Alex Tabarrok at Marginal Revolution points out that, without the run up in house prices, we do not get Piketty’s trend of rising capital to output ratios in the data. This is very true, and was one of the key reasons why I wasn’t convinced that Piketty’s explanation of his data was the best available.
Now Piketty expressly discusses capital gains in his book – and he points out that he does not view the current increase in the value of capital as a bubble, instead it is the value of capital returning to its “real” level. In that way, he views the idea of saying that we have a bubble as both wrong and beside the point.
Say that we accept the implied assumption he works with – that there isn’t (and hasn’t been) a bubble in housing markets. Given this, it is important at this point to consider the narrative he has for history. He discusses a period (pre-WWI) where governments offered a high risk free rate of return, where wealth was (in some ways) heavily insured by government, and where (as a result) the value of capital was high and the private risk premium was low [best example of this was his discussion of the UK, where government debt offered a high risk free yield for those who could invest in it]. WWI and WWII – with the combination of war and the change in government policies (towards appropriation and direct regulation) changed this – the private risk premium was now a lot higher, and the value of capital dropped as a result. Government protection and regulation is BUILT INTO the price of an asset!
In Piketty’s data we are looking at a situation where government policies have changed, and as a result so has the inherent private risk premium associated with assets, pushing up the price of assets. This description suggests that, if there is a failure, it is due to an “implicit subsidy” by governments to capital owners – it is in essence the same policy failure that those in financial/macroeconomics have been discussing for years now (a quick look on the blog for recent posts gives these 1,2,3,4 - more importantly don’t forget this and suggestions by Cochrane to make the financial system run free and remove this implicit subsidy).
If this is the real cause of the changing capital to output ratios, then it suggests economists have already been investigating the key cause – and that there is no natural tendency for capitalism to head this way. Even if we don’t deal with the inherent injustice, capital/output ratios shouldn’t intensify. And furthermore, this would suggest that there is no need for a capital tax to deal with the perceived injustice – instead we just need to remove an implicit subsidy, and it make investigation into financial regulation even higher on the research agenda!
This is an incredibly important issue to investigate with respect to Piketty’s central thesis – his data set is incredible, but there is a lot of work to be done teasing out what it actually means, let alone defining what correct policy is. Even while I was reading this book, I could not get this alternative hypothesis out of my head – and Tabarrok’s post has just increased my belief that this alternative hypothesis is the correct one.