The housing bubble: Why implicit insurance may well be the real driver of Piketty’s concerns
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.
If the increase in inequality has been driven by an increase in legal-political support for finance, that would be consistent with the observed fact it has accrued mostly in the top 0.1%.
Changing the rules of the game is hard but not harder than implementing a global wealth tax. Better to tackle a problem head on than introduce a Rube Goldberg solution, if we have the choice. And in countries with a free press we have seen a little pegging back of the implicit subsidy. What is democracy for if not this?
Imagine an imaginary island which has not so much Capital but is rich in bounteous Land. Imagine the rulers of this island had passed so many regulations regarding Land and the non-taxation thereof that it amounted to a vast implicit subsidy. And it so disenfranchised the youth of this island that they had to take on vast debts just to acquire enough land to live on. Would it be better to dismantled some of the regulations? Or to create a giant Tool to stop the young people trying to buy more Land?
The key thing is that Piketty would view our view (as I share your view here), that financial regulation and implicit views on government appropriation, are the dominant drivers as wrong. This is why there needs to be work “comparing hypotheses” before we can come to policy conclusions!
Good post but, on my reading of Piketty, subsidies for the wealthy are not exogenous. Policy is skewed in favour of the wealthy. Campaigning to get rid of such implicit subsidies might well be as tough as imposing a wealth tax.
Piketty touches on a lot of mechanisms that could drive policy – which is fair enough, he is trying to express a data set that is showing an increasing concentration of wealth.
However, if it is to do with financial regulation rather than an inherent tendency it changes both the forecast of what will happen and what “best” policy is. Combined with the fact there is already pressures to remove implicit subsides (the OBR in New Zealand can be seen as an example of this – although one that also illustrates some of the pitfalls), this suggests that focus here makes significantly more sense than a tax on the value of capital.
Remember, the capital tax was justified on the basis of increasing wealth concentration – if it is due to regulation in this sense the increasing wealth concentration in the future doesn’t follow!
Interesting questions. I’m sceptical of the importance of any sort of implicit insurance story as an explanation for capital stock trends over long periods of time. One should be particularly wary of accepting that “fractional reserve banking” is a material part of any story: as George Selgin has argued for years, in unregulated market monetary systems “fractional reserve banking” shows up as the normal conventional model, and 100% reserve models (old or new) do not.
But the questions Piketty poses are good ones. For NZ, we really need someone to put the work in to create some similar data series. For the data we do have – the SNZ real capital stock numbers – there has been no sign of an obvious change in K/GDP over recent decades. Of course, those numbers exclude land, and rural land is a much more important part of the capital/wealth stock in NZ than it is in most advanced countries (perhaps around 100% of GDP or more). Sadly, and unlike the ABS, SNZ do not publish data on land values, but it should not be beyond the skill of a careful researcher to use what price data we do have – going back a long way – to construct some plausible time series estimates.
I certainly wouldn’t lay it at the hands of fractional reserve banking – but as a story of evolving expectations of bailouts, or gradual investment by financial intermediaries to make themselves ‘too big to fail’ there is some plausibility. Only enough plausibility to tell me it is a hypothesis worth investigating though – certainly not one that tells me we should set policy based on it!
Agreed regarding NZ data, the K/Y ratios look pretty stable but without land this is a bit empty. I am hoping that Piketty motivates someone in NZ to do this sort of research – I am being sort of selfish as I have just started research on the personal income distribution, and having someone else do this more macro story would really help me improve my own narrative 🙂
My broader point here (if I had written the post a bit better) is that there are alternative explanations to the data Piketty put together, explanations that don’t rely on either an elasticity of substitution in net factors of more than 1 or real rates of return being macrosocial. In that light his text tells us we should really look deeply into the causes, then consider policy – however, he merely calls it a natural tendency of capitalism and suggests a capital tax which from my reading is a long bow to draw (even though I have some inherent sympathy for the view, especially if we expect technology to be increasingly labour saving).