Monday, 28 September 2015

Headwinds ahead for Piketty´s r>g?

Fast rewind some 40 years back:  The initial opening of China and India to world markets really became felt from the 1980s – a ‘one-off’ event that integrated 2 billion people or 40% of global labour force in the global market economy. The opening to trade increased the share of workers with basic education in the world labour force and lowered the world average capital/labour ratio. The relative endowments of other countries were thus shifted in the opposite directions, which tended to move their comparative advantage away from labour-intensive manufacturing (Wood and Mayer, 2012[1]).
The impact on real wages in advanced countries is easily captured in a simple Cobb-Douglas production function. With factor shares a third each for labour, capital, and Know How (Mankiw, Romer & Weil, 1992[2]), I had estimated that the mechanical opening impact on global real equilibrium wages was round 16.5% (Wolf, 2006[3]). A doubling of the global labour force with basic skills had halved labour productivity on impact; multiplied with the labour share of 0.33 produced the result[4]. Moreover, a sharp increase in the prime working age population added to the larger global labour force. The joint effect of the initial opening of the Asian giants and demographic factors pushed real wages lower and inequality much higher in the advanced economies.
Meanwhile, the drop in capital per labour combined with global imbalances supported corporate profits, capital returns and interest rates. Francis and Veronica Warnock had shown that international capital flows have an economically important effect on the most important price in the largest economy in the world, that of the ten-year U.S. Treasury bond[5]. Their analysis indicated that roughly two-thirds of the impact comes directly from East Asian sources. In addition, some of the foreign flows were owed to the recycling of metal- and petrodollars, as oil and metal exporters benefited from China´s motorization, urbanization and industrialization.
In his celebrated book[6], Thomas Piketty had established that capitalism had a fundamental force for divergence and greater wealth inequality, summed up in the inequality r>g. The formula relates the rate of return on capital (r) to the rate of economic growth (g), where r includes profits, dividends, interest, rents and other income from capital; g is measured in income (wages) or output. Note that Piketty in his book had conceded that the inert trend towards higher inequality was reversed between 1930 and 1975, due to some rather ´unique´ circumstances. Interestingly, 1975 coincides with the beginning of Shifting Wealth Phase I, which has come to an end a couple of years ago. Maybe, those circumstances that had disturbed that inert capitalist trend toward higher inequality were not that ´unique´, after all?
A new fascinating study headed by Charles Goodhart[7] marshal evidence to answer the question “Is Piketty history? We think so”.  The study focuses on the projected trajectory of global working age population (see Figure). Just as a larger labour pool pushed real wages lower and inequality up in the advanced countries, it is argued, a smaller labour force will lead to rising wages, a larger share of income for labour and a decline in inequality. The yearly rise in global working age population growth has peaked around 2005 at 70 million people; the rise is projected to drop to 30 million by 2040. China will actually face a shrinking labour force pool very soon, while Africa and India continue to see a rising labour force. Migration to advanced countries can dampen the positive wage effect but it must be massive (as in Germany currently).

Working Age Population, 1950 – 2040
yearly changes in million

Source: Morgan Stanley Research, based on UN Population Database

While the depressive impulse on wages is likely to attenuate as a result of changing labour force dynamics, the Morgan Stanley study foresees also an ageing-driven drop in capital returns. The advent of an ageing society will lead to a greater proportionate fall in personal saving than in personal sector investment (housing). The corporate sector is predicted to respond by raising the K/L ratio, i.e., by adding capital to compensate for the factor of production that is getting scarcer and more expensive. The overall rise in the K/L ratio, as the growth of the working population falls, is consistent with some decline in capital returns. However, interest rates are projected to rise as ageing lowers ex ante saving. As a result, the Piketty formula r>g might be replaced by w>r, with wages rise exceeding capital returns and inequality trends abating in advanced countries. Now that would run against against new conventional wisdom! 

[1] Wood, Adrian and Jörg Mayer, “Has China de-industrialized other developing countries?”, Review of World Economics, Vol. 147, 325 – 350.
[2] Mankiw, N.G., D. Romer and D.W. Weil (1992), “A Contribution to the Empirics of Growth”, Quarterly Journal of Economics, Vol. 107.2, May, pp. 407 - 437.
[3] Wolf, Martin (2006), „Answer to Asia´s rise is not to retreat“, Financial Times, 14 March. Martin cites slides of my Basel University lectures.
[4] δw* = δY/L = 1/3(-0,5) = 0,165, derived from Y = αL (1)K;  with δK/L = -0,5; L/Y = 1/3.
[5] Warnock, F. and V. Warnock (2006), “International Capital Flows and U.S. Interest Rates”, NBER Working Paper No. 12560, October.
[6] Piketty, Thomas (2013), Le capital au XXIe siècle, Paris: éditions du Seuil, August.
[7] Goodhart, C., M. Pradhan and P. Pardeshi (2015), Could Demographics Reverse Three Multi-Decade Trends?, Morgan Stanley Research, Global Issues, 15 September. Thanks to Prof. Goodhart for providing me with a copy.


  1. Very interesting post. I just wonder how long it takes all these trends to play out. Also to see some real wage inflation in Japan, which appears to only just getting started and no real change in LT bong yields

  2. Re the following quote...
    Interestingly, 1975 coincides with the beginning of Shifting Wealth Phase I, which has come to an end a couple of years ago

    Could you provide a link to this Phase I reference?

    Thank you!

  3. Hi Helmut Reisen, great discussion on "Headwinds ahead for Piketty´s r>g". You have nicely discussed about the issue. I am studying on finance management for Holborn Assets but stumbled here on shiftingwealth. Thanks.