Like Alexis de Tocqueville almost two centuries before him, the French economist Thomas Piketty has a distinctively American spirit—more than we might think, in fact. American social scientists lean heavily toward what is called “methodological individualism.” Like our fellow citizens, we tend to think that the mechanics of, and solutions to, our social, economic, and political problems are located in individual incentives and attitudes. And among the many voices remarking on the growth of American inequality, most focus on the forces and policies that affect individual citizens. These voices have come to the eminently sensible conclusion that the growth of American inequality has mainly to do with changes in the labor market and social policy— globalization of supply chains, outsourcing of manufacturing, changes in taxation, developments in education and family structure, weakening of labor organization and bargaining power. That collective hunch has received perhaps its strongest academic support from Piketty’s landmark book Capital in the Twenty-first Century, published in April of last year. Piketty’s book harnesses the power of centuries-long data series that reflect a striking and growing divergence among household incomes in France, England, and the United States. His principal proposed solution to rising inequality—a global tax on assets—is a tool that targets wealthy people and families more than companies, banks, and labor unions. According to Piketty, the basic problem is an ever more yawning gulf in the spread of individual incomes; the basic solution is thus a tax on wealth held by individuals.
Piketty is right in many respects. No discussion of the causes or solutions to the inequality crisis can ignore changes in how work and investment are compensated, and no attack on inequality could possibly dispense with taxation as a salve. Wealthy individuals stash untold trillions of dollars in offshore accounts, thousands of miles away from the taxing powers of the nation-states whose institutions protect the very markets that made the wealth possible in the first place. (One of Piketty’s collaborators, Gabriel Zucman, estimates that the amount of asset storage in offshore tax havens is at least $7.6 trillion; other estimates place the amount two to four times as high.)
Still, it is more than odd that an economist writing a magnum opus on capital and inequality in the wake of the financial crisis of 2007-08 pays so little attention to the regulation of banks and financial institutions as cause, symptom, and partial cure in the inequality crisis. There is no better example of exploding top incomes—explosions largely robust to the recent recession—than the compensation of bankers, lawyers, analysts, and executives in the financial industry, and the financial crisis shriveled and decimated the fortunes of tens of millions of working-class and poor families in the United States and Europe. Of course, just because the financial sector is involved in inequality’s run-up does not mean that financial regulation is. We tend to think that regulation is a matter of keeping the banking system safe and of protecting consumers of all incomes and classes. Outside of preventing a crisis, how could it possibly shape inequality?
The answer is found in Piketty’s basic argument. Piketty believes that the key to understanding changes in macroeconomic inequality is found in the expression “r > g,” which states that the rate of return on capital (r) is greater than the rate of economic growth (g). What Piketty calls the “core contradiction of capitalism,” r > g reflects a world in which even growing economies will pay off those who hold capital more than those who labor.
In any economy, some—usually those with higher incomes—will hold more capital than others. (An illustrative exception would be the working-class stiff, maybe recently laid off, who nonetheless owns a home in a very rapidly gentrifying neighborhood, or whose mother just died and passed him a large estate.) If the imbalance of r > g holds stably for a long time, then the payoff for one class (those whose incomes depend on capital) will be consistently higher than that for another (those whose incomes depend on labor). It’s not simply that the wealthy are making more money, Piketty asserts, but that their lives are organized around a factor of production that systematically pays off more than economic growth does. Accordingly, a key part of Piketty’s book shows that the higher a person is in the income distribution, the greater the dependence of their income on inherited assets and the returns on the investment based on those assets.
Financial regulation may seem like a far remove from these dynamics, except when we pause to consider the possibility that when well applied, it can drive growth rates and capital returns closer together rather than farther apart. Put differently, financial under-regulation and deregulation are prime suspects in the recent run-up of inequality. Why? Because appropriate financial regulation prevents an economy from becoming overly “financialized,” where more and more effort goes into capital returns for their own sake (often by speculation), raising r, and less and less goes into productive investment, lowering g and the lower-class income gains that come from it.
Financialization is a word that describes a state of economic play. For many, it refers to the outsized role of financial institutions in the economy. In the economy as a whole, the financial sector occupies a growing role as a source of overall profits. Yet a key feature of American financialization is that even nonfinancial companies like automakers have begun to make their money from financial operations rather than from building cars. As the sociologist Greta Krippner described it in her groundbreaking 2012 book Capitalizing on Crisis, financialization reflects a “pattern of accumulation in which profit making occurs increasingly through financial channels rather than through trade and commodity production.”
A lot of recent research in finance, economics, and economic sociology has produced firm-level and macro-level evidence consistent with Krippner’s observations. Companies are observed to hold significantly more cash than they did in the 1960s and 1970s, and cash flow volatility has increased apace with these developments. A portfolio shift toward more and more financial assets has occurred across the distribution of firms and is not merely concentrated in large or small organizations. Companies increasingly engage in “equity buybacks,” wherein nonfinancial companies repurchase their own stock, a pattern that has exploded since the mid-1980s.
What does this mean for growth, especially of the industrial and service-oriented sort that can help enrich middle-class American workers (or what is left of them)? Again, a slew of diagnostic studies shows that various forms of “real capital investment” have declined as nonfinancial companies have become financialized. Firms that hold more cash are characterized by less working capital and by decreasing capital expenditures. (In general, capital expenditures have in recent years been negatively correlated with cash holding.) In a recent study of thousands of nonfinancial corporations over the period 1971 to 2011, the Middlebury College economist Leila Davis finds that stock buybacks are associated with reduced “real” capital investment in both the short run as well as the long run, and also that the financial volatility of nonfinancial companies (which appears to reflect those companies’ increasing financialization) is associated with reduced real capital investment.
When properly designed and implemented, financial regulation limits financialization because it polices and limits speculation and provides proper incentives for investment to turn toward “real capital” or “productive capital.” As the University of Chicago scholars Eric Posner and Glen Weyl have noted, financial markets have a crucial difference from others, in that they can be used to gamble as well as to provide insurance. The insurance provides economic value, whereas the gamble does not. In cases where that gambling risk is aggregated to take up a broad swath of an economy’s funding, the financial system’s safety and soundness are threatened. Because the global stakes are so high, the government simply must act as lender of last resort. Yet beyond this, when large institutions pour deposit-backed funds into more and more speculative activity, it is also real capital investment that suffers.
How can financial regulation combat these jeopardies? Financial regulation does a lot of things, so as examples, let’s take a simplified look at the Glass-Steagall Act of 1933, securities regulation, and prudential regulation.
The idea of Glass-Steagall was to provide depository insurance only for those banks that were dedicated to providing depository services to citizens and depository functions to the economy. You could be an investment bank like Goldman Sachs or Morgan Stanley, or you could be a depository institution like Peoples Trust & Savings Bank of Clive, Iowa, but you couldn’t be both. The worry at the time—which many observers seem to see as proven after the repeal of Glass-Steagall in 1999—was that banks whose deposit-based assets were backed by government guarantees would have extra incentive to gamble as opposed to using the money to make capital loans or engage in less risky forms of investment. Glass-Steagall, in other words, was not just about keeping the banking system safe. It was also about orienting deposit banks toward more productive investment. Whether the Volcker Rule is an adequate placeholder for Glass-Steagall is a question for study and monitoring. I have my doubts. At the very least, however, the Volcker Rule and any other separation of depository from commercial banking should be evaluated not only for whether it makes our system “safer” but for whether it leads to more productive capital investment.
The Securities and Exchange Commission, that target of so much criticism in the wake of the Bernie Madoff scandal and the crisis, also played an important role in enabling a more financialized economy. It was the SEC’s rule changes in the 1970s and 1980s—not least the “safe harbor” provision of Rule 10b-18 in 1982—that helped pave the way for the explosion of stock buybacks. As with most things in securities regulation, the devil here is in the details, particularly the details of enforcement. In two ways, Rule 10b-18 opened the floodgates to stock buybacks (more than $550 billion worth from 1996 to 1998, according to one analysis, up from $25 billion a year in the 1980s). Not only did the rule give implicit legitimacy to stock repurchases, but beyond that, the SEC’s rules and enforcement activities were so light as to permit stock buybacks to proceed without transparency. A 2003 study in the Journal of Business determined that one in four repurchases did not comply with SEC guidelines but that the SEC was powerless to detect this fact because the actions were not transparent. There is more transparency in the murky world of insider trading than there is in stock buybacks, the authors concluded. Suffice it to say that it’s plausible (and perhaps time will tell) that if the SEC regulated equity repurchases more stringently, companies would invest more heavily in capital-intensive projects that create better jobs.
The world of prudential regulation is a mix of American and international standards. The Basel Accords have been much criticized for their weakness, but they merely require banks to keep a safer form of capital in house (cash, certain bonds) so that when more risky investments fail, the banks will not fold. Again, the principal aim of these regulations—which have been lightly implemented in the United States—is to make banks and the banking system safer. Yet another possible outcome of core capital requirements—which have, in Canada’s illustrative case, been implemented more rigorously than they have in the U.S.—is that real capital investment is higher. A portfolio tilted toward core capital is one, historically, in which less leverage induces more business lending. Not coincidentally, when Canada in the 1990s and early 2000s tightly regulated core capital requirements for their banks, their real capital investment was significantly higher than in the U.S. (the height of the Canadian dollar has since muted these effects). The wisdom of Canadian bank regulation is not merely that its economy suffered less of a shock—that aspect is well known—but also that in the growth period of the 1990s and early 2000s, Canadian capital investment was high, contributing to the Canadian middle-class surge that so many observers have noted. Bank regulation didn’t just affect the financial sector in Canada. It plausibly shaped the industrial and service sectors too, limiting the growth of inequality there.
Glass-Steagall, regulation of stock buybacks, and core capital requirements are different from the tax policies favored by Piketty in many ways, but one crucial difference needs to be underlined. All of these policies target organizations and institutions of capital—banks, investment firms, and, in many cases, regulatory agencies themselves. This approach differs from Piketty’s methodological individualism because the targets of policy are less individuals—or not exclusively individuals—and more organizations and institutions. And following Daniel Seligman’s classic Public Interest article in 1970 on the transformation of Wall Street to a world of more organizational investors, it is organizations and not just individual investors that need to be regulated in the world of finance.
Critics of Piketty’s call for a global wealth tax have rightly noted that the infrastructure would be very difficult to build and maintain. Given the problems with offshore accounts, such an infrastructure may be worth constructing, but in this respect it is worth noting that a substantial, if somewhat flawed architecture for financial regulation already exists. There are already international organizations of core capital regulators, securities regulators, and bank regulators. There are already strong national and supranational government agencies with global reach. To be sure, these institutions may proceed too weakly by dint of risk aversion or what the legal scholar James Kwak has called “cultural capture.” Yet as my colleague David Moss of Harvard Business School and I have written, regulatory capture is not an insurmountable problem, but a long-term challenge that can be managed and prevented by degrees even when full success is not achieved. Agencies ranging from the Department of Transportation and the Food and Drug Administration to state insurance regulators, while influenced by regulated business, have limited the amount of capture by soliciting public and state government input on their proposals.
What I’ve sketched here is massively simplified, and the idea that financial regulation might constrain inequality depends on regulation working well. There are entire ideologies and industries dedicated to the silent proposition that regulation fails. And when it comes to inequality there are, to be sure, some forms of regulation—licensing for some occupations, where historical evidence suggests that we should be far less concerned about doctors and nurses and perhaps more concerned about barbers and hair stylists—that may exacerbate inequality. There are, however, other forms of consumer protection regulation—food and drug safety, for instance—that shape inequality because they provide a form of insurance that, while it has “public good” qualities in that everyone enjoys it and no one can really be excluded, is more valuable to those on the lower rungs of the socioeconomic ladder. The self-protective actions that people would take in the absence of product regulation—getting better education about the safety and quality of foods and drugs, insuring against risks, covering losses from bad outcomes—are far easier for the rich to handle than for the poor. Deregulation of consumer protection, by weakening these protections, effectively raises the costs of insurance for the non-wealthy.
Regulatory limits and failures aside, if America’s long-term discussion about economic and social inequality forgets regulation, the country will forfeit a grand opportunity to target policy correctly, and will in fact position itself to get policy wrong. If Piketty is right that r > g is driving inequality, at least part of the solution has to be more than taxing capital. Ideally, solutions will also seek to drive the rate of return on capital closer to productivity growth. By policing speculative investment and turning investment toward real capital outlays, financial regulation does more than perform its usual safety function. Wise financial regulation might contribute to constraining inequality, too.