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Sunday, June 1, 2014


Some of you will recall that I was first put on to Thomas Piketty's Capital in The Twenty-First Century by my son, Patrick Wolff.  Patrick has had two careers, though he is only in his forties -- first as a world-famous Chess Grandmaster who twice won the U. S. Championship, now as the founder and Managing Director of Grandmaster Capital, a San Francisco-based hedge fund.  Patrick and I corresponded about Piketty while I slowly read through it and then wrote my multi-part review.  Now Patrick has taken some time from his managerial duties to write the following extremely interesting reflection on Piketty's work.  The title, by the way, is a reference to a famous essay by Isaiah Berlin.  Here is Patrick's take on Piketty:

The Hedgehog, the Fox and Thomas Piketty
By Patrick Gideon Wolff

“The fox knows many things, but the hedgehog knows one big thing.”

Thomas Piketty has attracted quite a lot of attention with Capital in the Twenty-First Century. I will try to add a few perspectives that I hope may usefully complement the book’s huge and growing volume of thoughtful discussion.

Piketty is one of several economists (most notably also including Emmanuel Saez) who have pioneered developing the data on the distribution of wealth and income within economies across countries and over time. Their scholarship is well known and impeccable. Everything has been placed transparently and voluminously online for inspection and analysis. The data that Capital in the Twenty-First Century draws upon is part of this enormous mosaic, and will be critiqued, corrected and reformulated for many years to come. From this perspective, it seems clear to me that the recent kerfuffle raised by Chris Giles at the FT is misguided. Of course errors will be found in Piketty’s book. But the broad facts of income and wealth inequality are well documented and not subject to a “gotcha” fact checking exercise. Anyone who seriously wants to advance the frontier of knowledge in this area must engage with the broader project.

(As an aside, it is worth noting how much the Internet has improved data scholarship by making this kind of project possible. For example, compare Piketty’s book to another famous data-driven economics book: A Monetary History of the United States. The data in that book were painstakingly developed by Milton Friedman and Anna Schwartz. Imagine how much faster their data could have been checked and interpreted if it had been possible to put it all online. How many innocent errors in their work have never been corrected due to this lack of access? I suspect that we greatly underestimate the base rate of academic error in such data work, simply because it has never before been possible to analyze as quickly and transparently as it is now. And we therefore probably fail to appreciate how much better such data work can become in this century thanks to computers and the internet.)

But Piketty’s book is more than just a compilation and synthesis of the data regarding how income and wealth are now and have historically been distributed. It is an attempt to use that data to ask a deeply fundamental question: What failures of capitalism develop from the evolution of the distribution of income and wealth, and what remedies suggest themselves? The attention that Piketty’s book has attracted testifies to the poignancy of this question at this moment in time.

Piketty had a choice between two approaches in answering this question: he could have been a hedgehog or a fox. I submit that he chose wrongly. He tried and failed to be a hedgehog. He would have done better to be a fox.

The “one big thing” Piketty thinks he knows is that “r,” the (real) private rate of return on capital is greater than “g,” the (real) growth rate of GDP. [Henceforth, the discussion of “r” and “g” will be real rates, i.e. net of inflation, unless otherwise indicated.] Piketty believes that, (a) this has generally been true historically, although not true for much of the twentieth century for idiosyncratic reasons, (b) it is highly likely to be true again in the twenty-first century, and (c) when it is true it inexorably drives greater and greater economic inequality unless stopped or reversed by explicit economic policies. This idea has been critiqued from several directions, e.g. Larry Summers ( and Jamie Galbraith ( In my opinion the general direction (and many of the specific points) of these critiques are correct and will ultimately undermine Piketty’s “r > g” argument. I have nothing of value to add from an economics perspective, but I would like to make a small contribution to this critique from my perspective as a professional money manager.

Piketty claims that the rate of return on capital has been in the neighborhood of 4-5% in the 18th and 19th centuries, and is likely to be close to 5% in the 21st century. Piketty emphasizes that these are market rates of return. It therefore seems sensible to look at today’s markets to assess the situation. I believe he significantly overestimates the likely future returns.

Start with interest rates: the 10-year bond currently (as of May 30, 2014) yields about 2.5%. If we assume that inflation over the next ten years will be 1.5%, that is a real rate of return of 1% – and that’s before taxes. (You can get a little bit more yield from the 30-year bond, 3.3%, but the inflation risk is greater, too.) You can get a higher – although not much higher these days! – yield with corporate bonds, but much (although hopefully not all) of that extra yield will be lost over time to the odd default that pops up, i.e. it is compensation for default risk.

What about real estate? Real estate is much more local, so deriving a universal rental yield is impossible. Still, my guess is that a house in a major metropolitan area might sell for a little less than 17 times annual rent, for a rental yield of 6%. Since rents should generally rise somewhat in line with inflation over time, one might initially think that this is a real rate of return of 6% before taxes. But hold on! Unlike a bond, a house has expenses associated with it, and those expenses could easily eat up 2-3% of that return in order to keep its rental yield in line with inflation. And oh, yes, there’s also risk: unlike a government bond, whose primary risk is inflation, any real estate investment has other risks that could impair its value over time. This is an important point, because it means that just like the corporate bond described above, in aggregate some (but not all) of the yield in excess to government bonds may be lost to the risk entailed.

And stocks? Well, the S&P 500 right now yields a bit less than 2% and sells for around 17 times earnings. I agree with Warren Buffett that stocks are in a “zone of reasonableness” right now in terms of valuation. When stocks are reasonably valued, one should generally expect to earn the growth in earnings per share (EPS) plus dividends over time, but no more. Nobody knows at what rate EPS will grow but I think a reasonable guess is 5-6%, so long as corporate profit margins remain at their presently very high level relative to history. So maybe you can expect to earn 7% before inflation and about 5% afterwards – again, before taxes. Plus of course, there’s risk: profits might decrease (e.g. if wages for low-skilled labor pick up), and every so often a crisis likes 2008 forces many people to sell at precisely the wrong time.

In other words, a quick scan of the market suggests that the 5% real rate of return that Piketty breezily assumes is – in the US, at least – at best on offer only in the very riskiest asset class. Now you might say that since the rich can shoulder that risk most easily they will earn the highest possible return. Well, maybe, but be careful of the fallacy of composition: since we are talking about the economy as a whole, we have to think about the return of all assets, and can adjust only on the margins for how the rich might construct their portfolios. (To put it more plainly: every asset must be owned by someone, and the more assets that the rich own, the more what the rich own will represent the whole.) Very roughly, if we average the prospective future return on capital from bonds, real estate and stocks in the US, I think you might earn a 3% real rate. That’s not shabby, but it’s not 5% either. And it’s before taxes.

(Maybe returns will be better outside the US? Space does not permit a detailed response to that very reasonable question, but I can summarize my best guess: probably not. Real interest rates are very low in virtually all rich, developed countries, and property values are much higher relative to rents in Europe. Stocks in many developed markets do look somewhat cheaper, but not dramatically so, and the risks abroad are also greater right now in my opinion. And for reasons I have no space to explain here, I do not believe that less developed countries in aggregate will offer anything like the same returns prospectively as they have done over the last dozen years.)

Piketty is an empirically driven academic. Shouldn’t he have addressed the current state of markets before prognosticating on the outlook for future returns on capital? But this is the problem with the hedgehog approach: once you are committed to the “one big thing” you think you know (i.e. that r > g is the “principal destabilizing force” that is “potentially threatening to democratic societies and to the values of social justice on which they are based” [quotes from the first page of the Conclusion], all your intellectual efforts go towards buttressing that one thing. By fixing your eyes straight ahead, you miss everything else around you – as well as potential pitfalls that lie underneath the intellectual path you tread.


Now what if he had been a fox instead? In that case he could have made many individual observations rather than try to provide a grand, unified theory. It would have been less elegant, but possibly much more fruitful. I cannot possibly do justice to the richness of the observations that he could have offered, but let me very briefly outline three broad areas of interest.

ONE: One striking pattern from the data is that it is persistently the case that at least 50% of the population (for any economy at any time) fails to accumulate practically any private wealth. This is an amazing fact. It seems to me one of the strongest arguments that could be made in favor of the modern welfare state. It would have been fascinating to read a chapter or more by Piketty devoted to this topic.

TWO: Middle class wages sometimes track and sometimes undershoot their marginal productivity – and for the last forty years, they appear to have undershot. Piketty could potentially have made a very valuable contribution by using his understanding of the patterns of income distribution to try to explain why and to analyze this issue in more depth.

THREE: The very, very top income echelons (the top 0.1% and top 0.01%) have been dramatically pulling away from the rest of the population over the past few decades, particularly in the US. Piketty does not overlook this topic (indeed, he helped discover it through his data research), but as it does not fit into his grand r > g framework his treatment in the book is superficial. I suspect that his American readers in particular would have appreciated a much richer analysis.


Like many others, I found Piketty’s book to be a fascinating and engaging read. Its popularity shows how much people care about its topic and how well it is written. I suspect, however, that the verdict of history will be to regard Capital in the Twenty-First Century more as a lost opportunity than as an enduring classic. Perhaps its greatest contribution will ultimately be to evangelize the extraordinary, ongoing data project regarding the distribution of income and wealth, a project of which Piketty has been one of the leaders and for which he has deservedly earned his stellar academic reputation.


Jerry Fresia said...

This truly one of the more insightful reviews that I have read of Piketty's work. Nicely written too.

Perhaps at some point, Mr. PG Wolff could blog on the art and challenges of hedge fund managing.

Magpie said...

Apologies for joining the discussion so late.

While I am satisfied with the author's argument that Piketty may have overestimated r, I have a question:

The fact that wealth inequality has increased seems indisputable. Other researchers have confirmed this and, well, it actually seems evident from just reading the news.

How does this fit with the author's critique? Maybe g was also exaggerated? Maybe current returns on investment are abnormally low?

Tom Grey said...

Really nice note, coming from MR -- where Alex also showed how the Piketty assumptions about savings and depreciation replacement are so at variance with reality.

On income at the top 0.1%, there should be more talk about restricting monopoly protection by the gov't against digital sharing ("intellectual property) for all works where at least one principal has received 100 years of median wages (about $5mil at the current median of about $51k)

ChipTex said...

Have not read Piketty, but clearly the problem does not lend itself to one big explanation, so cheers to Patrick for sussing that out

R can easily be less than G, or both negative, but, in a kleptocracy, the oligarchs/rulers will take all the oxygen.

In the end, the poor eat the rich, one way or another, and the cycle repeats.