A Challenge to Thomas Piketty: Is Income Inequality Rooted in Housing?

Graduate student Matthew Rognlie has put forward the most serious challenge to Thomas Piketty’s “Capital in the Twenty-First Century” arguing that income inequality is rooted in housing.

Brief reminder of Thomas Piketty’s theory

Since the publication of “Capital in the Twenty-First Century”, Thomas Piketty’s surprise bestseller which put forward the theory that Western-style capitalism inexorably creates inequality of income and wealth, more than 1.5 million copies have been sold and it has been lauded by Nobel-prize winners and politicians. There have also been many attempts to poke holes in the thesis. But none has been as serious as that of Matthew Rognlie, a 26-year-old graduate student at the Massachusetts Institute of Technology, who presented a paper, A note on Piketty and diminishing returns to capital, at the Brookings Papers on Economic Activity earlier this year.

As a brief reminder, Piketty argues that capital and the money it produces (the return on investments) accumulates faster than the rate of economic growth in capitalist societies. And because that capital is disproportionately held by the rich, the fortunes of the rich can grow at a much faster rate than the fortunes of those earning their wealth, which can only ever grow at the same rate as the economy. This, he argues, gives rise to an elite class of inherited and accumulated super-rich which drives inequality.

Matthew Rognlie’s theory

However, Matthew Rognlie has a different take. Originally published in a 459-word blog post, he argues that “recent trends in both capital wealth and income are driven almost entirely by housing.”

Rognlie argues that Piketty’s argument is flawed in three key ways. Firstly, he says that Piketty did not fully take into account the effects of depreciation. Due to the law of diminishing marginal returns, Rognlie argues that investments in capital will not offer the long-term advantage Piketty claims and instead will decline over time. He writes: “If the return on capital falls quickly enough when more capital is accumulated, capital’s share of income will fall rather than rise—so that even as the balance sheets of capital owners expand, their claim on aggregate output will shrink.” Rognlie also argues much of the income growth of capital holders in the last six decades has been from capital gains – from stocks going up – while book value has remained lower. And where returns from wealth may well be rising, they will not necessarily rise in net terms as a larger portion of the gains from each investment will need to be reinvested. Rognlie highlights the example of investment in technology, a driver of wealth in the last decades, claiming that technology or software, as intellectual property that is always rapidly evolving, won’t hold value for very long and will instead start to depreciate as something new comes along.

Rognlie believes that housing lies at the root of income and wealth inequality.

Secondly, Rognlie raises the issue of the elasticity of substitution between capital and labour. Elasticity measures the extent to which firms can substitute capital for labour as the relative productivity or the relative cost of the two factors change. When this number is large, it means that firms can easily substitute between capital and labour, and it is associated with a higher share of capital income. When the elasticity is less than one, the opposite is true. Piketty argues that the ease of substitution is important. For example, technology is making it easier for companies to replace workers with automated machines and drones, reducing the demand for labour and increasing the income from capital. For Rognlie, the crucial detail is whether this elasticity is defined in gross or net terms; net subtracts depreciation from income, while gross does not. Piketty analysed gross elasticity, but Rognlie argues we should use net elasticities, which are much lower than gross ones. Rognlie’s research found net elasticities at less than 1, which falls below the levels needed to maintain Piketty’s argument.

Finally, Rognlie argues that once adjusting for depreciation, the returns of wealth are not distributed equally across all investments. Indeed, he finds that the majority of the increase in existing capital comes not from products or intellectual property but from housing – houses, apartments, buildings, and land.  He writes: “Also using Piketty’s data, I finds that a single component of the capital stock—housing—accounts for nearly 100% of the long-term increase in the capital/income ratio, and more than 100% of the long-term increase in the net capital share of income.”

The decline in affordable housing

Housing, or a lack of affordable housing, is a key topic at the moment as housing in the world’s booming cities becomes increasingly unaffordable and land becomes too expensive for its workers. Indeed, the more productive the city and the more talent and investment it attracts, the stronger this relationship seems to become, and so millennials are being increasingly priced out of buying (and benefitting from building equity), and instead pushed into a circle of ever-increasing rents paid to landowners.

For example, in the UK, between 2007 and 2011, in the wake of the financial crisis, London’s economy grew by 12.4% – about double the rate of any other region. But today, the average house in London costs more than one could borrow on the prime minister’s salary. Or in the US, in San Francisco, San Jose, and Los Angeles, the typical millennial doesn’t make even half of what’s needed to afford a home. And as early as 2004, the median rent exceeded 30% of the median household income for young workers, the threshold at which housing experts say rent is no longer affordable.

What does it really mean for Piketty?

So, should governments be rethinking income inequality policy in favour of housing rather than Piketty’s preferred tax on the super-rich? It certainly sounds like a convincing argument, and Piketty himself has since suggested that he is open to policies relating to housing. But where an argument of a wealthy elite boosting their wealth through land and rents seems in line with his theory, Piketty maintains that only progressive taxation can truly change the balance.