In Thomas Piketty’s doomsday model, slowing of growth in the twenty-first century will cause an inexorable increase in inequality. Piketty is not the first to propose a grand model of inequality and growth. To get some perspective on his model, let’s see what the “classical” economists had to say (Part I), and how the “neoclassical” economists responded (Part II).
Part 1. The Classical Economists on Inequality and Growth
The first generation of “classical” economists, notably Francois Quesnay (1694-1774) in France and Adam Smith (1723-1790) in England, knew perfectly well where inequality came from. It was simply a fact of life that most land and other natural resources belonged to a small hereditary nobility. In England, some 2% of the population owned most of the land. This nobility, or their ancestors, gained their estates by force, favoritism, or fraud: that is, conquest, gifts from the king, or bribes to magistrates.
The classical economists recognized that landowners, large and small, received unearned income for the mere fact of holding titles protected by the state. They called this unearned income “rent”. Besides the landowners, these economists identified two other social classes: capitalists who received profit by investing or interest by lending, and workers who received wages. (Of course they recognized that the classes overlapped; successful capitalists soon bought land or married their daughters to landowners.)
Smith, witness to the English industrial revolution, proposed the first coherent theory of economic growth. At the start of his Wealth of Nations (1776), he explains how production increases dramatically when workers cooperate and specialize. This can happen both within an enterprise—he gives an example of a “pin factory”—and through market exchange. Hence both increase in population density and improved trade—greater “extent of the market” as Smith puts it—will generate economic growth. That’s why Smith, like Quesnay, advocated free trade, both domestic and international. They opposed government-granted monopolies, such as exclusive trading privileges given to the British East India Company. They also advocated shifting taxes off of activities such as transport and sale of merchandise and onto rent, by taxing land values—what Smith termed the “most equitable” of taxes.
Smith observed that growth was already improving workers’ living standards, as well as undermining the elite landholders. So in his view, growth reduced inequality.
The next generation of classical economists brought new and more dramatic perspectives to growth and inequality.
Thomas Malthus (1776-1834) claimed that workers’ wages would forever remain at “subsistence” due to their alleged propensity to breed faster than food production could increase. Any efforts to feed or otherwise assist the poor were actually counter-productive; the poor would just breed faster. By this logic, growth increased inequality, because the bottom remained stuck. This view, while pleasing to the elite, would have horrified the humane Adam Smith.
David Ricardo (1772-1823), Malthus’s contemporary and friend, proposed a “marginal” theory to explain the magnitude of land rent. The rent of a given parcel of land depends, he said, on its superiority to land barely worth using, that is, “marginal” land. Imagine you are a farm operator. How much more would you be willing to pay the owner of a fine flat parcel down in the valley over a remote, steep parcel you could use for next to nothing? That extra payment is your rent—income to the landowner for the mere fact of holding legal title to land. (Note that location is usually the most important component of land quality.)
Ricardo’s rent theory led him to propose a doomsday model even more frightening than Piketty’s. As population grows, he said, the economy must expand onto lower and lower quality land. Since rent depends on the difference between the best and the poorest land in use, more and more of the economy’s production will go to landowners as rent. Eventually the landowners will take so much that there won’t be enough to provide even starvation wages to workers or minimal profits to capitalists. Only improved technology and gains from trade can stave off collapse. Hence, Ricardo vigorously advocated free trade.
In the final generation of classical economists, two—Karl Marx (1818-1883) and Henry George (1839-1893)—attacked inequality with such force as to provoke a powerful backlash.
Karl Marx, a German revolutionary exiled to England, rejected Malthus’s wage theory. He focused on exploitation of workers by capitalists, among whom he now included landlords. However, like Ricardo, he predicted that growing inequality would lead eventually to a collapse of the capitalist system, and its replacement by a new socialist society. In effect, Marx said growth increases inequality, leading to revolution followed by equality.
Henry George’s bestseller Progress and Poverty (1879) threw a searchlight on the inequities of the late nineteenth century. With Marx, George rejected Malthus’s wage theory. He added his own twist to Ricardo’s theory of land rent. Just as marginal land determines rent, he said, it also determines wages—because a worker will not accept wages lower than what he could earn for himself on marginal land. But the greater the inequality of ownership of land (and other natural resources) the lower will be the quality of marginal land—and hence the lower the wages.
George also added a twist to Adam Smith’s theory of growth. Yes, growth results from cooperation and specialization, and the larger the population and the greater the “extent of the market” the greater the potential for growth. But also, the more equal the people, the greater their ability to cooperate. In George’s words: “association in equality is the law of progress.”
Marx saw history as progressing by action and reaction toward the inevitable overthrow of capitalism. By contrast, George combined his modified growth theory with Ricardo’s inequality theory to argue that progress carries the seeds of its own destruction: A fortunately-situated, relatively egalitarian society may begin to grow and prosper, expanding and attracting population. However this growth primarily benefits the holders of key parcels of land—such as parcels on the waterfront of port cities. As the economy grows, so does inequality. Wages fall, relatively if not absolutely. A wealthy, corrupt elite increasingly controls government. Eventually, the society collapses, or becomes so weak as to fall to invaders—as for example did the Western Roman Empire.
George feared this fate would soon befall the United States. Like his classical predecessors, he opposed government-granted monopolies, notably vast tracts of land handed to railroad companies like Southern Pacific. Also like his predecessors, he proposed shifting taxes onto the unearned income of land and other natural resources. But unlike his predecessors, George turned land taxation into a major and partially successful political crusade, not only in the United States, but in other countries, notably England and its colonies in Canada, Australia, New Zealand, South Africa and Hong Kong.
In practice this meant increasing the land component of ordinary property taxes and removing the component on buildings and other improvements, a proposal easy to understand and implement back when property taxes were the primary taxes.
Marx and George—and the huge political movements they inspired—scared the pants off the elites of Europe and the United States. They had to be stopped, and not just physically. The classical focus on inequality and unearned income had to be disappeared from economics. As we will see in part II, that was the purpose of “neoclassical” economics.