Thomas Piketty’s contentious thesis about ever-increasing inequality rests on the surprisingly conventional premise that aggregate wealth grows faster than overall income. Financiers and public officials have peddled virtually the same idea for decades in claiming that stocks and homes will always keep ahead of GNP and inflation.
Unfortunately, this is a fantasy.
The Dow-Jones index would have to close at about 2,000,000 on December 31, 2099, Warren Buffett has pointed out, just to match its 5.3% nominal gain of the 20th century (when it rose from 66 to 11,497).
Worse, because the belief that wealth grows faster than incomes is now so deeply embedded, it threatens our financial security, helps inflate bubbles, and by promoting a perverse redistribution of income, undermines the legitimacy of profit-seeking enterprise.
Comparing the growth rates of income and wealth is rather like comparing apples and unicorns.
Incomes are in the here and now: hard cash which we can all spend right away on things and experiences that we desire. Wealth reflects hopes and dreams—expectations in economists’ argot—projected from nebulous current facts. People might hope to use their wealth to buy things in the future, but it can’t work for everyone at once. We couldn’t all spend all our wealth tomorrow, the way we do our incomes—who would suddenly conjure up all the stuff we would want to purchase?
Moreover, unlike total income, which is simply the sum of everyone’s earnings, total wealth isn’t the sum of everyone’s expectations.. Rather, the value of the assets in which our wealth reposes reflects a few transactions and the expectations of their specific buyers and sellers. All apartments and houses are appraised at values set by the prices of the few that are actually sold. Thus during the Japanese housing bubble in the 1980s, the grounds of the Imperial Palace were claimed to be worth more than the value of all the real estate in California, when neither the Imperial Palace ground nor all the real estate in California was actually being sold.
How beliefs have changed
In earlier times, the ephemeral nature of wealth encouraged attention to the stream of hard cash that it could be counted on to provide. Anxious mothers deemed Mr. Darcy a prize catch in Pride and Prejudice because of the £10,000 plus income his assets provided each year, rather than value of the assets producing the income. Bonds were purchased for their coupons and property for rents received or avoided. Stocks were considered a prudent investment only to degree that they paid dividends large enough to compensate for their volatile prices.
Nowadays, the prevailing orthodoxy couldn’t be more different. Safe, income-producing bank deposits and bonds, we are warned, shrink with inflation whereas assets that provide little to no income such as stocks, commodities, art, collectibles and prize properties more than hold their value, appreciating faster than the economy as a whole.
The notion that we can all become rich Millionaires Next Door simply by investing in assets once considered risky is backed up by extensive historical data. But successful investment strategies invariably fizzle after they are widely imitated: To expect that stocks and other risky assets will continue to provide their historically outsized returns for all investors requires implausible assumptions. Crucially, it requires happy surprises—developments that are not already “in the market” when we buy—to boost the prices of our assets at a rate faster than the economy as a whole.
Consider for instance Facebook whose stock market valuation of $157 billion amounts to nearly 80 times the company’s profits, or Twitter now valued by the stock market at nearly $18 billion though it has no profits at all. It is conceivable that these companies could eventually make profits more in line with their stock prices or perhaps even pay dividends. Supposing that now opportunities, not incorporated in already heady valuations, will arise that justify further appreciation of Twitter and Facebook’s stock prices requires a considerable leap of faith however. And the notion that this happy fate will forever befall the average company so its profits continually beat expectations beggars the imagination.
On occasion, the prices of most stocks certainly can rise much faster than GDP because investors started out being too pessimistic. After deeply gloomy times, say after the crash of 1987 or 2008, stocks may appreciate rapidly because investors are relieved that the world did not end. But expectations aren’t usually depressed and brokers and advisers are paid to sell sunny futures. It is hard to imagine that overall expectations would normally be too low.
Similarly, luck—or exceptional talent—may make some investors rich. But luck can also quickly evaporate large fortunes—ask Eike Batista who recently lost more than 98% of his $30 billion fortune in less than two years. And even if the rich can protect lucky or hard-earned fortunes, luck or effort cannot create a Lake Woebegone state in which everyone enjoys exceptional returns.
The dangers of Pollyanna-ish delusions
The fantasy that we can all invest in a share of rapidly appreciating wealth when the economy just plods along poses a real threat. Even after recent downward revisions, most public and many private pension plans assume they will earn between 7% to 8% a year for the foreseeable future. That’s more than twice the rate of most estimates of long-term economic growth. These rosy assumptions allow cash-strapped governments to minimize their contributions to pension plans, but in so doing set the stage for a widespread, Detroit-like crisis.
Magical thinking about house prices also poses hazards. In deciding whether to rent or buy a home, especially in desirable locations, people routinely factor in robust appreciation in prices—and dismiss the possibility of declines. After several years of double-digit gains that have made renting a more compelling choice in places like Cambridge and Manhattan, buyers expect appreciation without end because “everyone wants to live there.” Few ask why that desire might have intensified in the last few years—and whether it will continue to intensify.
Indiscriminate buying, whether of stocks, commodities, or houses, stoked by expectations of ever increasing prices helps create bubbles. Manias stoked by cunning practice will always be with us, but typically they are well separated by time and space. The British Railway mania of the 1840s came more than a century after the South Sea Bubble of 1720. Nearly four decades elapsed between the Great Crash that ended the Roaring Twenties and the Nifty Fifty nuttiness of the late 1960s and early 1970s. Thanks to a virtually institutionalized “can’t lose” mindset, the current debacles have been much more closely spaced. Just eight years separated the internet blowup and the 2008 housing meltdown. Commodities then soared and collapsed in two years after that.
Bubbles inflated by thoughtless buying can provide a bonanza for the exceptionally lucky or enterprising. John Paulson made almost $4 billion as the housing bubble collapsed. The social media bubble has made the founders and early investors of the likes of Twitter, WhatsApp and Zynga make fortunes that took the founders of Federal Express, Wal-Mart, Apple, Microsoft, and Dell decades to accumulate. But bubble-based windfalls for a few come at the expense of losses incurred by many.
Partisans argue that financial systems that channel savings into risky investments are an essential feature of an advanced economy: compare, they say, the US economy with China’s or Russia’s. The US financial system is certainly more sophisticated, but it has long been so. And, the expansion of finance in recent decades doesn’t seem to have turbo-charged the economy; as financiers have channeled more funds into risky investments, growth in overall incomes and productivity has if anything flagged, while the compensation of financiers, never paltry, has unmistakably jumped.
Others claim that the mindless investing that inflates bubbles is a desirable feature, not a defect, of modern capitalism because it leaves behind valuable technologies and infrastructure. The tech bubble for instance is said to have financed Amazon’s revolutionary retailing model and huge investments in internet connectivity. But these residues do not justify the havoc that manias leave in their wake any more the technological advances they can catalyze to justify wars. And as the examples of Wal-Mart and the personal computer revolution show, great transformations don’t require mindless investment.
How government has promoted Piketty-esqe fantasies
Our government’s complicity in these investment fantasies is long-standing and manifold. The US Federal Reserve’s failure to control inflation in the 1970s eroded investors’ faith in bonds and bank deposits while pension rules and regulators encouraged a shift to stocks and other higher risk assets. Until 1968, for example, public funds in California and 15 other states did not own any stocks. The state laws prohibiting stock purchases were then repealed. Rules intended to ensure that pension plans were properly funded encouraged state and other pensions to buy stocks that are thought to have greater upside than bonds. Now, 65% of public funds are invested in stocks, real estate and other alternative investments.
Securities laws enacted during the New Deal and their vigorous enforcement have made buying and trading stocks respectable. Previously and for much of America’s history, “the public reaction to the stock market was one of general distrust.” Shady activities were rampant through the nineteenth century, and in the early twentieth century, the stock market was still “a shadow world in which only the initiated could find their way.”
The Fed, established to prevent collapses in old-fashioned bank loans, has also become a stalwart supporter of stocks. Chairman Alan Greenspan created the impression that the Fed would do everything it could prevent stock prices from falling.
Government mortgage guarantees and purchases of mortgage-backed securities have turned millions of the not particularly well off into leveraged speculators in real estate. Earlier, bank regulators frowned upon mortgage lending, so until 1930 banks extended mortgages to borrowers who could pay off their loans in three years or less, while demanding 50% down payments.
These interventions may have been well-intentioned efforts to give everyone a share of the miraculous transformation of good economic growth into great wealth. But far from spreading the riches around, the government has bestowed great fortunes on a few who would otherwise merely have been prosperous. And promoting Wall Street’s self-serving fantasies has jeopardized the legitimacy of a capitalist system that provides great reward for great contribution.
People on Main Street, regardless of their political persuasion, recognize that the scale of the fortunes recently secured by a few do not map into a commensurate increase in their economic contribution. Piketty’s tax proposals and calculations are highly controversial. But even his harshest critics should give heed to why he has struck such a nerve.