A follow up of Solow review of Piketty

by Joshua Gans The Capital Creators: Piketty and Growth Theory discusses a point which will be much discussed.
"Thus, we could have a situation where r > or < g. r > g corresponded to having a relatively low capital stock whereas r < g corresponded to having a relatively high capital stock.

Those who have read Piketty will note that we run into an issue here. If one wanted to rationalise the Solow growth model with the data, Piketty argues that r > g most of the time (indicating the existence of scarce capital) except during the Great Depression and World War II (at least for Europe) and the 1950s (for the US) where correspondingly, the amount of capital would be relatively abundant. Maybe that is a classification issue (just which capital was productive when) but Piketty’s account and the Solow model do not appear to sit comfortably together. Indeed, Solow said as much when he argued that diminishing returns would eventually cause r to fall at a greater rate than g:[quote from Solow]

Before doing so, I wanted to point out that these implications of the Solow model for income and wealth distribution had been explored before. Luigi Pasinetti drew some of the chords together but it was aPhD student at MIT in the mid-1960s that was most obsessed about the implications of the Solow model for income distribution. What the young Joseph Stiglitz found in a paper subsequently published inEconometrica was that there were actually strong forces bringing about a more equal distribution of income but that there was also the possibility of a steady state growth trap that had with it an associated increasing inequality of income as the capital share of income grew. This happened when the capital to labour ratio was relatively low. There is certainly a plausible case that the US in the 1950s found itself on the good steady state and that something has shifted it to the bad steady state today.

Piketty did not refer to this work and the papers that followed it at all. That is one of the costs of bypassing the system. But that is too bad because, if he did, he would have seen that Stiglitz justified the very sort of taxes Piketty is now advocating and demonstrated how they might be employed to both bring about a more equal income and wealth distribution and a higher rate of growth. Instead, Piketty has been left open to the fair criticism that his proposed wealth tax is simplistic and not thought out. By contrast, there was past research that did some of this work.

Actually, it is worth noting here that Piketty does more than not use theory to justify his approach, predictions and policy recommendations. He argues (at least in my reading) that he shouldn’t be required to do so. That is one of the benefits of being less restricted but it comes at considerable cost. One cost is that without theory, it is hard to justify both predictions of the future and also policy recommendations and their likely effects (another form of prediction). Only theory can help make that argument and help us understand what we need to know in order to act.

But the other cost is that theory helps ensure that our explanation of the past is internally consistent. As noted earlier, Piketty’s argument relies on there being a lack of diminishing returns to capital. The alternatives are obvious — increasing returns to capital as my co-blogger Erik Brynjolfsson has been arguing for so forcefully recently. In other words, Piketty’s argument requires there to be capital creators — that is, people who find ways to deploy the wealth of the rich in ways that forestalls the otherwise likely effect of diminishing returns. But who are the capital creators and, if they are there, aren’t they also likely to be the ones increasing g? Put simply, if you don’t believe in diminishing returns, how is it that you are also pessimistic about the long-run rate of growth? It seems to me there is an inconsistency here."