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What does R>G mean in economics? What is one of the fundamental laws of capitalism?
The formula R>G states that the net rate of return on capital (R) is greater than the economic growth rate (G). In Capitalism in the Twenty-First Century, Thomas Piketty claims this is one of the fundamental laws of capitalism.
Read more to learn how R>G explains wealth inequality.
R>G: Returns Are Higher Than Growth
Piketty observes that historically, the rate of return on capital r has almost always been higher than the economic growth rate g. Piketty expresses this mathematically as r>g, and he labels it as a fundamental law of capitalism.
This means that the capital-to-income ratio has a natural tendency to grow—because the returns on existing capital enable the accumulation of ever-greater stocks of capital, which earn more returns, which are then reinvested to acquire even more capital, and so on.
Piketty stresses that these massive fortunes of the ultra-wealthy are so astronomical that they can’t help but grow on their own, even once their owners stop working. They simply generate much more income than can be spent in multiple lifetimes so that nearly all of the returns can be reinvested into the capital stock to earn more returns. It’s nearly impossible for wealth accumulation to stop at such a threshold.
For example, Facebook founder Mark Zuckerberg has a net worth of nearly $60 billion. Even if he earned “only” the average return of 5% per year, that would earn him an additional $300 million per year just on the returns from his existing wealth. Since that $300 million is, by itself, a staggering sum that most people would struggle to spend in a lifetime, Zuckerberg could consume only a relatively small portion of those returns (perhaps $37 million to purchase another sprawling estate in Palo Alto) and reinvest the remaining returns into his existing portfolio to earn even greater returns the next year.
Over time, the law of r>g will result in an enormous divergence of wealth. Piketty warns that, if left unchecked, a rising capital/growth ratio will enable capital to devour an ever-growing share of global income.
The Elasticity of Substitution and the Uninvested “Returns” From Housing
Some writers have argued that Piketty overstates the case about the law of capitalism r>g. Former US Treasury Secretary Larry Summers writes that returns to capital diminish much more quickly than Piketty says and that far fewer returns to wealth are reinvested than Piketty claims. Summers argues that returns to capital hinge upon what economists call the elasticity of substitution, or the ease with which you can alternate between factors of production (primarily capital and labor).
In this case, Summers asks how much the returns to capital decline with each additional percentage point of capital. In other words, if capital increases by 1%, does the return on it relative to an equivalent increase in labor decline by more or less than 1%? Summers argues that if it declines by more than 1%, then the capital-to-income ratio will fall. Summers contends that the latter is usually the case, as the depreciation of capital tends to increase proportionally with the overall share of capital, which is also increasing.
Summers further argues that the largest component of capital in the US is housing. But, he writes, the most significant returns from this asset class come in the form of imputed income—the rent that owners pay themselves. Since this “return” is non-financial, it cannot be reinvested. This, Summers reasons, poses a significant problem for Piketty’s argument that there is a fundamental divergence in capitalism.
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Here's what you'll find in our full Capital in the Twenty-First Century summary :
- An analysis of incomes, tax returns, and estate tax returns across different countries
- How capitalism, by its nature, generates economic inequality
- How inherited wealth will soon account for more than earned income