As I start to read Piketty, the following train of thought occurred to me.
How would I explain fluctuations in the ratio of wealth to income? In particular, why did that ratio fall in the 1930s and why has it risen in recent decades?
My first thought is to look at stock prices, and at the P/E ratio. As the P/E ratio goes up, the ratio of stock market wealth to earnings goes up.
What drives the P/E ratio? The standard explanation would use some version of the discounted earnings model. That is, the P/E ratio will be high when the discount rate is low and/or expected future earnings are high. Over the past century, stock prices have trended upward because of one or both of these factors. That is, investors have been willing to discount earnings at lower rates or they have raised their expectations for earnings.
Call the discount rate r and the expected growth rate of earnings g. In short, the discounted earnings model says that the P/E ratio will be high when r is low and/or g is high.
Yet Piketty sees the rise in the ratio of wealth to income as caused by the opposite configuration. That is, he thinks it has taken place because r is high and g is low.
Of course, his r is “return to capital,” not the discount rate. And his g is the growth rate of total income, not corporate earnings. But I wonder how one sorts this all out, and how one goes about choosing between the finance-theoretic explanation of changes in the ratio of wealth to income and the Piketty-Marxist explanation.
UPDATE: James Galbraith writes,
when asset values collapsed during the Great Depression, it mainly wasn’t physical capital that disintegrated, only its market value. During the Second World War, destruction played a larger role. The problem is that while physical and price changes are obviously different, Piketty treats them as if there were aspects of the same thing.
DeLong has a nice model of all these different rates and how they interact that is at least clearer than anything I have heard.
A couple of comments. First, how do we know the amount of wealth? And who owns it. Income we can get from tax returns, but not wealth (I know of attempts to get wealth from tax returns, but I doubt they are accurate). If the Texas Teachers Retirement Fund owns some real estate, is that spread over all the retired teachers in the correct ratio? And how is that done. So I take any wealth numbers with a grain of salt (as a tax lawyer, the income numbers, which come from the IRS, are used to paint a misleading picture: why should one thing bad numbers will lead to a more accurate picture).
Second, it makes sense the income to wealth ratio should declined in the 30s as asset prices in general declined in the wake of the great depression. It also makes sense the ratio has increased as the long decline in interest rates and current “financial repression” have reduced the income you can obtain from assets, thus making an asset producing the same amount of income more valuable.