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.