Scott Sumner  

The First Fundamental Law of Capitalism

PRINT
Cartoon Introduction to Cli... The Daily Hell of the War on D...

Suppose that I made the following claim:

The formula M*V = P*Y 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 money supply, the price level, and real GDP.
How would you react? You might wonder what this has to do with "capitalism." Isn't it also the first fundamental law of communism, and feudalism, and socialism? After all, it's an identity. Next you might ask why the money supply, price level, and real GDP are the most important "concepts" for analyzing the capitalist system. What makes them so important?

Here's Thomas Piketty (p. 52):

The formula a = r*B 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.
After an earlier post, some commenters suggested that parts of Piketty's message were lost in translation. I suspect that is the case here. After all, the three concepts cited by Piketty seem far less important than M, P and Y. Is it possible he meant "system of capital", not "capitalism"?

I was criticized for being too negative in my previous post; so let me praise Piketty for the following (pp. 31-32):

I did not find the work of US economists entirely convincing. To be sure, they were all very intelligent, and I still have many friends from that period of my life. But something strange happened: I was only too aware of the fact that I knew nothing at all about the world's economic problems. My thesis consisted of several relatively abstract mathematical theorems. Yet the profession liked my work. I quickly realize that there had been no significant effort to collect historical data on the dynamics of inequality since Kuznets, yet the profession continued to churn out purely theoretical results without even knowing what facts needed to be explained. And it expected me to do the same. When I returned to France, I set out to collect the missing data.

To put it bluntly, the discipline of economics has yet to get over its childish passion for mathematics and for purely theoretical and often highly ideological speculation, at the expense of historical research in collaboration with the other social sciences.


Although I differ with Piketty on policy questions, I am very fond of his views on methodology.

I've just finished the second chapter (the first after the intro), and found it to be very clear and easy to understand. My only quibble (in addition to the 1st fundamental law of "capitalism") is the following claim (p. 71):

China, for example, still imposes controls on capital: foreigners cannot invest in the country freely, but that has not hindered capital accumulation, for which domestic savings largely suffice. Japan, South Korea, and Taiwan all financed investment out of savings.
Here Piketty failed to do his homework on East Asian growth. During its high growth period of roughly 1960 to 1997, South Korea relied very heavily on foreign savings to finance its investment. This allowed South Korea to have higher living standards during its period of rapid growth than China, which severely squeezed consumption in order to generate enough savings for their high-growth model.

Comments and Sharing





COMMENTS (9 to date)
...some commenters suggested that parts of Piketty's message were lost in translation.

Which is the kindest thing that can be said about Piketty's book, as the first fundamental law of capitalism is, 'Absent coercion, no one will enter into an agreement or an exchange unless they think they'll be better off for so doing.'

The second fundamental law is that through those voluntary exchanges a society will be at its most productive. That interference with those exchanges by 'bullies' will make the society poorer.

Of course, you can't derive an 80% marginal income tax rate out of those two laws, so what use are they to a French socialist.

Brian Mannix writes:

As you go through the remainder of the book, see if you are as surprised as I was at the total lack of thinking at the margin, even when he drills down from national statistics to talk about individual firms. Instead, he talks about "shares" of income -- and not simply in a measurement sense (as in market "shares"), but in the "can't we all share" sense. As if firms were not price takers in capital and labor markets, but actually decided income shares; and, since they are doing it unfairly, as if some third party needed to correct them. When you don't consider incentives, economics becomes sterile indeed.
To his credit, though, Piketty is not only a good, engaging writer; he also struck me as an honest empiricist, who is completely transparent about his methods and his biases. It makes the book well worth reading; it also makes it a book that Paul Krugman could never write.

Scott Sumner writes:

Patrick, He doesn't seem to like "the economic way of thinking."

Brian, That's my impression so far:

1. Accounting more than economics.

2. Great writer, tries to be fair, but has some (left) liberal bias and gets some facts wrong. And I'm not talking about the data dispute. Trivial things like saying India's population will overtake China by 2020, or that German inflation averaged about 17% during the interwar period. That sort of error. Unlike most bloggers, he doesn't seem that well-informed outside his research area. The good news is that his research area is large, and he knows a lot within it.

Later I plan a post on how this book fits in with the revival of old Keynesianism--I see clear links.

Roger McKinney writes:

China was the number one destination for foreign direct investment for decades. How can Piketty say they financed growth through savings? China grew mostly from expatriate Chinese from all over SE Asia returning home and investing with friends and family in China.

I have a lot more criticism of Piketty on my blog.

Thiago Ferreira writes:

"the first fundamental law of capitalism is, 'Absent coercion, no one will enter into an agreement or an exchange unless they think they'll be better off for so doing.'

The second fundamental law is that through those voluntary exchanges a society will be at its most productive. That interference with those exchanges by 'bullies' will make the society poorer."

These ones are the ones you invented in your head. Capitalism means private property and search for profits, the rate on return on capital seems pretty important to me in this sense.

MV = PV is only important once velocity is constant.

Roger McKinney writes:

Thiago, the return on capital is very important, but Piketty assumes that roc is fixed and capitalists will get it no matter what. The only factors he sees that can change it are wars and massive taxation.

He was trained in mainstream economics which has no understanding of the real world of capital. Capital depreciates and replacing/repairing it requires entrepreneurial decision making every time. One mistake can make it disappear permanently.

Yes the top 1% has been accumulating capital, but the make up of the 1% changes constantly as many go broke and fall out of the category while newly wealthy join. New tech, changes tastes, bad management and many other things destroy capital.

At the same time, wage earners depend on capital for their jobs. No jobs in the modern economy exist that don't require some kind of capital investment. When capital gets destroyed so do the jobs that depend on it.

Piketty sees capital and labor as dogs fighting over a bone, but in reality they are married to each other and depend on each other. If income accrues to the capitalists faster than to the workers, that's because the capitalists have stopped investing and are consuming more or sending their investment to a foreign country. They quit investing when the return on capital falls below opportunities elsewhere or the opportunity cost of consumption.

It's no wonder labor's share of income has fallen in the West. Governments do all they can to discourage capitalists from investing through high taxes and massive regulations. It's more profitable to borrow at low interest rates and invest in the stock market or government debt.

Thiago Ferreira writes:

Roger,
If what you said is correct then it would be correct to say that if inequality is rising somewhere there should be a place where inequality is diminishing, but the main tenet of piketty's book, I believe, is to show that inequality is rising generally in the world

Vangel writes:

The formula M*V = P*Y is a pure accounting identity.

Money Paid = Money Received

This tells us nothing. Just like Piketty's methodology.

Joshua Lyle writes:

@Thiago Ferreira

But inequality is /not/ rising generally in the world. It's falling in the world while rising in many (most?) sub-units of the world.

Comments for this entry have been closed
Return to top