Some definitions of “capital” hold that the term should apply only to those components of wealth directly employed in the production process. For instance, gold might be counted as part of wealth but not of capital, because gold is said to be useful only as a store of value. Once again, this limitation strikes me as neither desirable nor practical (because gold can be a factor of production, not only in the manufacture of jewelry but also in electronics and nanotechnology). Capital in all its forms has always played a dual role, as both a store of value and a factor of production. I therefore decided that it was simpler not to impose a rigid distinction between wealth and capital.
Similarly, I ruled out the idea of excluding residential real estate from capital on the grounds that it is “unproductive,” unlike the “productive capital” used by firms and government: industrial plants, office buildings, machinery, infrastructure, and so on. The truth is that all these forms of wealth are useful and productive and reflect capital’s two major economic functions. Residential real estate can be seen as a capital asset that yields “housing services,” whose value is measured by their rental equivalent. Other capital assets can serve as factors of production for firms and government agencies that produce goods and services (and need plants, offices, machinery, infrastructure, etc. to do so). Each of these two types of capital currently accounts for roughly half the capital stock in the developed countries.
To summarize, I define “national wealth” or “national capital” as the total market value of everything owned by the residents and government of a given country at a given point in time, provided that it can be traded on some market.8 It consists of the sum total of nonfinancial assets (land, dwellings, commercial inventory, other buildings, machinery, infrastructure, patents, and other directly owned professional assets) and financial assets (bank accounts, mutual funds, bonds, stocks, financial investments of all kinds, insurance policies, pension funds, etc.), less the total amount of financial liabilities (debt).9 If we look only at the assets and liabilities of private individuals, the result is private wealth or private capital. If we consider assets and liabilities held by the government and other governmental entities (such as towns, social insurance agencies, etc.), the result is public wealth or public capital. By definition, national wealth is the sum of these two terms:
National wealth = private wealth + public wealth
Public wealth in most developed countries is currently insignificant (or even negative, where the public debt exceeds public assets). As I will show, private wealth accounts for nearly all of national wealth almost everywhere. This has not always been the case, however, so it is important to distinguish clearly between the two notions.
To be clear, although my concept of capital excludes human capital (which cannot be exchanged on any market in nonslave societies), it is not limited to “physical” capital (land, buildings, infrastructure, and other material goods). I include “immaterial” capital such as patents and other intellectual property, which are counted either as nonfinancial assets (if individuals hold patents directly) or as financial assets (when an individual owns shares of a corporation that holds patents, as is more commonly the case). More broadly, many forms of immaterial capital are taken into account by way of the stock market capitalization of corporations. For instance, the stock market value of a company often depends on its reputation and trademarks, its information systems and modes of organization, its investments, whether material or immaterial, for the purpose of making its products and services more visible and attractive, and so on. All of this is reflected in the price of common stock and other corporate financial assets and therefore in national wealth.
To be sure, the price that the financial markets sets on a company’s or even a sector’s immaterial capital at any given moment is largely arbitrary and uncertain. We see this in the collapse of the Internet bubble in 2000, in the financial crisis that began in 2007–2008, and more generally in the enormous volatility of the stock market. The important fact to note for now is that this is a characteristic of all forms of capital, not just immaterial capital. Whether we are speaking of a building or a company, a manufacturing firm or a service firm, it is always very difficult to set a price on capital. Yet as I will show, total national wealth, that is, the wealth of a country as a whole and not of any particular type of asset, obeys certain laws and conforms to certain regular patterns.
One further point: total national wealth can always be broken down into domestic capital and foreign capital:
National wealth = national capital = domestic capital + net foreign capital
Domestic capital is the value of the capital stock (buildings, firms, etc.) located within the borders of the country in question. Net foreign capital—or net foreign assets—measures the country’s position vis-à-vis the rest of the world: more specifically, it is the difference between assets owned by the country’s citizens in the rest of the world and assets of the country owned by citizens of other countries. On the eve of World War I, Britain and France both enjoyed significant net positive asset positions vis-à-vis the rest of the world. One characteristic of the financial globalization that has taken place since the 1980s is that many countries have more or less balanced net asset positions, but those positions are quite large in absolute terms. In other words, many countries have large capital stakes in other countries, but those other countries also have stakes in the country in question, and the two positions are more or less equal, so that net foreign capital is close to zero. Globally, of course, all the net positions must add up to zero, so that total global wealth equals the “domestic” capital of the planet as a whole.
The Capital/Income Ratio
Now that income and capital have been defined, I can move on to the first basic law tying these two ideas together. I begin by defining the capital/income ratio.
Income is a flow. It corresponds to the quantity of goods produced and distributed in a given period (which we generally take to be a year).
Capital is a stock. It corresponds to the total wealth owned at a given point in time. This stock comes from the wealth appropriated or accumulated in all prior years combined.
The most natural and useful way to measure the capital stock in a particular country is to divide that stock by the annual flow of income. This gives us the capital/income ratio, which I denote by the Greek letter β.
For example, if a country’s total capital stock is the equivalent of six years of national income, we write β = 6 (or β = 600%).
In the developed countries today, the capital/income ratio generally varies between 5 and 6, and the capital stock consists almost entirely of private capital. In France and Britain, Germany and Italy, the United States and Japan, national income was roughly 30,000–35,000 euros per capita in 2010, whereas total private wealth (net of debt) was typically on the order of 150,000–200,000 euros per capita, or five to six times annual national income. There are interesting variations both within Europe and around the world. For instance, β is greater than 6 in Japan and Italy and less than 5 in the United States and Germany. Public wealth is just barely positive in some countries and slightly negative in others. And so on. I examine all this in detail in the next few chapters. At this point, it is enough to keep these orders of magnitude in mind, in order to make the ideas as concrete as possible.10
The fact that national income in the wealthy countries of the world in 2010 was on the order of 30,000 euros per capita per annum (or 2,500 euros per month) obviously does not mean that everyone earns that amount. Like all averages, this average income figure hides enormous disparities. In practice, many people earn much less than 2,500 euros a month, while others earn dozens of times that much. Income disparities are partly the result of unequal pay for work and partly of much larger inequalities in income from capital, which are themselves a consequence of the extreme concentration of wealth. The average national income per capita is simply the amount that one could distribute to each individual if it were possible to eq
ualize the income distribution without altering total output or national income.11
Similarly, private per capita wealth on the order of 180,000 euros, or six years of national income, does not mean that everyone owns that much capital. Many people have much less, while some own millions or tens of millions of euros’ worth of capital assets. Much of the population has very little accumulated wealth—significantly less than one year’s income: a few thousand euros in a bank account, the equivalent of a few weeks’ or months’ worth of wages. Some people even have negative wealth: in other words, the goods they own are worth less than the debts they owe. By contrast, others have considerable fortunes, ranging from ten to twenty times their annual income or even more. The capital/income ratio for the country as a whole tells us nothing about inequalities within the country. But β does measure the overall importance of capital in a society, so analyzing this ratio is a necessary first step in the study of inequality. The main purpose of Part Two is to understand how and why the capital/income ratio varies from country to country, and how it has evolved over time.
To appreciate the concrete form that wealth takes in today’s world, it is useful to note that the capital stock in the developed countries currently consists of two roughly equal shares: residential capital and professional capital used by firms and government. To sum up, each citizen of one of the wealthy countries earned an average of 30,000 euros per year in 2010, owned approximately 180,000 euros of capital, 90,000 in the form of a dwelling and another 90,000 in stocks, bonds, savings, or other investments.12 There are interesting variations across countries, which I will analyze in Chapter 2. For now, the fact that capital can be divided into two roughly equal shares will be useful to keep in mind.
The First Fundamental Law of Capitalism: α = r × β
I can now present the first fundamental law of capitalism, which links the capital stock to the flow of income from capital. The capital/income ratio β is related in a simple way to the share of income from capital in national income, denoted α. The formula is
α = r × β
where r is the rate of return on capital.
For example, if β = 600% and r = 5%, then α = r × β = 30%.13
In other words, if national wealth represents the equivalent of six years of national income, and if the rate of return on capital is 5 percent per year, then capital’s share in national income is 30 percent.
The formula α = r × β is a pure accounting identity. It can be applied to all societies in all periods of history, by definition. Though tautological, it should nevertheless be regarded as the first fundamental law of capitalism, because it expresses a simple, transparent relationship among the three most important concepts for analyzing the capitalist system: the capital/income ratio, the share of capital in income, and the rate of return on capital.
The rate of return on capital is a central concept in many economic theories. In particular, Marxist analysis emphasizes the falling rate of profit—a historical prediction that turned out to be quite wrong, although it does contain an interesting intuition. The concept of the rate of return on capital also plays a central role in many other theories. In any case, the rate of return on capital measures the yield on capital over the course of a year regardless of its legal form (profits, rents, dividends, interest, royalties, capital gains, etc.), expressed as a percentage of the value of capital invested. It is therefore a broader notion than the “rate of profit,”14 and much broader than the “rate of interest,”15 while incorporating both.
Obviously, the rate of return can vary widely, depending on the type of investment. Some firms generate rates of return greater than 10 percent per year; others make losses (negative rate of return). The average long-run rate of return on stocks is 7–8 percent in many countries. Investments in real estate and bonds frequently return 3–4 percent, while the real rate of interest on public debt is sometimes much lower. The formula α = r × β tells us nothing about these subtleties, but it does tell us how to relate these three quantities, which can be useful for framing discussion.
For example, in the wealthy countries around 2010, income from capital (profits, interests, dividends, rents, etc.) generally hovered around 30 percent of national income. With a capital/income ratio on the order of 600 percent, this meant that the rate of return on capital was around 5 percent.
Concretely, this means that the current per capita national income of 30,000 euros per year in rich countries breaks down as 21,000 euros per year income from labor (70 percent) and 9,000 euros income from capital (30 percent). Each citizen owns an average of 180,000 euros of capital, and the 9,000 euros of income from capital thus corresponds to an average annual return on capital of 5 percent.
Once again, I am speaking here only of averages: some individuals receive far more than 9,000 euros per year in income from capital, while others receive nothing while paying rent to their landlords and interest to their creditors. Considerable country-to-country variation also exists. In addition, measuring the share of income from capital is often difficult in both a conceptual and a practical sense, because there are some categories of income (such as nonwage self-employment income and entrepreneurial income) that are hard to break down into income from capital and income from labor. In some cases this can make comparison misleading. When such problems arise, the least imperfect method of measuring the capital share of income may be to apply a plausible average rate of return to the capital/income ratio. At this stage, the orders of magnitude given above (β = 600%, α = 30%, r = 5%) may be taken as typical.
For the sake of concreteness, let us note, too, that the average rate of return on land in rural societies is typically on the order of 4–5 percent. In the novels of Jane Austen and Honoré de Balzac, the fact that land (like government bonds) yields roughly 5 percent of the amount of capital invested (or, equivalently, that the value of capital corresponds to roughly twenty years of annual rent) is so taken for granted that it often goes unmentioned. Contemporary readers were well aware that it took capital on the order of 1 million francs to produce an annual rent of 50,000 francs. For nineteenth-century novelists and their readers, the relation between capital and annual rent was self-evident, and the two measuring scales were used interchangeably, as if rent and capital were synonymous, or perfect equivalents in two different languages.
Now, at the beginning of the twenty-first century, we find roughly the same return on real estate, 4–5 percent, sometimes a little less, especially where prices have risen rapidly without dragging rents upward at the same rate. For example, in 2010, a large apartment in Paris, valued at 1 million euros, typically rents for slightly more than 2,500 euros per month, or annual rent of 30,000 euros, which corresponds to a return on capital of only 3 percent per year from the landlord’s point of view. Such a rent is nevertheless quite high for a tenant living solely on income from labor (one hopes he or she is paid well) while it represents a significant income for the landlord. The bad news (or good news, depending on your point of view) is that things have always been like this. This type of rent tends to rise until the return on capital is around 4 percent (which in this example would correspond to a rent of 3,000–3,500 euros per month, or 40,000 per year). Hence this tenant’s rent is likely to rise in the future. The landlord’s annual return on investment may eventually be enhanced by a long-term capital gain on the value of the apartment. Smaller apartments yield a similar or perhaps slightly higher return. An apartment valued at 100,000 euros may yield 400 euros a month in rent, or nearly 5,000 per year (5 percent). A person who owns such an apartment and chooses to live in it can save the rental equivalent and devote that money to other uses, which yields a similar return on investment.
Capital invested in businesses is of course at greater risk, so the average return is often higher. The stock-market capitalization of listed companies in various countries generally represents 12 to 15 years of annual profits, which corresponds to an annual return on investment of 6–8 percent (before taxes).
Imagine another company that uses less capital (3 million euros) to produce the same output (1 million euros), but using more labor (700,000 euros in wages, 300,000 in profits). For this company, β = 3, α = 30 percent, and r = 10 percent. The second firm is less capital intensive than the first, but it is more profitable (the rate of return on its capital is significantly higher).
In all countries, the magnitudes of β, α, and r vary a great deal from company to company. Some sectors are more capital intensive than others: for example, the metal and energy sectors are more capital intensive than the textile and food processing sectors, and the manufacturing sector is more capital intensive than the service sector. There are also significant variations between firms in the same sector, depending on their choice of production technology and market position. The levels of β, α, and r in a given country also depend on the relative shares of residential real estate and natural resources in total capital.
Capital in the Twenty-First Century Page 7