Casey Mulligan wants to add another to my list of factors that might have been responsible for the steep and unanticipated decline in asset prices over the past year and a half: the pace of capital accumulation — especially the country’s residential capital stock — over the past five years. With every extra piece of capital comes a reduction in the average dividend it will pay and also a reduction in the present worth of that future dividend — so when there is more capital each unit of capital is worth less.
This channel produces a smooth and anticipated decline in the price p of capital goods — as we used to chant while studying for Olivier Blanchard’s midterm in Econ 2410b: “pdot = rp – d,” the rate of decline in the price of capital goods is the required ex ante rate of return r times the current price of capital goods p minus the current dividend d.
And this is, I think, a problem. For we have to account for not a slow, anticipated, continuous fall in the prices of risky claims to capital but for a sudden, unanticipated, discrete collapse in those values. Capital accumulation won’t do that for us: we need discrete and unexpected changes in resources, technologies, or preferences — and a collapse in risk tolerance, a sudden discrete change in marketwide preference for risk is that one that seems most plausible to me.