The First Fundamental Law of Capitalism
By Scott Sumner
Suppose that I made the following claim:
The formula M*V = P*Y is a pure accounting identity. It can be applied to all societies in all periods of history, by definition. Though tautological, it should nevertheless be regarded as the first fundamental law of capitalism, because it expresses a simple, transparent relationship among the three most important concepts for analyzing the capitalist system: the money supply, the price level, and real GDP.
How would you react? You might wonder what this has to do with “capitalism.” Isn’t it also the first fundamental law of communism, and feudalism, and socialism? After all, it’s an identity. Next you might ask why the money supply, price level, and real GDP are the most important “concepts” for analyzing the capitalist system. What makes them so important?
Here’s Thomas Piketty (p. 52):
The formula a = r*B is a pure accounting identity. It can be applied to all societies in all periods of history, by definition. Though tautological, it should nevertheless be regarded as the first fundamental law of capitalism, because it expresses a simple, transparent relationship among the three most important concepts for analyzing the capitalist system: the capital/income ratio, the share of capital in income, and the rate of return on capital.
After an earlier post, some commenters suggested that parts of Piketty’s message were lost in translation. I suspect that is the case here. After all, the three concepts cited by Piketty seem far less important than M, P and Y. Is it possible he meant “system of capital”, not “capitalism”?
I was criticized for being too negative in my previous post; so let me praise Piketty for the following (pp. 31-32):
I did not find the work of US economists entirely convincing. To be sure, they were all very intelligent, and I still have many friends from that period of my life. But something strange happened: I was only too aware of the fact that I knew nothing at all about the world’s economic problems. My thesis consisted of several relatively abstract mathematical theorems. Yet the profession liked my work. I quickly realize that there had been no significant effort to collect historical data on the dynamics of inequality since Kuznets, yet the profession continued to churn out purely theoretical results without even knowing what facts needed to be explained. And it expected me to do the same. When I returned to France, I set out to collect the missing data.
To put it bluntly, the discipline of economics has yet to get over its childish passion for mathematics and for purely theoretical and often highly ideological speculation, at the expense of historical research in collaboration with the other social sciences.
Although I differ with Piketty on policy questions, I am very fond of his views on methodology.
I’ve just finished the second chapter (the first after the intro), and found it to be very clear and easy to understand. My only quibble (in addition to the 1st fundamental law of “capitalism”) is the following claim (p. 71):
China, for example, still imposes controls on capital: foreigners cannot invest in the country freely, but that has not hindered capital accumulation, for which domestic savings largely suffice. Japan, South Korea, and Taiwan all financed investment out of savings.
Here Piketty failed to do his homework on East Asian growth. During its high growth period of roughly 1960 to 1997, South Korea relied very heavily on foreign savings to finance its investment. This allowed South Korea to have higher living standards during its period of rapid growth than China, which severely squeezed consumption in order to generate enough savings for their high-growth model.