One of my favorite blogs came out of hibernation to comment on Piketty (Warning, it's pretty overtly political), and it reminded me that I still haven't contributed.
A lot of ink has been spilled the question of whether or not the return on capital after will be above the growth rate for significant periods of time. The merits of the arguments generally fall on the side of r > g in perpetuity being nonsense. Either labor prices have to eventually rise (on a global basis they are doing just that) or the return on capital needs to fall.
How can the return on capital fall? Two ways come to mind.
1. Earnings stop growing. This can happen when effective taxes go up more than prices rise to compensate for the increase. This would also occur if unit labor costs started increasing more quickly than the prices of goods sold and profit margins fall. Already, the sales growth of the S&P 500 has been below the economic growth rate of the economy for the past few years - and this is noteable because the S&P also has exposure to faster growing emerging market economies.
2. The expected return of assets fall.
#2 has been interesting - because it is what has been happening over the past few years and yet analysts have if anything gotten more worried about wealth inequality. That's because in order for the expected future returns to capital to fall, prices today need to go up. A company with an earnings to enterprise value of 10% has a much higher expected future return than a very similar company with the ratio at 2.5%. But if the company is earning one million dollars a year in cash, it would have to move from a $10 million dollar valuation to a $40 million dollar valuation in order to reduce the expected return on capital.
Analysts looking at the 16.0% total return to the S&P 500 in 2012 and 32.4% returns in 2013 will plug those numbers into models which uses past returns to predict future returns for various asset classes. After the recent bull market, they might assume that the future return on capital will be even higher than it was in the past. But over this time period, the price to earnings ratio rose from 14.87 to 18.15. In other words, the average earnings yield of all of the companies fell from 6.7% to 5.5%. Instead of concluding that the expected rate of return on capital is higher, analysts should be assuming that future returns will be lower.
The same principles apply to other asset classes, but in many cases interest rates are already below the nominal growth rate of the economy. Equities are one of the few places where the earnings yield is above the growth rate. So if we find ourselves watching the stock market go up over the next few years, it actually means Piketty is more likely to be empircally wrong than right in his r > g prediction on a forward looking basis..