Yves here. One of the main agendas of neoclassical economics is to give Panglossian defenses of the current order a veneer of intellectual legitimacy. If our system is the result of individuals and businesses behaving in logical ways, at least in the minds of economists, surely the outcome is inevitable, and therefore virtuous, or else those operators would do things differently. The Big Lie in all of this is that neoclassical economics takes power completely out of the equation. While it does assume selfishness, in that everyone is out or himself to maximize his utility, it also assumes atomized actors who lack the power to influence markets. As we wrote in ECONNED:

To put it another way: the neoclassical paradigm is that of pure competition, where providers are mere price takers and cannot influence market dynamics. But that is a profoundly unattractive business proposition. Even if one were to wave a wand and reconfigure the modern economy along those lines, it would in short order coalesce into larger units as individuals did deals (either via alliances or merging operations) to gain the advantages of greater size, and sought to distinguish their offerings to give them pricing power. And differentiation doesn’t necessarily mean having unique products, but can come through the service related to the products. For instance, convenience stores charge more for staples like milk by virtue of location (on highways where there are no alternatives nearby) or being open at 3:00 a.m. Yet larger enterprises, or indeed anywhere group ties matter, are weirdly disturbing to neoclassical loyalists. One of the reasons they cling so fiercely to ideas like individuals as the locus of activity, along with rationality and welfare-maximizing results (despite the considerable distortions that result) is that they believe any other stance would support a restriction of personal rights. (An aside: this view is counterfactual. Societies where social bonds have broken down and many individuals are isolated are in fact much more subject to totalitarianism and manipulation by propaganda.)

One widely repeated bit of propaganda in the US is that how much people earn reflects their worth in an economic sense. Given how important business is in American society, maintaining this belief is critical to maintaining legitimacy; otherwise, more and more people would see corporate executives not as captain of enterprise but individuals by luck or connivance, got in a position where they could exploit a system that gives them control over assets and cash flows with perilous little in the way of controls over them (there is a vast literature on principal/agent issues in large corporations).

Here, Ed Walker explains how Piketty took a wrecking ball to the ideas that compensation at the top end of the pay spectrum has anything to do with the type of performance economists care about: marginal productivity. It is telling that this part of Piketty’s argument hasn’t gotten the attention it warrants.

By Ed Walker, who writes as masaccio at Firedoglake. You can follow him at Twitter at @MasaccioFDL, and here’s his author page at Firedoglake.

One of the major criticisms of Capital in the Twenty First Century is that Thomas Piketty relies heavily on the ideas of neoclassical economics in his presentation, as here and here. Others recognize what seems to me to be the most important aspect of the book, it’s relentless assault on neoclassical economic theory, and its political cousin, neoliberalism. Here’s one example.

It’s not possible to tell what Piketty has in mind on this point. As I noted before, he is quite capable of working out ideas in the neoclassical mold, as he does with a study of the role of inheritance in wealth formation in a paper written with Gabriel Zucman. I think he is cutting out the heart of neoclassical theory, and slapping at the neoliberals who love it. To support my view, we can look at his discussion of marginal productivity as an explanation for wildly unequal income distribution. Neoliberals claim that the market rewards people according to their value in production. John Foster and Michael Yates give a good example:

Likewise Robert Lucas, Jr. of the University of Chicago, the most influential macroeconomist of his day, was merely stating the dominant view of the profession and of the establishment as a whole when he opined in 2004, “Of the tendencies that are harmful to sound economics, the most seductive, and in my opinion the most poisonous, is to focus on questions of [income] distribution. Fn omitted.

Piketty’s discussion of marginal productivity begins at page 304, for those who want to follow along in the text. He says that the main explanation for rising inequality of income is the race between education and technology. Those who have more education are better able to cope with technology, and thus are worth more in the marketplace of employment.

This theory rests on two hypotheses. First, a worker’s wage is equal to his marginal productivity, that is, his individual contribution to the output of the firm or office for which he works. Second, the worker’s productivity depends above all on his skill and on supply and demand for that skill in a given society.

This theory is crucial in the construction of the neoliberal project. First, it justifies the massive amount of money going to the C-Suite, the group Piketty sees as a crucial part of the new wealth oligarchy. Second, it has been internalized by most of our fellow citizens, who blame themselves for their economic status and are blind to the impact of social norms and governmental actions. Let’s first see what Piketty says, and then look at the impact on the neoliberal project.

“This theory is in some respects limited and naïve”, he tells us. First, the productivity of any given worker is not a fixed and immutable number, as he puts it, “inscribed on his forehead.” Second, he says that the relative power of each group is a crucial factor in determining how much each gets from revenues produced by the firm. He thinks that education and technology play a significant role:

…[I]f the United States (or France) invested more heavily in high-quality professional training and advanced educational opportunities and allowed broader segments of the population to have access to them, this would surely be the most effective way of increasing wages at the low to median end of the scale and decreasing the upper decile’s share of both wages and total income.

This analysis is based on a book by Claudia Goldin and Lawrence F. Katz The Race Between Education And Technology, and not any special analysis by Piketty. It seems odd that one would draw the conclusion that raising the supply of educated workers would increase the price paid for their labor. It seems to contradict the law of supply and demand, and smells something like Say’s Law. One way to think about it is that labor is not a commodity like coke and iron ore; there is something special about it, an idea rejected by the neoliberals. And even in the long run, how does it work for the unlucky sperm club? And how did it work out for everyone who graduated in 2008 and thereafter? Perhaps he gets it right with this: “…theoretical discussion of educational issues and of meritocracy is often out of touch with reality….” 307.

He then takes up marginal productivity theory in more detail, eviscerating the role of training and education as setting wages in the short run. It is silly to believe that even trained workers are paid according to marginal production. First, it is impossible to measure this accurately, even in the case of repetitive tasks. Second, technology is not always available that requires highly trained people. Third, education is not solely instrumental; it has value in itself. The biggest issue, though, is that the simple theory is unable to account for differences across countries. Worker pay is the outcome of the way the society is organized. He discusses the role of the minimum wage in setting wages. It makes sense, he says to limit the power of the employer to set wages in many settings, obviously where there is a monopsony of employment, but more generally where the power of the employer is overwhelming. That would be the case where unemployment is ridiculously high, as it is today, and where the ability of workers to organize is ridiculously low, as it is today in the US.

In sum, Piketty rejects the theory of marginal productivity as a predictor of wages, and considers it irrelevant in understanding the growth of inequality.

He then asks why there is such a large variance in the growth of wage income at the very top of the income scale. The answer is not simply education, because most of the people in the top quintile have equivalent educations. The explosion of incomes in the top centile happened in the US and England, but not in continental European nations or in Japan. That blows another hole in the idea that marginal productivity explains the rise in top incomes. The data show that the top .01% in France, Japan and Sweden grew rapidly, almost doubling, while quintupling in the US. This difference cannot be explained by differential technological change, because that is fairly constant in all these countries.

The idea that marginal productivity explains anything about the very top incomes is laughable in Piketty’s telling. Consider a firm with 100,000 employees and 10 million Euros in revenues, and a cost of good and services purchased of 5 million Euros. The firm has 5 million Euros to divide among its employees. How should it set the compensation of its CFO? The theory of marginal productivity says we should figure out the value of the contribution of the CFO to the 5 million Euro figure. That’s not possible.

Let’s put this into a real life setting. Barry Ritzholz has the figures on the distribution of the bonus pool of $1.5 billion available at Pimco to be divided among 60 managing directors. Felix Salmon breaks it down:

The top of the food chain, that year, looked something like this*: Bill Gross: $290 million

Mohamed El-Erian: $230 million

Daniel Ivascyn: $70 million

Wendy Cupps: $50 million

Douglas Hodge: $45 million

Jay Jacobs: $22 million … Obviously, the numbers here are mind-bogglingly enormous. But on top of that, they’re incredibly skewed towards the very, very top of the income distribution, in a perfectly Piketty-like manner.

The top two get 35% of the pool, the next three get 8%, and the other 55 get less than the average. Gross managed The Total Return Fund, which shrank nearly 1/3 during the last 16 months. Ivascyn managed the Income Fund, which has grown by 30% over that same year. In fact, Gross committed a stunning mistake, betting on an increase in interest rates in 2011 that seriously damaged the fund. Krugman called him on it in real time. So, it isn’t competence that resulted in the giant paycheck. Paying for lousy performance is pretty much the exact opposite of the marginal productivity theory. But there are plenty of studies showing that paying for lousy performance is common in big businesses, like the recent paper described here.

…[T]he companies run by the CEOS who were paid at the top 10% of the scale, had the worst performance. How much worse? The firms returned 10% less to their shareholders than did their industry peers. The study also clearly shows that at the high end, the more CEOs were paid, the worse their companies did; it looked at the very top, the 5% of CEOs who were the highest paid, and found that their companies did 15% worse, on average, than their peers.

Read the comments, and you’ll see how desperately people cling to the obviously false idea that pay is related to performance, which brings us back to the neoliberal project.

Philip Mirowski gives a brief description of the neoliberal project here, and a longer one in Chapters 2 and 3 of his book, Never Let A Serious Crisis Go To Waste. As I read Mirowski, the point of the neoliberal project is to recreate the mass of humans as homo economicus, the economic person. One of its principal ideas has to do with the notion of human capital, that bizarre idea of Gary Becker of the University of Chicago. Mirowski quotes Michel Foucault in his book:

The Entrepreneurial Self cannot be passive, but must move strategically in a world rife with risk. Hence, reward and punishment are accepted by the agent as the outcome of calculated risk, not the dictates of ‘justice’. Id at 96.

Neoliberals have convinced the vast majority of our fellow citizens that they and they alone are responsible for their fates. They took risks and they lost, but it was their choice. I can hear Rick Santelli ranting in the background. At the same time, neoliberals insisted that governments everywhere bail out the filthy rich and their corporations, especially their financial corporations, and governments obliged. So, we screw the productive members of society and reward the slugs, all in line with neoliberal theory.

Neoclassical economics undergirds the neoliberal project. Piketty slashes at a piece of that foundation with his attack on marginal productivity. What now is the justification for the absurd compensation of the filthy rich? Tort law failed to deal with the sins of the bankers. Why aren’t they in jail? One more block pulled from the Jenga pile of vicious ideas so beloved of the rich and their government agents.