Elasticity of Substitution

And now I've wrapped up the fourth book in my current series, tentatively titled "Completely Unrelated Books That I Happen To Be Reading Simultaneously For No Good Reason." This ends us on a strong nonfiction note with The Economics of Inequality, a relatively slim book on economic theory. It was written by Thomas Piketty in the 1990s, and was translated into English after the success of his later works.

Before reading this book, I saw some online reviews along the lines of "A good introduction to Piketty's ideas" and "More approachable than Capital in the Twenty-First Century." I have to disagree with those assessments. It's a good book and well-written, but also much more technical than his later books. It looks less intimidating thanks to being much shorter, but it's primarily written for other economists and doesn't have the easy flowing narration or friendly language of his doorstop books. Which is all to say that I'd recommend this for people who already like Piketty and are interested in the topic, not as a gateway to his other writing.

That said, I do recommend the book. I'd kind of expected it to be an introduction to his works on inequality or a rough early draft. Instead, it goes over different ground: while Cit21C and Capital & Ideology are primarily oriented towards explaining the origins of inequality and documenting how much it has risen, The Economics of Inequality is focused on finding the best tools for reducing inequality: what specific policies governments or society should take to make life more equitable for its citizens.

Reading this book was a little trippy at times: it was written in the 1990s, but pays a lot of attention to ideas that I personally have only more recently become aware of. There's a lot of focus on social justice, which is closely tied to but not synonymous with equality. Later in the book he writes at some length about universal basic income; even at the time the idea was several decades old, but at least here in the states it's only relatively recently that it's come to the forefront of political dialogue.

TEoI starts relatively slow with a chapter that mostly recaps (or, I guess, precaps) the idea of deciles and centiles from Cit21C. Piketty gives a pretty thorough explanation of what these segments mean and how they are calculated; having read over two thousand pages from Piketty this level of explanation felt a bit overlong, but it was probably very important to readers back then, and it may even be a better introduction now for new readers than his more recent books.

Things really start moving in Chapter 2. As we've been discussing since at least Marx, the main problem is that workers tend to receive relatively little from their labor while owners tend to receive large amounts, which results in wealthy people growing even wealthier over time while the working poor tend to remain poor. This is historically called the "labor/capital split", namely, how much of the revenue generated by economic activity should be paid as wages to labor versus how much should be collected as profit to owners. Historically the focus has been on "direct redistribution", where laws or labor action forces the owners to convert some additional profit back into wages. This works if labor and capital aren't very elastic: that is, if you always need X workers per Y machines in order to create Z output, then as long as the owners still earn some profit you can happily increase the workers' wage.

But Piketty finds that in practice labor and capital are elastic, especially as the economy evolves to be more service-oriented. There is a high "elasticity of substitution", which means that to some degree you can replace workers with machines or vice versa. (One periodic, mild point I tend to stumble over is the overloading of the world "capital" in these books. The classical definition of "capital" is "something that is used in production without being consumed", like a hammer or a factory. But its more prevalent modern form is basically a synonym for "wealth", like shares of stock or an interest-bearing loan. In this specific case Piketty is referring to the economic capital, while elsewhere he is referring to financial capital.) What is the implication of a high elasticity of substitution? If the price of labor rises, then owners will try to eliminate jobs and replace them with machines. We're seeing this happen now with self-check-out lanes in supermarkets; those machines are very expensive to install and somewhat expensive to operate, but they don't require health-care benefits or wages. This will reduce the amount of revenue flowing to wages, which automatically increases the share going to the owners.

Piketty argues that instead of direct redistribution tactics, like requiring owners to pay for benefits, we should use fiscal redistribution. This means taxing owners (well, everyone really, but owners pay the most) based on the profits they earn, and then use those revenues to transfer wealth to the lower-income people of the country, in the form of direct payments or social programs or education. This accomplishes the game goals as direct redistribution, as it is taking money from the rich and giving it to the poor, but importantly it decouples the tax burden from the use of labor. An owner who earns $1M a year will owe the exact same tax whether they employ 0 workers, 10 workers or 100 workers. So there is no added incentive for the owner to downsize.

Reading this was a little surprising, mostly because it's probably the clearest contemporary argument I've read for old-school capital-L Liberalism. The idea of collecting lots of taxes to accomplish social goals was dominant in the mid-century, but seems to be universally derided today, with the right obviously hostile towards any redistribution (and often believing that the poor deserve their lot due to inferior work ethics) and the left today much more energized by progressivism, which generally seeks a small but strong state that compels actors to behave well rather than a large state directly facilitating social transfers.

Piketty backs up his arguments with the same sort of comparative analysis he uses in his later books, particularly focusing on France, the United States, United Kingdom and Germany for the last 130 years or so. This allows us to see what aspects remain consistent over time, and how other elements trend one direction or another based on policies. He notes in the foreword and a footnote where some specific statements may not be accurate; in particular, in the book's original text he observed that the labor share is consistently about 2/3 of GDP, but further research since then has shown that this share has declined since the 1980s. That doesn't invalidate his point, but it adds more nuance (which, now that I think about it, is one of the big thrusts of Capital & Ideology.)

As with his other books, Piketty carefully distinguishes between income and wealth. At the time he was writing this book in the 90s, income was the biggest driver of inequality: after a long period where the richest 10% of people in a country would earn about 2.5x the average wage, it had climbed to about 3.8x the average (and of course would continue to rise in later decades). After looking at after-the-fact redistribution, he then focuses on how and why wages have diverged so much. An early topic is education, sometimes called "human capital", which he mentions in his other books but is more of a focus here.

It takes time and money to acquire skills that you hope will increase your income. In an ideal world, everyone would have meaningful access to acquire these skills so they can eventually perform the jobs that they are best suited for. In practice, though, the wealthiest people from high-status backgrounds will be able to complete their educations and get great jobs, continuing their privilege down to the next generation. People from poorer backgrounds may do even better at those jobs, but they don't get those opportunities: they can't afford a four-year degree, or fear going into debt, or are mindful of the risks they will bear without money or connections to backstop potential failure. There's an obvious social-justice component to this problem: it is unfair that people who are already advantaged increase their advantages. But there's also an argument to make on the basis of pure economic efficiency. If the entire labor force de-facto had access to education, then the best people would end up in the right roles, and the economy as a whole would be more productive.

There are some really interesting specific examples Piketty looks at. In Germany, many large employers fund apprenticeship programs and trade schools, free of charge to anyone who enrolls. And there's no requirement that someone completing the free program has to work for the company that paid for their education. Why do employers pay for these programs, then? It's because Germany's strong labor unions have negotiated strict wage schedules across the entire industry, so the same position pays the same wage at every company, so there's no incentive for a worker to take free training from one company and then switch to another for paid employment.

This sort of scheme almost certainly wouldn't work in the United States. Even by the 90s we had seen two decades of wage competition between companies, causing bidding wars that drove up the prices of managers, doctors, lawyers and other high-income people. So, for example, a hospital here wouldn't want to underwrite the cost of a doctor's medical training, because that doctor could and probably would leave to work for a higher-paying clinic.

France was outraged to learn that it was rated the "least egalitarian" country. France prides itself on giving all citizens access to a public education, but in practice the elite (children of managers, politicians, etc.) go to elite schools, and the state spends 10x as much per student in an elite school as it does on a non-elite school. There's a big gap between the ideals of an education system and the reality of who benefits and why. Germany doesn't make the same lofty claims as France, but in practice the German system is more egalitarian.

 As usual, Piketty is good at being precise about what he's talking about. Here he distinguishes between whether a course of action is good for social justice purposes, for economic efficiency, or both. Even though he shows in Chapter 2 that fiscal redistribution is preferable to direct redistribution, he notes that minimum wages are still important in many contexts, in particular in monopsony markets (where a single employer or group of employers artificially hold wages lower than they should be). Similarly, affirmative action policies help unlock the untapped potential of historically disadvantaged groups, which benefits the economy as a whole in addition to being morally just.

The US comes off pretty well in this book. It has its problems with rising inequality, but has done a better job at employing more workers at all levels than France. The Earned Income Tax Credit in particular receives praise for helping to fight the "U curve" of marginal rates (there's a "poverty trap" where someone who was previously unemployed and starts working finds their social benefits dramatically reduced, decreasing their incentive to take a low-paying job in the first place; the EITC compensates for this, and Piketty would like to see other changes like reducing or eliminating payroll taxes at low income levels). Of course, this book was written in the 90s before George W. Bush was "elected" and his tax cuts passed, which strangled the capacity for transfer payments, slashed the taxation of financial capital and places most of the burden on work instead of wealth. It's a bit disenheartening to think about where we might be at now if we hadn't taken that turn; still on a bad trend after Reagan, but the broad-based economic growth of the 90s might have continued longer instead of our rapid return to Gilded Age levels of inequality.

The book ends with this excellent conclusion: "Although it is essential to identify efficient redistribution wherever it exists, it is pointless to denounce every inequality as a sign of gross inefficiency that the right policy can eliminate. To do so is to delegitimize the taxes needed to finance fiscal transfers, which may not eliminate every imagined inequality but nevertheless help to attenuate very real inequalities in standards of living." I think this kind of sentiment is what I love and admire most about Piketty's writing. He isn't a cold realist or a starry-eyed idealist: he's a serious, practical and humble man who recognizes that perfection is impossible but we can certainly make things far better than they are now, and the tools to do so are absolutely within our grasp.