June 10, 2014

Naive and Ignoring Basic Economics

Donald J. Boudreaux

Senior Fellow, F. A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics
Summary

Thomas Piketty's 2014 volume, “Capital in the Twenty-First Century,” will likely become the most influential economics book since John Maynard Keynes' 1936 “General Theory of Employment, Interest, and Money.” That's quite an accomplishment for professor Piketty. But also like Keynes, Piketty's popularity springs more from his cleverness at justifying certain government policies rather than from the soundness of those attempted justifications.

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Thomas Piketty's 2014 volume, “Capital in the Twenty-First Century,” will likely become the most influential economics book since John Maynard Keynes' 1936 “General Theory of Employment, Interest, and Money.” That's quite an accomplishment for professor Piketty. But also like Keynes, Piketty's popularity springs more from his cleverness at justifying certain government policies rather than from the soundness of those attempted justifications.

As explained in my previous column “Pikettymania” , Piketty's book is stuffed with faulty economics. Consider, for example, his discussion of the rising pay of corporate executives in America. Piketty blames this rising pay for driving most of the recent increase in U.S. income inequality.

According to Piketty, executive compensation, especially in America, has nothing to do with managers' productivity and everything to do with the cozy relationship between managers and corporate boards. Managers and board members are clubby friends scratching each other's well-massaged backs and setting each other's astronomical salaries.

Specifically, Piketty blames what he assumes to be excessively high and wasteful executive pay on lax American “social norms,” combined with cuts in income-tax rates. Piketty reasons that, because tax cuts mean that executives keep more of what they're paid, tax cuts give managers stronger incentives to lobby corporate boards harder for higher pay. (Ironically, here's one of the few occasions when Piketty recognizes that cutting taxes causes people to work harder to get higher pay!)

Mysteriously, Piketty never asks the obvious question: Why do shareholders continue to invest in corporations that so wastefully spend their funds?

Here's an even deeper mystery: If current patterns of executive compensation serve no purpose except to enrich unproductive corporate oligarchs, what explains the rising market value of the capital that Piketty believes to be the central driver of increasing wealth inequality? Piketty doesn't ask this question because, for him, wealth perpetuates itself. It grows automatically.

In reality, of course, wealth doesn't grow automatically. Although Piketty is blind to this fact, wealth must first be created and then carefully, skillfully and continually nurtured if it is to grow. Therefore, if Piketty's peculiar “theory” of executive compensation were correct, corporate boards' inattention to the productivity of their management teams would cause the market value of corporations to plummet. Capitalists and the masses both would sink ever more deeply into poverty.

Fortunately, neither the rich nor the rest of us are suffering any such lamentable impoverishment.

Had Piketty examined more carefully the empirical literature on executive compensation, he would have discovered that this compensation is indeed tied closely to managerial productivity. As University of Chicago professor Steven Kaplan reported last year in Foreign Affairs, when he and co-author Joshua Rauh analyzed 1,700 firms they “found that compensation was highly related to performance: the companies that paid their CEOs the most saw their stocks do the best, and those that paid the least saw their stocks do the worst.”

Of course. Yet it's easy for an observer to miss such a fact when he is perched so high above reality that he sees none of the all-important details on the ground. And that's the ultimate problem with Piketty's narrative.

Like Keynes, Piketty ignores basic economics and instead writes mainly about big, all-encompassing social aggregates (such as the distribution of income). These aggregates are portrayed as having motive forces all their own — forces that can be controlled only by the interventions of governments, which are assumed to be well-intentioned. And so, also like Keynes, Piketty is shockingly naïve about the realities of politics.