Does Inequality Hinder Economic Growth?


Thomas Piketty argues economic inequality is an obstacle for economic growth in his latest book Capital and Ideology. Justin Kempf reflects on the implications of this idea as he works to develop his own ideas of economics compatible with a political theory of democracy.

An Institutional Theory of Economics

It has never been clear for me where the line belongs between the political, economic, and social spheres of society. They run together and overlap. Economics is often political, while purely social aspects of life can easily become economic or political. Consequently, economics does not begin much differently than an analysis of politics or culture. Every economy is based on a series of institutions guided by norms of behavior. 

The discipline of economics takes both the market and the state for granted. But the market itself is a series of institutions which exist in an environment of widely accepted norms of behavior. Markets break down when these norms are absent. For example, Francis Fukuyama has emphasized the importance for trust for the development of economic and political organizations. Obviously these norms can evolve and change. Indeed, markets are often the catalyst for change. Modernization has often relied on markets to produce monetary incentives to encourage the ruthless efficiency evident in contemporary culture. 

Economic institutions exist all around us. Stock markets, corporations, and internships are all examples of economic institutions. Some institutions rely on formal organizations like corporations or firms. Others are taken for granted as necessary to organize behavior like an office environment. But like political institutions, economic institutions give meaning and purpose to human relationships. Sometimes they establish authority. But they always have their own peculiar rules and behaviors specific to them.

Institutions as Infrastructure

Institutions are the infrastructure of society. They are built upon each other to create increasingly complex ways of organizing human activity. The state establishes the infrastructure necessary for an independent market to thrive. The courts, roads, and schools are examples where the state provides public goods necessary for the private market to thrive. Neoliberals too often focus on the moments when the state has overreached. Of course, sometimes neoliberals have falsely believed the state was unnecessary only to discover critical regulations were necessary to maintain stability within markets. 

Nonetheless, the state does provide key public goods the private sector relies upon for their business. The state fosters the foundations of the economy, while the private sector is an extension of this critical foundation. Roads are a perfect example where the state provides a network of transportation throughout the community. Local governments build roads that connect parts of the community few people travel. Some libertarians have actually advocated for the privatization of roads. But even the roads where tolls exist are viable only because of the network of less profitable corridors to encourage transportation. 

Businesses depend on the infrastructure the state provides. UPS and FEDEX would not exist unless the state connects communities and residents through roads and other forms of transportation. The internet was largely developed by the American military., but today the largest companies in the world are built upon the world wide web. None of them would have considered a project so ambitious as the internet simply so they could develop the services they now market. The private sector is an extension of public infrastructure. Market economies cannot develop unless the state offers a foundation for its development. 

Economies as a Web of Infrastructure

Nonetheless, the state is not alone in the construction of infrastructure. All institutions, including corporations and firms, represent forms of infrastructure. For instance, a local economy is a network of business connections. The disappearance of a large factory from a small town demonstrates how interdependent each business is upon each other. The closure of a major factory leads to the loss of residents, restaurants close, and services disappear. The smaller manufacturers who supplied the larger factory may close or relocate accelerating the economic decay. Economic infrastructure builds upon itself. Each new business relies on a network of suppliers, employees, and customers to remain viable. 

The digital economy has exploded as foundations have become secure. The dominance of Google, Amazon, Facebook, and others have kept competitors out of the market, but they have also offered the stability for new companies to develop based on their foundations. Many companies depend on search engine optimization and social networking to communicate their messages. Other companies rely on Amazon for distribution or cloud services. 

New Interpretations of Valuation

Thomas Piketty largely overlooks the importance of networks and infrastructure in his understanding of economics. He is almost a Marxist in his materialism. For instance, he measures the capital assets of the state purely in physical manifestations like the value of buildings. In business terms, he emphasizes book value over market value. Few investors put much weight on book value unless they plan to dismantle a firm and sell off its physical assets. The value of any firm is typically found in its nonphysical assets. The production of a good or service relies on the contributions of many people. The networks necessary to connect suppliers, production, and channels for distribution to customers are not easily replicated. 

Karl Marx, of course, saw capitalism as a centralization of wealth through a control of the means of production. But the gig economy has shown this insight was misplaced. Uber does not own its drivers’ cars. It controls the infrastructure necessary to connect drivers to customers. The service economy has many other examples. Lawyers do not depend on law firms to practice law. Many lawyers establish independent practices. But the firm offers value for lawyers through its ability to acquire clients and offer regular work. Its value is not found in physical assets, but its organization.

How to Value the State

Piketty underestimates the value of the state when he focuses on its possession of physical assets to calculate its wealth. The value of a school is not its building or property, but its ability to facilitate education through its teachers, students, and its traditions. It is important to properly understand valuation, because it helps distinguish between expenses and investments. The difference between the two is not minor. It changes the perspective on allocation of resources. An expense pays for an activity, but its value is expended. An investment retains its value and appreciates over time.

Conservatives often ask government to run like a business, while liberals largely oppose this idea. But neither truly appreciate the implications of this idea. Successful businesses understand the difference between an expense and an investment. They look for opportunities to make investments, while they reduce expenses. A common aphorism is, ‘It takes money to make money.’ Many tech companies have taken this idea too far. WeWork is a classic example of a company who mischaracterized its expenses as investments. The strongest organizations find ways to turn expenses into investments and avoid making investments that turn into expenses. 

Bad Investments are Expenses, Good Expenses are Investments

Bad investments eventually become expenses. Accountants literally write off investments once their value is lost. The change is recorded on the income statement and the balance sheet even though no change is made to cash flow. But expenses are never reclassified as investments. The salary of the long-term employee who mentors future company leaders is classified the same as the salary of every unsuccessful hire. But they are not the same. The value some employees deliver lives on beyond their service to a company. Their legacy is better classified as an investment made through their salary than an expense. 

The value of public assets are difficult to assess because they are largely based on human capital. But their value is not simply the sum of the individual employees. Network effects compound the contributions of each public sector employee. The aim of the public sector is to produce common goods like a clean environment, national defense, and fair elections. These are real deliverables even if their value is dificult to calculate. The challenge for legislators and bureaucrats is to recognize the difference between investments and expenses in the public sector. Unfortunately, sometimes the difference is not clear between the two until the effects are felt years down the road. 

Economic Inequality

The problem of Inequality has captured the attention of economists in recent years. Among the most influential has been Piketty. Now it helps to recognize he does not argue economic inequality is ipso facto wrong. Nevertheless, he does not advocate for an acceptable amount of inequality either. He hints that the early postwar period of the fifties and sixties had acceptable levels of inequality, but even then it is offered as a comparison. It is not held up as the ideal. Nonetheless, Piketty does imply that he believes in a Rawlsian difference principle, yet he recognizes quite explicitly that his interpretation remains vastly different than neoliberal economists like Hayek.

Economic inequality is neither good nor bad in itself. It represents a centralization of resources. The creation of large, independent companies and firms rely on resources set aside for their construction. Constant and total redistribution would disrupt the formation of independent firms. Amazon and Facebook may never have been created had Jeff Bezos and Mark Zuckerberg had to unload their holdings in these companies regularly through aggressive redistribution. Inequality relies on savings. The term savings, of course, has many normative implications. The poor are blamed for their overconsumption, while the rich can easily save because their incomes are more than they can spend. The cause of savings here is not important. Its consequence is the creation of independent firms.

Inequality as a Challenge to Growth

On the other hand, too much centralization of wealth stifles creativity and dwindles the size of the market. The market naturally redistributes resources from investors to entrepreneurs to encourage startups. Henry Ford is said to have increased the pay for his workers to produce new customers for his cars. Indeed, it is not sustainable for wealth to remain in the hands of just a few individuals. Land redistribution has been a surprising spark for economic development throughout history. Indeed, an overzealous preoccupation with property rights can stifle economic development and growth. 

Piketty offers a strong refutation of the neoliberal case that ignores inequality to emphasize growth. But he does not offer reasons why. His case for reducing inequality is surprisingly normative for an economist. He does use empirical analysis to demonstrate the exacerbation of inequality. But his solutions are grounded in normative arguments. His perspective makes the publication of Capital and Ideology a natural evolution from Capital in the Twenty-First Century. His latest work argues the presence of inequality depends on ideological justifications. It is a natural insight because his own case for reducing inequality is also ideological. 

Nonetheless, Piketty recognizes how public policies designed to produce greater economic equality did not stifle economic growth. But he fails to explain why. It simply becomes a justification for policies designed to reduce inequality. Yet it is not clear whether inequality is a cause or a symptom of a different problem. Now Piketty does answer this challenge in his own fashion. He believes inequality is the cause of political ideology. But he fails to answer it as an economist. What is the relationship between economic (in)equality and economic growth?

Keynesianism Revisited

John Maynard Keynes offers a clearer answer in his General Theory of Employment, Interest, and Money. Keynes argued economic growth depends on greater economic dependence. Self-reliance reduced the potential for economic activity. The more people became engaged in the economy, the more they depended on services and goods from others. For example, two income households rely on childcare. Their economic production creates additional jobs for others in the formal economy. Keynesian economics looked to expand economic growth through increasing demand. Keynes understood capital formation was easier to accomplish for the market than developing demand.

Adam Smith and other classical economists believed wages could not pay below the amount necessary for subsistence. They assumed people had options outside the formal economy. But modernization erases all options outside the formal economy. During the eighteenth century, wage labor was an alternative to traditional work on the land. Traditional methods of subsistence farming do remain viable options in some places today. But subsistence farming disappears during the process of economic modernization and development. Without government assistance or charity, people in a fully modernized economy will find they have to accept the best wages they can find. Marx for his part found many factories did pay less than subsistence because of an overabundance of labor. 

Nonetheless, Keynes recognized the process of modernization remained incomplete even in fully developed economies. The development of new inventions and services drew people into the formal economy in new ways and produced economic growth. Keynes understood as people earned more money they became tied even closer to the formal economy. Money did not produce economic independence, but dependence. Nonetheless, this dependence also tied people closer to their community and society. It even produced cultural dynamism.

The State, Inequality, and Economic Growth

Neoliberalism, on the other hand, leads to an economic dead end because it believes economic investments depend on an overabundance of capital. This is a false assumption. Capital does not lead to investment. Today’s economy has plenty of capital. Venture capitalists compete to invest in new startups who fail to develop a path toward profitability. The economic challenge for the contemporary economy is not a paucity of capital. Interest rates for government debt is so low because investors have nowhere else to invest. 

Economic growth now relies on smart public investments. Investments into the environment, education, and even redistribution will produce new foundations for the private sector to develop. However, weak state investments will weaken the capacity for the private sector to develop. Some may argue socialism took state investments too far. But its deficiencies are not due to the size of the state. Socialism values the state’s economic role in its own right. It is not a means to develop a vibrant and dynamic economy. Rather it becomes the end in itself. Investments into the public sector do not require a turn to socialism. The private sector has always relied on an unspoken partnership with the state.

The public sector will determine the trajectory for the economy in the future. The revitalization of the private sector depends on the ability of economies to invest in public goods. But I diverge from Piketty because it is not enough to simply redistribute income and wealth or expand the state. The private sector explodes when the state makes sound investments in public goods. The debate between small and big government was always misguided. The future will rely on smart government. 

Related Content on Inequality

Jacob Hacker and Paul Pierson on the Plutocratic Populism of the Republican Party

Barbara Freese on Corporate Denial

Thoughts on Thomas Piketty’s Capital in the Twenty-First Century

One thought on “Does Inequality Hinder Economic Growth?

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  1. It appears that inequality leads to a capital surplus or a demand shortfall, which is reflected in negative interest rates. One can argue, for instance, that neoliberalism caused this. Capital income could grow at the expense of labour income. The shortfall was at first made up by borrowing. But at some point, borrowers can’t borrow more because of interest payments, so interest rates must go down. This dynamic might continue until interest rates are all in negative territory and the excess capital is redistributed. So, apart from government policies, the market might redistribute income too from capital owners to consumers.

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