Capital in the Twenty-First Century

by Thomas Piketty

  This is particularly clear in the monumental Monetary History of the United States published in 1963 by Milton Friedman and Anna Schwartz. In this fundamental work, the leading figure in monetary economics follows in minute detail the changes in United States monetary policy from 1857 to 1960, based on voluminous archival records.19 Unsurprisingly, the focal point of the book is the Great Depression. For Friedman, no doubt is possible: it was the unduly restrictive policy of the Federal Reserve that transformed the stock market crash into a credit crisis and plunged the economy into a deflationary spiral and a depression of unprecedented magnitude. The crisis was primarily monetary, and therefore its solution was also monetary. From this analysis, Friedman drew a clear political conclusion: in order to ensure regular, undisrupted growth in a capitalist economy, it is necessary and sufficient to make sure that monetary policy is designed to ensure steady growth of the money supply. Accordingly, monetarist doctrine held that the New Deal, which created a large number of government jobs and social transfer programs, was a costly and useless sham. Saving capitalism did not require a welfare state or a tentacular government: the only thing necessary was a well-run Federal Reserve. In the 1960s–1970s, although many Democrats in the United States still dreamed of completing the New Deal, the US public had begun to worry about their country’s decline relative to Europe, which was then still in a phase of rapid growth. In this political climate, Friedman’s simple but powerful political message had the effect of a bombshell. The work of Friedman and other Chicago School economists fostered suspicion of the ever-expanding state and created the intellectual climate in which the conservative revolution of 1979–1980 became possible.

  One can obviously reinterpret these events in a different light: there is no reason why a properly functioning Federal Reserve cannot function as a complement to a properly functioning social state and a well-designed progressive tax policy. These institutions are clearly complements rather than substitutes. Contrary to monetarist doctrine, the fact that the Fed followed an unduly restrictive monetary policy in the early 1930s (as did the central banks of the other rich countries) says nothing about the virtues and limitations of other institutions. That is not the point that interests me here, however. The fact is that all economists—monetarists, Keynesians, and neoclassicals—together with all other observers, regardless of their political stripe, have agreed that central banks ought to act as lenders of last resort and do whatever is necessary to avoid financial collapse and a deflationary spiral.

  This broad consensus explains why all of the world’s central banks—in Japan and Europe as well as the United States—reacted to the financial crisis of 2007–2008 by taking on the role of lenders of last resort and stabilizers of the financial system. Apart from the collapse of Lehman Brothers in September 2008, bank failures in the crisis have been fairly limited in scope. There is, however, no consensus as to the exact nature of the “unconventional” monetary policies that should be followed in situations like this.

  What in fact do central banks do? For present purposes, it is important to realize that central banks do not create wealth as such; they redistribute it. More precisely, when the Fed or the ECB decides to create a billion additional dollars or euros, US or European capital is not augmented by that amount. In fact, national capital does not change by a single dollar or euro, because the operations in which central banks engage are always loans. They therefore result in the creation of financial assets and liabilities, which, at the moment they are created, exactly balance each other. For example, the Fed might lend $1 billion to Lehman Brothers or General Motors (or the US government), and these entities contract an equivalent debt. The net wealth of the Fed and Lehman Brothers (or General Motors) does not change at all, nor, a fortiori, does that of the United States or the planet. Indeed, it would be astonishing if central banks could simply by the stroke of a pen increase the capital of their nation or the world.

  What happens next depends on how this monetary policy influences the real economy. If the loan initiated by the central bank enables the recipient to escape from a bad pass and avoid a final collapse (which might decrease the national wealth), then, when the situation has been stabilized and the loan repaid, it makes sense to think that the loan from the Fed increased the national wealth (or at any rate prevented national wealth from decreasing). On the other hand, if the loan from the Fed merely postpones the recipient’s inevitable collapse and even prevents the emergence of a viable competitor (which can happen), one can argue that the Fed’s policy ultimately decreased the nation’s wealth. Both outcomes are possible, and every monetary policy raises both possibilities to one degree or another. To the extent that the world’s central banks limited the damage from the recession of 2008–2009, they helped to increase GDP and investment and therefore augmented the capital of the wealthy countries and of the world. Obviously, however, a dynamic evaluation of this kind is always uncertain and open to challenge. What is certain is that when central banks increase the money supply by lending to a financial or nonfinancial corporation or a government, there is no immediate impact on national capital (both public and private).20

  What “unconventional” monetary policies have been tried since the crisis of 2007–2008? In calm periods, central banks are content to ensure that the money supply grows at the same pace as economic activity in order to guarantee a low inflation rate of 1 or 2 percent a year. Specifically, they create new money by lending to banks for very short periods, often no more than a few days. These loans guarantee the solvency of the entire financial system. Households and firms deposit and withdraw vast sums of money every day, and these deposits and withdrawals are never perfectly balanced for any particular bank. The major innovation since 2008 has been in the duration of loans to private banks. Instead of lending for a few days, the Fed and ECB began lending for three to six months: the volume of loans of these durations increased dramatically in the last quarter of 2008 and the first quarter of 2009. They also began lending at similar durations to nonfinancial corporations. In the United States especially, the Fed also made loans of nine to twelve months to the banking sector and purchased long-dated bonds outright. In 2011–2012, the central banks again expanded the range of their interventions. The Fed, the Bank of Japan, and the Bank of England had been buying sovereign debt since the beginning of the crisis, but as the debt crisis worsened in southern Europe the ECB decided to follow suit.

  These policies call for several clarifications. First, the central banks have the power to prevent a bank or nonfinancial corporation from failing by lending it the money needed to pay its workers and suppliers, but they cannot oblige companies to invest or households to consume, and they cannot compel the economy to resume its growth. Nor do they have the power to set the rate of inflation. The liquidity created by the central banks probably warded off deflation and depression, but the economic outlook in the wealthy countries remains gloomy, especially in Europe, where the crisis of the euro has undermined confidence. The fact that governments in the wealthiest countries (United States, Japan, Germany, France, and Britain) could borrow at exceptionally low rates (just over 1 percent) in 2012–2013 attests to the importance of central bank stabilization policies, but it also shows that private investors have no clear idea of what to do with the money lent by the monetary authorities at rates close to zero. Hence they prefer to lend their cash back to the governments deemed the most solid at ridiculously low interest rates. The fact that rates are very low in some countries and much higher in others is the sign of an abnormal economic situation.21

  Central banks are powerful because they can redistribute wealth very quickly and, in theory, as extensively as they wish. If necessary, a central bank can create as many billions as it wants in seconds and credit all that cash to the account of a company or government in need. In an emergency (such as a financial panic, war, or natural disaster), this ability to create money immediately in unlimited amounts is an invaluable attribute. No tax authority can move tha
t quickly to levy a tax: it is necessary first to establish a taxable base, set rates, pass a law, collect the tax, forestall possible challenges, and so on. If this were the only way to resolve a financial crisis, all the banks in the world would already be bankrupt. Rapid execution is the principal strength of the monetary authorities.

  The weakness of central banks is clearly their limited ability to decide who should receive loans in what amount and for what duration, as well as the difficulty of managing the resulting financial portfolio. One consequence of this is that the size of a central bank’s balance sheet should not exceed certain limits. With all the new types of loans and financial market interventions that have been introduced since 2008, central bank balance sheets have roughly doubled in size. The sum of the Federal Reserve’s assets and liabilities has gone from 10 to more than 20 percent of GDP; the same is true of the Bank of England; and the ECB’s balance sheet has expanded from 15 to 30 percent of GDP. These are striking developments, but these sums are still fairly modest compared with total net private wealth, which is 500 to 600 percent of GDP in most of the rich countries.22

  It is of course possible in the abstract to imagine much larger central bank balance sheets. The central banks could decide to buy up all of a country’s firms and real estate, finance the transition to renewable energy, invest in universities, and take control of the entire economy. Clearly, the problem is that central banks are not well suited to such activities and lack the democratic legitimacy to try them. They can redistribute wealth quickly and massively, but they can also be very wrong in their choice of targets (just as the effects of inflation on inequality can be quite perverse). Hence it is preferable to limit the size of central bank balance sheets. That is why they operate under strict mandates focused largely on maintaining the stability of the financial system. In practice, when a government decides to aid a particular branch of industry, as the United States did with General Motors in 2009–2010, it was the federal government and not the Federal Reserve that took charge of making loans, acquiring shares, and setting conditions and performance objectives. The same is true in Europe: industrial and educational policy are matters for states to decide, not central banks. The problem is not one of technical impossibility but of democratic governance. The fact that it takes time to pass tax and spending legislation is not an accident: when significant shares of national wealth are shifted about, it is best not to make mistakes.

  Among the many controversies concerning limiting the role of central banks, two issues are of particular interest here. One has to do with the complementary nature of bank regulation and taxation of capital (as the recent crisis in Cyprus made quite clear). The other has to do with the increasingly apparent deficiencies of Europe’s current institutional architecture: the European Union is engaged in a historically unprecedented experiment: attempting to create a currency on a very large scale without a state.

  The Cyprus Crisis: When the Capital Tax and Banking Regulation Come Together

  The primary and indispensable role of central banking is to ensure the stability of the financial system. Central banks are uniquely equipped to evaluate the position of the various banks that make up the system and can refinance them if necessary in order to ensure that the payment system functions normally. They are sometimes assisted by other authorities specifically charged with regulating the banks: for example, by issuing banking licenses and ensuring that certain financial ratios are maintained (in order to make sure that the banks keep sufficient reserves of cash and “safe” assets relative to loans and other assets deemed to be higher risk). In all countries, the central banks and bank regulators (who are often affiliated with the central banks) work together. In current discussions concerning the creation of a European banking union, the ECB is supposed to play the central role. In particularly severe banking crises, central banks also work in concert with international organizations such as the IMF. Since 2009–2010, a “Troika” consisting of the European Commission, the ECB, and the IMF has been working to resolve the financial crisis in Europe, which involves both a public debt crisis and a banking crisis, especially in southern Europe. The recession of 2008–2009 caused a sharp rise in the public debt of many countries that were already heavily indebted before the crisis (especially Greece and Italy) and also led to a rapid deterioration of bank balance sheets, especially in countries affected by a collapsing real estate bubble (most notably Spain). In the end, the two crises are inextricably linked. The banks are holding government bonds whose precise value is unknown. (Greek bonds were subjected to a substantial “haircut,” and although the authorities have promised not to repeat this strategy elsewhere, the fact remains that future actions are unpredictable in such circumstances.) State finances can only continue to get worse as long as the economic outlook continues to be bleak, as it probably will as long as the financial and credit system remains largely blocked.

  One problem is that neither the Troika nor the various member state governments have automatic access to international banking data or what I have called a “financial cadaster,” which would allow them to distribute the burdens of adjustment in an efficient and transparent manner. I have already discussed the difficulties that Italy and Spain faced in attempting to impose a progressive tax on capital on their own in order to restore their public finances to a sound footing. The Greek case is even more extreme. Everyone is insisting that Greece collect more taxes from its wealthier citizens. This is no doubt an excellent idea. The problem is that in the absence of adequate international cooperation, Greece obviously has no way to levy a just and efficient tax on its own, since the wealthiest Greeks can easily move their money abroad, often to other European countries. The European and international authorities have never taken steps to implement the necessary laws and regulations, however.23 Lacking tax revenues, Greece has therefore been obliged to sell public assets, often at fire-sale prices, to buyers of Greek or other European nationalities, who evidently would rather take advantage of such an opportunity than pay taxes to the Greek government.

  The March 2013 crisis in Cyprus is a particularly interesting case to examine. Cyprus is an island with a million inhabitants, which joined the European Union in 2004 and the Eurozone in 2008. It has a hypertrophied banking sector, apparently due to very large foreign deposits, most notably from Russia. This money was drawn to Cyprus by low taxes and indulgent local authorities. According to statements by officials of the Troika, these Russian deposits include a number of very large individual accounts. Many people therefore imagine that the depositors are oligarchs with fortunes in the tens of millions or even billions of euros—people of the sort one reads about in the magazine rankings. The problem is that neither the European authorities nor the IMF have published any statistics, not even the crudest estimate. Very likely they do not have much information themselves, for the simple reason that they have never equipped themselves with the tools they need to move forward on this issue, even though it is absolutely central. Such opacity is not conducive to a considered and rational resolution of this sort of conflict. The problem is that the Cypriot banks no longer have the money that appears on their balance sheets. Apparently, they invested it in Greek bonds that were since written down and in real estate that is now worthless. Naturally, European authorities are hesitant to use the money of European taxpayers to keep the Cypriot banks afloat without some kind of guarantees in return, especially since in the end what they will really be keeping afloat is Russian millionaires.

  After months of deliberation, the members of the Troika came up with the disastrous idea of proposing an exceptional tax on all bank deposits with rates of 6.75 percent on deposits up to 100,000 euros and 9.9 percent above that limit. To the extent that this proposal resembles a progressive tax on capital, it might seem intriguing, but there are two important caveats. First, the very limited progressivity of the tax is illusory: in effect, almost the same tax rate is being imposed on small Cypriot savers with accounts of 10,000 euros and on Russian
oligarchs with accounts of 10 million euros. Second, the tax base was never precisely defined by the European and international authorities handling the matter. The tax seems to apply only to bank deposits as such, so that a depositor could escape it by shifting his or her funds to a brokerage account holding stocks or bonds or by investing in real estate or other financial assets. Had this tax been applied, in other words, it would very likely have been extremely regressive, given the composition of the largest portfolios and the opportunities for reallocating investments. After the tax was unanimously approved by the members of the Troika and the seventeen finance ministers of the Eurozone in March 2013, it was vigorously rejected by the people of Cyprus. In the end, a different solution was adopted: deposits under 100,000 euros were exempted from the tax (this being the ceiling of the deposit guarantee envisioned under the terms of the proposed European banking union). The exact terms of the new tax remain relatively obscure, however. A bank-by-bank approach seems to have been adopted, although the precise tax rates and bases have not been spelled out explicitly.