Capital in the Twenty-First Century–Economic Fairy Tales from the Kuznets Curve to the Laffer Curve

In his masterwork on the subject of economic inequality, Capital in the Twenty-First Century, Thomas Piketty talks in his introduction about the pessimistic conclusions drawn by the nineteenth-century economists Marx and RicardoThe economic analysis of Marx and Ricardo concluded that income inequality would automatically increase in advanced phases of capitalist development.    Piketty discussed some of the reasons why their conclusions were incorrect, which I discuss in my previous post written on 11/9/2014.

Piketty turns his attention to the optimistic or fairy-tale conclusions drawn by a twentieth-century economist, Simon Kuznets, who believed that income inequality would automatically decrease in advanced phases of capitalist development, as summed up in the phrase “growth is a rising tide that lifts all boats.”   This optimism seems almost quaint during the present period of lopsided economic growth in the United States, where the rising tide only seems to be lifting yachts, whereas ordinary boats are left stranded.

The big difference between the nineteenth and twentieth-century economists was that the latter were able to rely on data sources (such as US federal income tax returns) rather than just arguing based on logical principles.   In 1953 Kuznets published Shares of Upper Income Groups in Income and Savings, which dealt with the United States over a period of thirty-five years from 1913-1948.   Based on the income tax data, he was able to measure inequality in income distribution and to gauge its evolution over time.

His findings were that there was a sharp reduction in income inequality in the United States between 1913 and 1948.   So the top 10 percent of US earners claimed 45-50% of the annual national income in the period right after World War I, but that share had decreased to 30-35% in the period right after World War II.

What was the cause of the compression of high US income incomes in the period between 1913 and 1948?   Although he recognized it was due in large part to the multiple shocks to the US economic system delivered by the Great Depression and World War II, he claimed that inequality would follow a “bell curve”, called the “Kuznets curve”, which showed that inequality should first increase and then decrease over the course of industrialization and economic development.

His reasoning was that in the early phases of industrialization, only a minority of people are prepared to benefit from the new wealth that industrialization brings, but that as a larger and larger fraction of the population partakes of the fruits of economic growth, inequality automatically decreases.

In retrospect, however, Piketty believes that the “magical” Kuznets curve theory reflects an optimistic faith in the promise that all social groups would continue to share in the fruits of growth.   This stopped happening in the US in the 1970s for reasons which will be discussed later in the book.   The sharp reduction in income inequality that occurred between 1913 and 1948 was due to an “accident of history”, or actually two accidents, namely, the economic shock of the Great Depression and the military shock of World War II.

A similar fairy tale is found in the “Laffer Curve”, which was used in the Reagan administration to give an excuse to lower taxes on the rich, in the belief that rather than a rising tide lifting all boats, that the water lifting all boats would trickle down from above.   As Bill Murray’s homeless character remarked in a sketch on Saturday Night Live, optimism meant standing next to the gutter and waiting to be trickled on.    Such optimism is faith-based economics, as was Kuznets’ curve.   Liketty is trying to bring back the subject of income inequality to a reality-based study.

In the last part of his introduction, he previews what the conclusions are of his study.   This will be the subject of my next post on 11/30/2014.


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