Friday, November 28, 2014

Piketty’s Missing Knowhow

CAMBRIDGE – Theoretical frameworks are great because they allow us to understand fundamental aspects of a complex world in much simpler terms, just as maps do. But, like maps, they are useful only up to a point. Road maps, for example, do not tell you current traffic conditions or provide updates on highway repairs.

A useful way to understand the world’s economy is the elegant framework presented by Thomas Piketty in his celebrated book Capital in the Twenty-First Century. Piketty splits the world into two fundamental substances – capital and labor. Both are used in production and share in the proceeds.

The main distinction between the two is that capital is something you can buy, own, sell, and, in principle, accumulate without limit, as the super-rich have done. Labor is the use of an individual capacity that can be remunerated but not owned by others, because slavery has ended.

Capital has two interesting features. First, its price is determined by how much future income it will bring in. If one piece of land generates twice as much output in terms of bushels of wheat or commercial rent as another, it should naturally be worth double. Otherwise, the owner of one parcel would sell it to buy the other. This no-arbitrage condition implies that, in equilibrium, all capital yields the same risk-adjusted return, which Piketty estimates historically at 4-5% per year.

The other interesting feature of capital is that it is accumulated through savings. A person or country that saves 100 units of income should be able to have a yearly income, in perpetuity, of some 4-5 units. From here, it is easy to see that if capital were fully reinvested and the economy grew at less than 4-5%, capital and its share of income would become larger relative to the economy.

Piketty argues that, because the world’s rich countries are growing at less than 4-5%, they are becoming more unequal. This can be discerned in the data, though in the United States a large part of the increase in inequality is due not to this logic but to the rise of what Piketty calls “super-managers,” who earn extremely high salaries (though he does not tell us why).

So let us apply this theory to the world to see how well it fits. In the 30 years from 1983 to 2013, the US borrowed from the rest of the world in net terms more than $13.3 trillion, or about 80% of one year’s GDP. Back in 1982, before this period started, it was earning some $36 billion from the rest of the world in net financial income, a product of the capital that it had previously invested abroad.

If we assume that the return on this capital was 4%, this would be equivalent to owning $900 billion in foreign capital. So, if we do the accounting, the US today must owe the rest of the world roughly $12.4 trillion (13.3 minus 0.9). At 4%, this should represent an annual payment of $480 billion. Right?

Wrong – and by a long shot. The US pays nothing in net terms to the rest of the world for its debt. Instead, it earned some $230 billion in 2013. Assuming a 4% yield, this would be equivalent to owning $5.7 trillion in foreign capital. In fact, the difference between what the US “should” be paying if the Piketty calculation was right is about $710 billion in annual income, or $17.7 trillion in capital – the equivalent of its yearly GDP.

The US is not the only exception in this miscalculation, and the gaps are systematic and large, as Federico Sturzenegger and I have shown.

At the opposite extreme are countries such as Chile and China. Chile has borrowed little in net terms for the past 30 years, but pays to the rest of the world as if it had borrowed 100% of its GDP. China has lent to the rest of the world, in net terms, over the last decade, about 30% of its annual GDP but gets pretty much nothing for it. From the point of view of wealth, it is as if those savings did not exist.

What is going on? The simple answer is that things are not made just with capital and labor, as Piketty argues. They are also made with knowhow.

To see the effect of this omission, consider that America’s net borrowing of $13 trillion dramatically understates the extent of gross borrowing, which was more like $25 trillion in gross terms. The US used $13 trillion to cover its deficit and the rest to invest abroad.

This money is mixed with knowhow as foreign direct investment, and the return to both is more like 9%, compared to the 4% or less paid to lenders. In fact, 9% on $12 trillion is more than 4% on $25 trillion, thus explaining the apparent puzzle.

Chile and China put their savings abroad without mixing them with knowhow – they buy stocks and bonds – and as a consequence get just the 4-5% or less that Piketty assumes. By contrast, foreign investors in Chile and China bring in valuable knowhow; hence the gross capital that flows in yields more than the gross savings abroad. This return differential cannot be arbitraged away, because one needs the knowhow to get the higher returns.

The point is that creating and deploying knowhow is an important source of wealth creation. After all, Apple, Google, and Facebook are jointly worth more than $1 trillion, even though the capital originally invested in them is a minuscule fraction of that.

Who gets to pocket the difference is up for grabs. Knowhow resides in coherent teams, not individuals. Everybody in the team is crucial, but outside the team each individual is worth much less. Shareholders may want to take the difference as profits, but they cannot do without the team.

This is where the super-managers come in: they strive to pocket part of the value created by the team. Behind the growth of wealth and inequality lies not just capital, but also knowhow.

Read more from "Piketty's Charge"

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    1. CommentedMukesh Adenwala

      One more variable that is generally disregarded is that of power. Know-how or `Truth' - what is true - has two components: One is scientific knowledge that generates technology and lead to more efficient outcomes. But it is not only what is most useful is most rewarded. Facebook, for example has no productive value. The other is sheer power which establishes truth to the exclusion of all other alternative ideologies. The returns on the latter section of the know-how can perhaps explain the differences mentioned in the article.

    2. CommentedAlexander Guerrero

      It looks that in your production function, there are essentially 3 factors, namely, capital, labour and know-how. So, it is not difficult to erroneously conclude as Picketty, if we do as he does; comparing economic growth with the rate of return of capital, at the same time as considering that the rate of return from capital means exactly the same as the return from financial assts. Putting intergenerationally, as Picketty did, assuming that inherited wealth create more wealth, but, "unequally", which is at any event a false assumption made by Picketty.

    3. CommentedBruce Steinback

      Um, I thought that Piketty has argued, and some of his associates put into a paper (rats! I can't find the URL), that the balance of payments for developed countries has been greatly over-estimated because the 'dark money' out there (your term) is money that e.g. wealthy Americans have invested abroad, that is unaccounted for as hidden for tax purposes, suggesting that the gap in capital income is not a matter of 'knowhow', but of even worse inequality than is obvious.

      Your 'super-managers' argument also seems very weak to me. Inequality is worse in large part because the average CEO is paid way more than before. Indeed, the median CEO pay has been growing faster than the average over the last 20 years, meaning that the average (or worse) CEOs have been gaining faster than your 'super-managers'.

      And the highest incomes of the last decade or so have gone to hedge-fund managers, who add little if anything to the world economy, and have recently as often flamed out as provide benefit to anyone.

    4. CommentedGerald Silverberg

      According to the latest revision of SNA, R&D will now be counted as investment, so knowhow to some extent will be explictly incorporated into the definition of "capital" in national accounts. And Tobin's q also reflects knowhow in equity valuations.

      But whether the supersized incomes of "supermanagers" really reflect their contributions to "knowhow" or an abuse of managerial capitalism and the robber baron role of finance can be debated.

    5. CommentedEnrique Woll Battistini

      For about a decade now, the BRIC countries have been investing abroad, not just in stocks and bonds, but in making economic investment -Foreign Direct Investment- leading to Development in Latin America, For instance. China has invested significantly in this manner in countries such as Argentina and Peru, to name two. This trend may pick up, and regardless of the current know how and IP advantage currently enjoyed by developed countries such as the U.S. over the likes of China, for instance, developing countries are also accumulating their own stock of this complement to traditional capital and labor and will derive their own above-domestic returns through FDI. In my perception, FDI, whether by the U.S. or the BRICS, or any country, is a form or returns arbitrage leading in the very long term to basically equal risk capital returns and equilibrium.

    6. CommentedNathan Weatherdon

      Piketty doesn't have ALL of the answers, and he also failed to give perfect answers to as-yet-demonstrably-impossible questions.

      Therefore I reject his methods, conclusions, and all premises used at any stage of the game :)

    7. CommentedNathan Weatherdon

      Note that capital returns data do not include 100 million endeavours that never got far enough to make it onto the books. Thus, estimates should generally be considered as a higher bound.

      But curious minds were occupied in the meantime :)

    8. CommentedNathan Weatherdon

      I'm not sure I'd say they are worth $1 trillion, but the market consensus is that they will generate $1 trillion worth of profits for shareholders. Whether these profits are linked to $1 trillion in net social gains is another story altogether.

    9. CommentedJeff GE

      I am confused by this article. If it is knowhow that made the difference, why so-called "foreign direct investment" is made at their home country? Isn't the low labor costs and no environmental pollution costs that made foreign direct investment more profitable, as Larry Summers once said?

      As for market cap of Apple, Google, and Facebook and the like, if we follow the author's logic, the bigger the stock market bubble, the more knowhow these companies have?

      There should be a difference between analysis and justification ....

        CommentedJulian McNally

        if we follow the author's logic, the bigger the stock market bubble, the more knowhow these companies have?

        Syllogistic fallacy there Jeff. Just because APPL, FB & GOOG produced bubble-sized profits due to the combination of knowhow, capital and labor, doesn’t mean that every bubble contains those factors. Hausmann isnt trying to explain bubbles, just to detect exceptions to Piketty's theory. Erroneously as Ken Presting explains in the post below.

        I'm relatively illiterate economically, but I'd add a couple of other flaws in Hausmann's argument:
        1) The premium the US has earned (capital rent not paid) over the 1983-2013 period may reflect its currency of last resort status - I guess - but correct me if I'm wrong.
        2) The knowhow of the supermanagers is not in deploying enterprise capital, but in deploying the intellectual capital Presting referred to. At the senior executive level this capital often consists in 'who you know' and how good you are at the marketing and politicking of your own reputation rather than enhancing capital returns.

    10. CommentedKen Presting

      Prof. Hausmann here joins a growing crowd of potentially helpful experts who could, if they tried, add light to the noise surrounding Piketty's work. Unfortunately he is adding to the confusion.

      It is simply irrelevant to observe that interest rates on US debt is very low nowadays, since Piketty's argument refers to a long-term average, over almost two centuries. Hausmann's argument here is as weak as those who deny climate change based on a chilly afternoon.

      It's more a shame that he couldn't explain for readers less well versed in economics that "knowhow," like every form of intellectual property, is included in economic theory as a capital investment. Individual workers who obtain experience or education have spent personal capital (or time) to gain that value. When they subsequently sell their labor for wages above market rates, they are profiting from "rent" because as a commodity, their time is scarce. Piketty's basic argument is *strengthened* by noticing the special nature of knowhow, but his statistics include that phenomenon as a natural consequence of the abstract concept of capital.

      I don't blame Hausmann for putting this worthless column on the site. I blame the editors who prefer a big name on the by-line over sincere thought in the article.

      P-S has a brilliant and indispensable concept, but you have to turn down bad submissions if you're going to post quality content. I love this site, but please, let's all pitch in to improve.

    11. CommentedPaul Daley

      US investors can have secure investments at home and go abroad in search of returns; foreign have good returns at home but need the security provided by US investments. Both are wise decisions.

      So, how does the difference in returns reflect a difference in know-how?