Few outside of a Trappist monastery will be unaware of the stir created by Thomas Piketty’s Capital in the Twenty-First Century. The book distills the fruits of a career in the econometrics of inequality. Recently under attack for some errors in basic arithmetic, its theoretical and empirical insights, literary grounding, and agile prose improbably propelled this massive economic tome to number one on the Amazon list!
Distilled to its essence, Capital posits that the real return on investment, ‘r’, is necessarily greater than the real growth of the economy, ‘g’. The gap between these two, estimated at 3% per year, drives wealth and income disparities around the developed world. With stagnating productivity and population growth, Piketty sees this gap widening, fueling ever-worsening inequality that threatens to recreate the hereditary wealth of Europe’s ancient regimes.
Nurtured in les grandes écoles, Piketty never descended into the grubby depths of practical finance; incredibly, he depends largely on Balzac and Austen to estimate r, which he sees as a near-gravitational constant of a real 5% per year. Would that he had studied actual market returns, readily available over a century-plus from Elroy Dimson and his colleagues, and the nature of historical dynastic wealth, as well as he had nineteenth century literature.
Better, we think, to read Dickens’ Bleak House, which saw a patrimonial fortune disappear into estate litigation. He is wrong in his core premise and hence about the risk of dynastic wealth. How many of today’s billionaire ‘dynasties’ descended from vast wealth? And how many fortunes of the Austen and Balzac eras survived? Piketty’s dynasties are a myth, more implausible today than ever.
Let’s examine why.
In theory, Piketty admits, ‘r’ falls with increasing societal wealth, but he ignores that this is ancient history: while Austen’s Regency Period characters thrived on 5% consols, by 1900 their yields had fallen to 2%. The encyclopedic data of Dimson, Marsh and Stanton show that while global equities indeed dealt out a real return of about 5% during the twentieth century, bonds returned only 2%, and bills 1%. Today, with real bond yields hovering near zero, even a 2% real return on a balanced financial portfolio seems wildly optimistic.
Much of the world’s wealth today consists of residential real estate. Today’s price/rent ratio of Paris flats allows Piketty to declare the same 5% current return on property enjoyed by Austen and Balzac’s protagonists. This would certainly surprise the Parisian property owner who is liable for taxes, repairs, periodic renovation, and depreciation as the properties age. These easily consume half of that 5% gross yield.
The tip-off that he would rather not consider the role of this tumbling forward-looking ‘r’ is his trumpeting of the more than tenfold increase in the fortunes of two billionaires, Bill Gates and heiress Liliane Bettencourt, between 1990 and 2010. It takes a peculiarly ideological blindness to ignore the fortuitously high ‘r’ of those two decades, and also to suppose that business acumen played no role in their fortunes.
Piketty touchingly believes that hedge funds, alternative investments, and private equity enable the One Percent to outperform the huddled masses and their pitiful index funds. We’re serious professionals, so we would appreciate it if Mr. Piketty refrained from trying to make us giggle.
In addition to expected real returns about half his presumptive 5% norm, Piketty ignores a laundry list of factors that further corrode family fortunes. Attentive observers might notice that even rich people breed, as did his beloved Austen and Balzac characters. Each generation saw a comfortable £1,000 annual income halved or worse unless, of course, they hijacked another family’s fortune through marriage. Estate taxes, non-existent in Austen’s England, can halve this yet again.
The rich also make performance-chasing investment blunders, give to charity, pursue costly estate battles, overpay for investment and tax advice, and suffer taxes on capital gains and interest/dividends.
By the way, do the rich and their heirs tend to spend? Yes, they do … sometimes a lot.
If each of these “wealth extinction factors” costs just 1% of annual return, personal real net worth tumbles more than ten-fold per generation. We think that a 2% average annual cost per factor is closer to the truth, in which case hereditary wealth evaporates within the proverbial two generations. Our eye settles on a family reunion held at Vanderbilt University in 1973 – less than a century after the death of Cornelius, then the wealthiest man in the world – with not a single millionaire among the 120 heirs in attendance.
Most of today’s affluent – even in France – earned their success through entrepreneurial risk-bearing, innovation, hard work, and much luck. Not that income and wealth inequality don’t concern us. Wherever social mobility is absent, they do. Dynastic wealth, which disappears faster than you can say “Vanderbilt” or “Bleak House”? Not so much.
William J. Bernstein is an American financial theorist whose bestselling books include The Birth of Plenty and A Splendid Exchange. Rob Arnott is the Chairman and CEO of Research Affiliates, a former Chairman of First Quadrant and has published over 100 financial articles in major journals, many of which have received awards.