Harry Geels: Views of financial economists are missing from the inequality debate
This column was originally written in Dutch. This is an English translation.
By Harry Geels
The public debate on inequality and taxation is heavily dominated by a macroeconomic way of thinking, whilst insights from financial economics are conspicuously absent. Among other things, the ‘risk premium’ is conspicuously absent from the debate.
The field of economics comprises various disciplines, such as macroeconomics, microeconomics, finance, econometrics and business administration. The debate on inequality, wealth and taxation is primarily led by macroeconomists. In a sense, this is hardly surprising, particularly when considering macroeconomic indicators. Yet I am increasingly struck by the feeling that something fundamental is missing from the debate. Not because macroeconomists fail to understand inequality, but because they often speak a different language to financial economists.
Macroeconomics is about averages: growth, inflation, unemployment and income distribution. Financial economics is about risk, uncertainty, expectations and behaviour. Both disciplines study the same reality, but view it through a different lens. To someone who sees economics as a single discipline, there appears to be no difference. In reality, however, there is a significantly different perspective on the matter, with major implications for public debate. Let us explore this further using three well-known economists: Thomas Piketty, John Cochrane and Friedrich Hayek.
Thomas Piketty
Although Piketty is not a typical macroeconomist – his methods are more historical and empirical than is usual – he does provide a good example of the difference in thinking between macroeconomists and financial economists. Take Piketty’s famous formula: r > g. According to him, the rate of return on capital (r) is structurally higher than income growth (g), meaning that wealth grows faster than income and inequality increases. This idea has had a major influence on thinking about wealth inequality worldwide.
From the perspective of financial economics, however, a question immediately arises. What risk is associated with r and g? After all, the return on shares, entrepreneurship, private investment or property is uncertain. It may go well, but it may also fall short of expectations. Income growth, by contrast, is an aggregate of an entirely different nature. A financial economist will therefore not only look at returns, but will always ask what risk premiums are embedded within them. What is striking is that this perspective is virtually absent from many public discussions. It is as if returns were a given that falls from the sky, rather than a reward for bearing uncertainty.
I previously wrote a column entitled ‘The Piketty craze is misplaced’, in which I explore the above points in greater depth.
John Cochrane
John Cochrane, in particular, has brought the debate on the difference in perspective between macroeconomists and financial economists into sharp focus. His central message is that macroeconomics and ‘finance’ have drifted too far apart. According to him, many macroeconomists ignore the information embedded in market prices, whilst it is precisely those prices that constantly reveal something about risk, expectations and uncertainty. This is no minor detail. Financial markets are not casinos: they are the place where millions of people try to value the future on a daily basis.
Friedrich Hayek
Friedrich Hayek forms an interesting bridge between these two worlds. Although he was not a financial economist, he emphasised that market prices contain information that is dispersed amongst millions of economic agents. In doing so, he laid the foundation for the idea that prices are more than just figures: they contain knowledge. His work is relevant to the current debate on wealth and taxation. Wealth is not only a matter of distribution, but also a carrier of information. Market prices reflect expectations, risks and knowledge that no policymaker can fully grasp.
Risk perception and behaviour
Those who look solely at wealth statistics see a distribution. Those who look at market prices also see expectations, risks, entrepreneurship and uncertainty. The first perspective tells us who is ‘rich’. The second seeks to understand why capital behaves as it does. Wealth taxes erode the reward for taking risks and lead to all manner of behaviours, such as deferring tax payments or tax avoidance, which mean that the allocation of capital is no longer efficient and markets function less effectively as mechanisms for discounting information.
When wealth is presented as a static stock that can simply be taxed, behavioural responses are easily overlooked. Entrepreneurs, investors and capital providers, however, respond to incentives. They adapt their behaviour, risk appetite changes and investments shift. This does not mean that taxes are wrong per se. It does mean, however, that taxes are never merely a matter of redistribution. They are also a matter of behaviour, expectations and risk. This is probably the greatest difference between macroeconomics and financial economics.
In conclusion
The debate on inequality is dominated by macroeconomists who focus primarily on averages, aggregates and distributions. This easily gives the impression that wealth is a static stock that can simply be taxed. In reality, that wealth represents claims on an uncertain future. Anyone who ignores the risk dimension runs the risk of designing redistribution policies that look attractive on paper but, in practice, undermine entrepreneurship, innovation and capital formation, meaning that tax revenues will be much lower than ‘planned’.
To throw in yet another metaphor: macro-economists focus primarily on who gets the cake, whilst financial economists first ask who devises the recipe, pays for the ingredients and is willing to turn on the oven. Cochrane’s call to integrate both (sub)disciplines therefore deserves to be repeated loud and clear. Hopefully, macroeconomists will soon start to view the effectiveness of taxation in a different light. At the same time, financial economists need to take greater account of the macroeconomic variables that exacerbate inequality.
This article contains the personal opinion of Harry Geels