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Studying for a test? Prepare with these 5 lessons on GDP: Measuring national income.
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Voiceover: Before going into depth and to some of the other charts of the book. Let's think about what's Thomas Piketty outlines is the two theories why we have this increasing income in inequality in the United States. One theory is that it's driven by labor, it's driven by layer, labor and in particular you have this phenomenon. So this is, you have this phenomenon where top managers, where we're talking about executives maybe of large corporations are getting a larger and larger share of income. Larger share of income. And he argues that this could be due to one of two reasons or maybe some combination of them. One might be the market just recognizing the value or the importance of having top managers. And so over the last few decades the market has realized "Hey, it's worth it to pay these folks "more and more and more money." Because even though those are large salaries these are a very very large enterprises and if you can measure that someone can drive a one or two or three percent better return on capital for multibillion dollar company or drive the growth faster for a multibillion dollar company then maybe it's completely worth it to giving them a larger and larger and larger share of income. So one possibility, one possibility is just the recognition. So let me write this way, this is the market recognition of value. Market recognition of value. But another thing he sites, and he actually implies and this is what he believes is the more likely one, is that over the last several decades you had situations where the top managers have been able to essentially control what they themselves get compensated and there's not a lot of checks and balances there. So this is the one that he actually argues is probably happening more. So, you can almost say this is kind of a self regulation of income. Self regulation and most folks, if they are allowed to self regulate their income would tend to increase it, or maybe it is a combination of both. So this is one dynamic that he argues could be driving this increase in inequality that top managers are getting a larger and larger share of income. The other one is driven by capital. So the other argument is one based on capital. So capital, and it's all around the idea if the return on capital is greater than growth than over generations, those who have capital, especially those who generated this proportion of share of their income from capital, are going to if their proportion of income, their proportional wealth is going to grow become a larger and larger and larger share of the economy. What do we mean there? Well, if most of your income is, comes from just your, from your labor, then your salary is just going to be based on market forces for how much value you might be able to add to a organization and how many other people have that skill, and your negotiating leverage and all of those types of things. But if most of your incomes starts to be generated not from labor but from returns on capital. So what do I mean by that? Well let's say that you are, let's say that you are a doctor, you are a doctor, and let's say you make $200,000 a year. So $200,000 a year, this is, let me do this in color that you can actually see. $200,000 a year, this is your income, this is your income from labor. Income from labor. But let's say that you come upon some inheritance and you have a 10 million dollar inheritance, so you have a 10 million dollar inheritance, and you invested, and you get a 5 percent return on it. So you're return on capital is five, so you get five percent, so let me write this, R is equal to five percent here. R is equal is to five percent. Well five percent of 10 million dollars is $500,000. $500,000 per year. So this right over here is income from capital. Income from capital. And so his argument here is, is once you get to a certain point and you start having a lot of capital, and if your return is greater than the growth in the economy, well then this, this doctor in this example. His wealth is going to go from 10 million to 10.5 million, it's going to grow by five percent again, year in, year out, it's going to grow faster than the economy. And then he could, I guess bequeath to his children or to someone else, and then they will be able to compound in the same way, and then over time, you might have some form of dynastic wealth, where wealth is being driven really you know, they don't really need to have a job. And just this phenomenon by itself, where you inherit some money, you invest it at a rate of return that is growing faster than the economy, and so this overtime is going to take up a larger and larger chunk of the economy. And I'll do a spreadsheet to kind of show at least this dynamic. Now he also points out, that look there could be other dynamics that bounce this off. In fact maybe this is one of the dynamics that really, I guess you could say, valued labor, whether, and we see that in some are areas, whether it's a sports stars or maybe in finance, where the best hedge fund manager is a portfolio managers who get a disproportion share of income. Maybe some of that is justified, or maybe you know even get this returned, you need some of it to go to a labor, but it goes the other way as well. When people get huge labor income that might allow them or potentially the people that they bequeath their money to, to kind of go into this category right over here, where they are getting a lot or all of their income or disproportionate share of their income from the return on their capital as opposed to their labor. And that's, this whole idea is really that you're just going to have a higher savings rate if you have a large income. And actually let me make that clear as well. So for example, for example, if, let's say there's two people, one person, so person A and person B, person B. Let's say person A makes a 100,000 a year. 100,000 a year. And let's say that person B, let me do those in the right colors. Let's say person A makes a 100,000 a year, and let's say person B makes 1 million. 1 million a year. Let me just write it this way. He makes 1 million a year. So that's their income, and we're not even saying how it's coming to them, whether it's labor or returns on capital. So that's their annual income. Now person A, you could consider them I guess upper middle class, they might have you know a mortgage, or house payments, send their kids to college, whatever. Their expenses might be 80,000 a year. Expenses are 80,000 a year. And let's say this is after tax just to make it simple. After, this is after tax income. So their expenses are going to be 80,000 a year. And so they will be left to save, so their savings, savings are going to be $20,000 per year. Now let's say person B their after tax income is a million dollars a year. Now they are able to live a more glamorous life I guess and so they have might more expenses. Maybe they spend, and you know maybe their families are the exact same size. Maybe they spend, I don't know, five times as much money. So this person is living a much more consumptive lifestyle I guess you could say. So they are spending $400,000 to live. And so their savings are going to be $600,000. $600,000. And so you see this idea that this person right over here has a 20% savings rate. They are saving 20% of their after tax income, 20k out of a 100k, while this person right over here has a 60, 60% savings rate. Now it's completely possible that this person could really you know live large and spend 800,000 a year. But it's this phenomenon that the larger that this goes, it's actually hard to spend that much money. In fact you could imagine if someone with a lower income, 40,000 or 50,000, where they have to spend all of their money and they actually have zero savings. So as you, as your income, as your after tax income becomes larger and larger relative to your standard of living, your cost of living. The savings rate generally goes up. And because the savings rate generally goes up. You start to go more into this category right over here, where you benefit, where you might benefit from returns of capital, especially if returns of capital are growing larger than the, going larger than, faster than the economy. And another question to ask is "Do you think this could happen "over very long periods of time?" So once again my point here is to really just to articulate what's going on in this what now seems to be a pretty, pretty popular book. But you should look at this one with an open mind, but also at a critical mind. Does this make sense? What are the balancing factors? Why this might not continue forever? Why R can't be greater than G forever? Or why this might break down? Or why this won't continue on and on forever?