Piketty’s miss­ing knowhow

Financial Mirror (Cyprus) - - FRONT PAGE -

The­o­ret­i­cal frame­works are great be­cause they al­low us to un­der­stand fun­da­men­tal as­pects of a com­plex world in much sim­pler terms, just as maps do. But, like maps, they are use­ful only up to a point. Road maps, for ex­am­ple, do not tell you cur­rent traf­fic con­di­tions or pro­vide up­dates on high­way re­pairs.

A use­ful way to un­der­stand the world’s econ­omy is the el­e­gant frame­work pre­sented by Thomas Piketty in his cel­e­brated book Cap­i­tal in the Twenty-First Century. Piketty splits the world into two fun­da­men­tal sub­stances – cap­i­tal and la­bor. Both are used in pro­duc­tion and share in the pro­ceeds.

The main distinc­tion be­tween the two is that cap­i­tal is some­thing you can buy, own, sell, and, in prin­ci­ple, ac­cu­mu­late with­out limit, as the su­per-rich have done. La­bor is the use of an in­di­vid­ual ca­pac­ity that can be re­mu­ner­ated but not owned by oth­ers, be­cause slav­ery has ended.

Cap­i­tal has two in­ter­est­ing fea­tures. First, its price is de­ter­mined by how much fu­ture in­come it will bring in. If one piece of land gen­er­ates twice as much out­put in terms of bushels of wheat or commercial rent as an­other, it should nat­u­rally be worth dou­ble. Other­wise, the owner of one par­cel would sell it to buy the other. This no-ar­bi­trage con­di­tion im­plies that, in equi­lib­rium, all cap­i­tal yields the same riskad­justed re­turn, which Piketty es­ti­mates his­tor­i­cally at 4-5% per year.

The other in­ter­est­ing fea­ture of cap­i­tal is that it is ac­cu­mu­lated through sav­ings. A per­son or coun­try that saves 100 units of in­come should be able to have a yearly in­come, in per­pe­tu­ity, of some 4-5 units. From here, it is easy to see that if cap­i­tal were fully rein­vested and the econ­omy grew at less than 4-5%, cap­i­tal and its share of in­come would be­come larger rel­a­tive to the econ­omy.

Piketty ar­gues that, be­cause the world’s rich coun­tries are grow­ing at less than 4-5%, they are be­com­ing more un­equal. This can be dis­cerned in the data, though in the United States a large part of the in­crease in in­equal­ity is due not to this logic but to the rise of what Piketty calls “su­per-man­agers,” who earn ex­tremely high salaries (though he does not tell us why).

So let us ap­ply this the­ory to the world to see how well it fits. In the 30 years from 1983 to 2013, the US bor­rowed from the rest of the world in net terms more than $13.3 trln, or about 80% of one year’s GDP. Back in 1982, be­fore this pe­riod started, it was earn­ing some $36 bln from the rest of the world in net fi­nan­cial in­come, a prod­uct of the cap­i­tal that it had pre­vi­ously in­vested abroad.

If we as­sume that the re­turn on this cap­i­tal was 4%, this would be equiv­a­lent to own­ing $900 bln in for­eign cap­i­tal. So, if we do the ac­count­ing, the US to­day must owe the rest of the world roughly $12.4 trln (13.3 mi­nus 0.9). At 4%, this should rep­re­sent an an­nual pay­ment of $480 bln. Right?

Wrong – and by a long shot. The US pays noth­ing in net terms to the rest of the world for its debt. In­stead, it earned some $230 bln in 2013. As­sum­ing a 4% yield, this would be equiv­a­lent to own­ing $5.7 trln in for­eign cap­i­tal. In fact, the dif­fer­ence be­tween what the US “should” be pay­ing if the Piketty cal­cu­la­tion was right is about $710 bln in an­nual in­come, or $17.7 trln in cap­i­tal – the equiv­a­lent of its yearly GDP.

The US is not the only ex­cep­tion in this mis­cal­cu­la­tion, and the gaps are sys­tem­atic and large, as Fed­erico Sturzeneg­ger and I have shown.

At the op­po­site ex­treme are coun­tries such as Chile and China. Chile has bor­rowed lit­tle in net terms for the past 30 years, but pays to the rest of the world as if it had bor­rowed 100% of its GDP. China has lent to the rest of the world, in net terms, over the last decade, about 30% of its an­nual GDP but gets pretty much noth­ing for it. From the point of view of wealth, it is as if those sav­ings did not ex­ist.

What is go­ing on? The sim­ple an­swer is that things are not made just with cap­i­tal and la­bor, as Piketty ar­gues. They are also made with knowhow.

To see the ef­fect of this omis­sion, con­sider that Amer­ica’s net bor­row­ing of $13 trln dra­mat­i­cally un­der­states the ex­tent of gross bor­row­ing, which was more like $25 trln in gross terms. The US used $13 trln to cover its deficit and the rest to in­vest abroad.

This money is mixed with knowhow as for­eign di­rect in­vest­ment, and the re­turn to both is more like 9%, com­pared to the 4% or less paid to lenders. In fact, 9% on $12 trln is more than 4% on $25 trln, thus ex­plain­ing the ap­par­ent puzzle.

Chile and China put their sav­ings abroad with­out mix­ing them with knowhow – they buy stocks and bonds – and as a con­se­quence get just the 4-5% or less that Piketty as­sumes. By con­trast, for­eign in­vestors in Chile and China bring in valu­able knowhow; hence the gross cap­i­tal that flows in yields more than the gross sav­ings abroad. This re­turn dif­fer­en­tial can­not be ar­bi­traged away, be­cause one needs the knowhow to get the higher re­turns.

The point is that cre­at­ing and de­ploy­ing knowhow is an im­por­tant source of wealth cre­ation. Af­ter all, Ap­ple, Google, and Face­book are jointly worth more than $1 trln, even though the cap­i­tal orig­i­nally in­vested in them is a mi­nus­cule frac­tion of that.

Who gets to pocket the dif­fer­ence is up for grabs. Knowhow re­sides in co­her­ent teams, not in­di­vid­u­als. Ev­ery­body in the team is cru­cial, but out­side the team each in­di­vid­ual is worth much less. Share­hold­ers may want to take the dif­fer­ence as prof­its, but they can­not do with­out the team.

This is where the su­per-man­agers come in: they strive to pocket part of the value cre­ated by the team. Be­hind the growth of wealth and in­equal­ity lies not just cap­i­tal, but also knowhow.

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