current per capita national income of 30,000 euros
per year in rich countries breaks down as 21,000 euros per year income from labor
(70 percent) and 9,000 euros income from capital (30 percent). Each citizen owns an
average of 180,000 euros of capital, and the 9,000 euros of income from capital thus
corresponds to an average annual return on capital of 5 percent.

Once again, I am speaking here only of averages: some individuals receive far more
than 9,000 euros per year in income from capital, while others receive nothing while
paying rent to their landlords and interest to their creditors. Considerable country-to-country
variation also exists. In addition, measuring the share of income from capital is
often difficult in both a conceptual and a practical sense, because there are some
categories of income (such as nonwage self-employment income and entrepreneurial income)
that are hard to break down into income from capital and income from labor. In some
cases this can make comparison misleading. When such problems arise, the least imperfect
method of measuring the capital share of income may be to apply a plausible average
rate of return to the capital/income ratio. At this stage, the orders of magnitude
given above (
β
=
600%,
α
=
30%,
r
=
5%) may be taken as typical.

For the sake of concreteness, let us note, too, that the average rate of return on
land in rural societies is typically on the order of 4–5 percent. In the novels of
Jane Austen and Honoré de Balzac, the fact that land (like government bonds) yields
roughly 5 percent of the amount of capital invested (or, equivalently, that the value
of capital corresponds to roughly twenty years of annual rent) is so taken for granted
that it often goes unmentioned. Contemporary readers were well aware that it took
capital on the order of 1 million francs to produce an annual rent of 50,000 francs.
For nineteenth-century novelists and their readers, the relation between capital and
annual rent was self-evident, and the two measuring scales were used interchangeably,
as if rent and capital were synonymous, or perfect equivalents in two different languages.

Now, at the beginning of the twenty-first century, we find roughly the same return
on real estate, 4–5 percent, sometimes a little less, especially where prices have
risen rapidly without dragging rents upward at the same rate. For example, in 2010,
a large apartment in Paris, valued at 1 million euros, typically rents for slightly
more than 2,500 euros per month, or annual rent of 30,000 euros, which corresponds
to a return on capital of only 3 percent per year from the landlord’s point of view.
Such a rent is nevertheless quite high for a tenant living solely on income from labor
(one hopes he or she is paid well) while it represents a significant income for the
landlord. The bad news (or good news, depending on your point of view) is that things
have always been like this. This type of rent tends to rise until the return on capital
is around 4 percent (which in this example would correspond to a rent of 3,000–3,500
euros per month, or 40,000 per year). Hence this tenant’s rent is likely to rise in
the future. The landlord’s annual return on investment may eventually be enhanced
by a long-term capital gain on the value of the apartment. Smaller apartments yield
a similar or perhaps slightly higher return. An apartment valued at 100,000 euros
may yield 400 euros a month in rent, or nearly 5,000 per year (5 percent). A person
who owns such an apartment and chooses to live in it can save the rental equivalent
and devote that money to other uses, which yields a similar return on investment.

Capital invested in businesses is of course at greater risk, so the average return
is often higher. The stock-market capitalization of listed companies in various countries
generally represents 12 to 15 years of annual profits, which corresponds to an annual
return on investment of 6–8 percent (before taxes).

The formula
α
=
r
×
β
allows us to analyze the importance of capital for an entire country or even for
the planet as a whole. It can also be used to study the accounts of a specific company.
For example, take a firm that uses capital valued at 5 million euros (including offices,
infrastructure, machinery, etc.) to produce 1 million euros worth of goods annually,
with 600,000 euros going to pay workers and 400,000 euros in profits.
¹⁶
The capital/income ratio of this company is
β
=
5 (its capital is equivalent to five years of output), the capital share
α
is 40 percent, and the rate of return on capital is
r
=
8 percent.

Imagine another company that uses less capital (3 million euros) to produce the same
output (1 million euros), but using more labor (700,000 euros in wages, 300,000 in
profits). For this company,
β
=
3,
α
=
30 percent, and
r
=
10 percent. The second firm is less capital intensive than the first, but it is more
profitable (the rate of return on its capital is significantly higher).

In all countries, the magnitudes of
β
,
α
, and
r
vary a great deal from company to company. Some sectors are more capital intensive
than others: for example, the metal and energy sectors are more capital intensive
than the textile and food processing sectors, and the manufacturing sector is more
capital intensive than the service sector. There are also significant variations between
firms in the same sector, depending on their choice of production technology and market
position. The levels of
β
,
α
, and
r
in a given country also depend on the relative shares of residential real estate
and natural resources in total capital.

It bears emphasizing that the law
α
=
r
×
β
does not tell us how each of these three variables is determined, or, in particular,
how the national capital/income ratio (
β
) is determined, the latter being in some sense a measure of how intensely capitalistic
the society in question is. To answer that question, we must introduce additional
ideas and relationships, in particular the savings and investment rates and the rate
of growth. This will lead us to the second fundamental law of capitalism: the higher
the savings rate and the lower the growth rate, the higher the capital/income ratio
(
β
). This will be shown in the next few chapters; at this stage, the law
α
=
r
×
β
simply means that regardless of what economic, social, and political forces determine
the level of the capital/income ratio (
β
), capital’s share in income (
α
), and the rate of return on capital (
r
), these three variables are not independent of one another. Conceptually, there are
two degrees of freedom, not three.

Now that the key concepts of output and income, capital and wealth, capital/income
ratio, and rate of return on capital have been explained, I will examine in greater
detail how these abstract quantities can be measured and what such measurements can
tell us about the historical evolution of the distribution of wealth in various countries.
I will briefly review the main stages in the history of national accounts and then
present a portrait in broad brushstrokes of how the global distribution of output
and income has changed since the eighteenth century, along with a discussion of how
demographic and economic growth rates have changed over the same period. These growth
rates will play an important part in the analysis.