EQUITY PREMIUM CHATTER….Via Tyler Cowen, New Economist has an interesting roundup of reactions to a new paper by Robert Barro purporting to explain the equity premium puzzle. In a nutshell, the puzzle is this: why do U.S. stocks have a higher long-term rate of return than Treasury bonds? In theory, investors should demand a higher return on stocks, but only enough to make up for the fact that stocks are riskier than bonds. In real life, though, it turns out that even when you take risk into account, stocks still have higher returns. Why?

Barro’s answer, which amplifies on a solution proposed nearly two decades ago by Thomas Rietz, is that investors are fundamentally irrational: they are overestimating the probability of unlikely but catastrophic losses, and this fear makes the demand for risk-free investments larger than it rationally ought to be and thus drives down their price. In other words, the mystery is not so much that returns from stocks are higher than they should be, but that returns from bonds are so low. As Barro puts it:

The equity premium is mostly about the very low risk-free real interest rate. The rare-disasters framework says that this low risk-free rate reflects the large demand for risk-free assets because of the potential for big disasters.

Needless to say, I have nothing to add to this, although it’s an explanation I find appealing because of my fondness for Prospect Theory, which is based on the fact that people are not so much risk averse as loss averse. It turns out that most people feel much more strongly about the probability of a loss than they do about the probability of an equivalent gain, and it seems like this is partly what’s going on here.

In any case, Barro argues that we can test his theory by examining interest rates in the wake of catastrophic events that increase the fear of future catastrophic events:

A small increase in this kind of risk ? as an example, due to the September 11th events ? leads to a noticeable response of real interest rates. When this probability goes up, the risk-free rate goes down because people put more of a premium on holding a relatively safe asset.

This debate is far from over, but Barro’s contribution is to propose an analytic framework that can be tested. I don’t think it can be easily tested, since it relies heavily on perceptions, which are not straightforward things to measure, but at least it’s something.

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