This post is slightly whimsical. I can't decide myself if I'm being totally serious. My argument is certainly less than watertight. But it's not (to me) obviously wrong either. So I'm just throwing it out there.
On average, stocks outperform government bonds. This is called the "Equity Premium". Nobody understands why (yes, we know stocks are riskier than bonds, but that doesn't seem to be enough to explain it). This is called the "Equity Premium Puzzle". (See Brad DeLong and Konstantin Magin (pdf) or Wikipedia for a discussion).
Lets say that the equity premium is around 5% for a ballpark estimate, which is good enough for my purposes here.
"Stock market capitalisation to GDP ratio" is the market value of all equities traded on stock exchanges as a ratio of annual GDP. This ratio varies across time and across countries.
A very quick and dirty Google gives me a ballpark estimate of around 100% for that ratio for advanced countries like Canada. Total stock market capitalisation is around the same size as annual GDP.
Suppose the government could wave a magic wand, make stocks as attractive to hold as government bonds, and abolish the equity premium. Multiplying my two ballpark estimates together, the benefits of waving the magic wand would be worth 5% of GDP, for each and every year the magic wand was waved. That's a big deal. And (assuming my two ballpark estimates are correct) that's a lower bound estimate of the benefits of waving the magic wand. Because if the wand were waved, and the equity premium were abolished, firms would presumably issue more stocks and households would hold more stocks. (Just like if you could wave a wand and make transportation costs disappear, the benefits would exceed current transportation costs, because more goods would be transported unless the supply or demand curves were perfectly inelastic. There's a triangle, as well as a rectangle, between the supply and demand curves.)
All we need is a magic wand.
We have a magic wand. It's monetary policy. All we need to do is have the central bank target the stock market total return index. If the central bank used monetary policy to target the total return index at (say) 7% per year, then anyone investing their savings in that stock market index would be guaranteed a return of 7% each and every year. That's a nominal return, of course, unadjusted for inflation. But it would be exactly the same as buying a government bond earning 7% per year nominal that could be bought or sold at face value any time you felt like it. Both returns would be guaranteed by the government. The stock market index portfolio, and government bonds, would become perfect substitutes. The equity premium would disappear.
Would having monetary policy target the stock market total return index be good for macroeconomic stabilisation? I don't know. But 5% of GDP (lower bound) is a benefit that's not to be sneezed at.
And maybe, just maybe, there would be a lot less bond-finance and bank-finance of investment if we abolished the equity premium, which would reduce the size and probability of financial crises too.
[Brad DeLong's recent post "The Economic Costs of Fear" inspired me to write this one.]
I'm off to buy myself a new canoe, to do my bit to increase Aggregate Demand, and because I deserve it. Back later this weekend.
Worthwhile Canadian Initiative 
I think I now get rsj’s point about risk. Let me restate it my way:
If I’m right about my “proposed” monetary policy eliminating the equity premium (assume I am right), then a likely consequence is that the real yield on stocks will fall. If so, that would mean that given changes in (e.g.) the growth rate of real earnings would cause larger percentage changes in stock prices, given the formula: P=E/(r-g) , where P is price of stocks, E is current earnings, r is equilibrium real rate of return on holding stocks, and g is expected real growth rate of earnings.
That’s correct. Is that an argument against the policy? Not so sure.
Phil: thanks, yes, I noticed that RA post. Sounds like he agrees with my old “concrete steppes” post.
Lord: OK, but that’s a purely demand side theory of GDP. In the long run, I would look at supply side theories of (real) GDP.
123: “Yes, NGDP would be too volatile. And I am afraid the excess volatility of NGDP might cause the real stockmarket risk premium to increase.”
That’s certainly possible. It might. I think it would depend on parameter values. Yep, monetary policy cannot peg real VIX.
JP: “If GDP is not the relevant metric, what element of the National Accounts would improve if the equity premium was abolished?”
Ah, the tyranny of accounting!
Assume the demand for canoes was perfectly inelastic (one new canoe per Canadian per decade, regardless of anything). And assume the supply of canoes was perfectly elastic (horizontal MC curve). Then if I waved a magic wand and made canoes twice as much fun, all canoists would be better off. But nothing would change in the national accounts, either income or wealth, because neither the quantity nor price of canoes will change. But the increase in welfare would equal the amount of GDP spent on canoes (even though that is unchanged), because they are now twice as much fun.
K: “I’m also having trouble understanding the welfare benefits. Or rather, I think there are big welfare benefits, but I don’t see where you’ve made the case for them, or how you arrive at your 5%/year benefit.”
I haven’t really made a watertight case for them. I’m just assuming that people would get as more “fun” out of holding stocks, and as much “fun” as they now get out of holding bonds. See my canoe example in response to JP.
Nick: “Yep, monetary policy cannot peg real VIX.”
And monetary policy cannot peg the volatility of NGDP, but it can (and should) sharply reduce it from current levels.
Nick, exactly, but the increase in volatilty means that even though the fed has reduced the risk premium — e.g. the cost of bearing a unit of volatility — it may have actually increased the total risk and therefore the total spread between riskless bonds and equities, because there is more volatility in capital prices now.
Moreover, as some stocks are more dependent on future growth rates to justify their market cap, those stocks would experience more volatility and be discounted more. So the relative price of growth to value stocks changes, causing real effects and possibly real distortions.
And I think there are other distortions, but am in the office now 🙂
Dlr,
You are assuming perfect certainty of future earnings, in which case there is no rationale for a risk premium. But if you believe that $1 of capital pays out 1% with 50% probability and 2% with 50% probability, then then the P/E multiple of the firm that re-invests half its earnings to purchase capital and pays half out will be different from the P/E multiple of the firm that sits on the same capital stock and pays out all earnings as dividends each period.
The ratio will change as the nominal short interest rate changes, even assuming that the above payouts are real. The relative price is not independent of the nominal short rate.
Moreover, you will not get high P/E multiples in the presence of risk, with any reasonable utility function, at some point lower nominal rates just translate into so much more volatility that any non-zero risk premium will result in P/E multiples much lower than you believe they should be in an environment of perfect certainty. There is a nominal return below which you cannot push equity, unless you can credibly commit to buying it all.
“I’m just assuming that people would get as more “fun” out of holding stocks, and as much “fun” as they now get out of holding bonds.”
But wouldn’t holding bonds get less “fun”?
Just prior to adopting a policy that targets 7% equity returns, bonds are willingly held by investors because of their unique range of features (low risk, senior to equity etc), features that stocks don’t have. After the policy is adopted, these features are no longer unique to bonds. In order for investors to willingly hold existing bonds, don’t bond prices have to fall to some lower level, thus providing a better return to compensate for features lost?
Nick: “That’s correct.”
I don’t think so. You’re assuming profit growth varies but the real rate stays unchanged. To first approximation, I’d assume they move in tandem. I.e. changes in the outlook for future growth are completely offset by changes in the real rate curve, so asset volatility is not driven by systemic changes in outlook.
The profit growth rate of each firm varies in lock-step with the real rate?
What if the profit growth of two different firms aren’t identical?
rsj,
I don’t see that relative prices matter to this conversation. I’m saying the growth rate on the income generated by the market portfolio moves in parallel with the real rate (risk premium being constant). And I’m not talking about just stocks. Stocks, bonds, all capital assets, are ultimately claims on the fraction of future output that doesn’t go to labour or government. That’s why I use the word income, rather than earnings or dividends.
With the current targeting regime, I believe that almost all systemic asset volatility is a result of expectations of failure of the target. In particular, it is expected that there will be periods of excess real rates (relative to income growth rates) at the ZLB resulting in demand deficiency. It is expectations of divergences between growth and real rates that cause asset volatility, not expectations of growth alone. A credible target will not permit divergences and will therefore stabilize asset prices. Unfortunately no targets, unless explicitly backed by the thing being targeted, can always work. That’s why I advocate backing by capital assets.
JP: “But wouldn’t holding bonds get less “fun”?”
If I waved my magic wand and canoes became more fun, that doesn’t make kayaks less fun in absolute terms, only relative to canoes. So the price of kayaks might indeed fall (depending on the elasticity of supply for kayaks), but that fall in price is simply a change in the distribution of income between kayak sellers (worse off) and kayak buyers (better off). It’s not a true negative externality from the benefits of me waving my wand to make canoes more fun. The gains and losses in the kayak market cancel out.
K,
Assume zero systemic risk. Everyone knows with completely certainty that the market return is 1% in every single period.
But each individual firm is subject to massive swings in earnings, all of which cancel out. Firms are driven out of business and their revenues are absorbed by incumbents, etc.
The investor can earn a premium by diversifying and getting more than the risk free rate, because the individual business owner (or manager), is exposed to the returns of the firm, by definition of their job role. To not be exposed to the earnings would be to have performance disassociated from pay. Even ignoring things like stock options and stock ownership, your reputation and future earnings are determined by your success or failure at managing a firm.
The one deciding whether to spend a billion to open a new chip fab in the case of Intel, or $100 to add a new counter to the coffee shop in the case of a small business, will still be risk-averse. If there is a 50% chance of 0 earnings and a 50% chance of earning $2, then they will not pull the trigger and invest. They will always prefer to just buy the 1% bond (which is what businesses are doing now).
And therefore each individual firm’s market cap will be discounted at a higher rate than the risk free rate regardless of what the government does. And if that is true of each individual firm, it will be true of the market as a whole.
You are always going to have a risk premium, even if market risk is always zero, and stock indexes can be predicted with perfect certainty. If you really can’t stand this arbitrage, then start levying taxes on investors rather than trying to buy up all the capital.
rsj,
“therefore each individual firm’s market cap will be discounted at a higher rate than the risk free rate regardless of what the government does. And if that is true of each individual firm, it will be true of the market as a whole.”
How the managers of a firm choose to make investment decisions has no impact on the market’s discounting of the firm’s liabilities. The market discounts securities based on the probability distribution of future income, whatever the decision making process that generates that income. The risk preferences of the managers are irrelevant to securities pricing.
“You are always going to have a risk premium, even if market risk is always zero, and stock indexes can be predicted with perfect certainty”
No. If both assets are risk free, they both earn the risk free rate. Two securities. Both pay $1 in a year with absolute certainty. One yields more than the other. Are you saying you’d buy the more expensive one?
How the managers of a firm choose to make investment decisions has no impact on the market’s discounting of the firm’s liabilities. The market discounts securities based on the probability distribution of future income, whatever the decision making process that generates that income. The risk preferences of the managers are irrelevant to securities pricing.
I would buy the one the one that yields more!
But riddle me this: if all the decision makers (for real investment, not purchases of paper claims on profits) are risk averse, which they should be given their outsized stake in the success of the firm, and demand a premium of x% over the risk-free rate, then you will have a discrepancy between return on invested capital and the risk-free rate, which is the case. Now if you bid up the share price of firms so that the return on equity is the risk-free rate, where the former is always greater than the latter, then you are in a situation in which the market price of a firm is always greater than the book value of the firm.
So there are two opposing arbitrage relations, and which of them will win out? I can think of a lot of reasons why neither arbitrage is real — e.g. you don’t know with certainty that $1 in lost earnings by one firm will result in $1 of increased earnings by another. Book value is not liquidation value, and privately held equity is greater in value than publicly traded equity, etc.
But the argument that there should be an equity premium of zero is equivalent to saying that the first arbitrage should always dominate the second, or that book value should be permanently less than the market value of a firm in all cases, provided that preferences are unchanged, and that also doesn’t make sense.
The opposite of tranching comment.
Tranching is one of the oldest tricks in finance. Let’s take a company that is owned by a person, who just owns the equity and there’s no debt. Then a banker comes and tells the person to borrow money and pay himself a dividend. Surprise! We’ve just tranched the company to two tranches, the safe debt tranche and the more risky (now levered) equity tranche.
Most of the security design is about tranching some cash flow rights in a way that creates very safe (looking) securities and riskier securities. The market, for many reasons, pays more for the tranches than the whole and “value” is created.
Your scheme is “untranching” the economy, turning low risk government bonds and high risk stocks into medium risk untranched securities.
rsj,
“So there are two opposing arbitrage relations, and which of them will win out?”
There is no contradiction in arbitraging both since both the relative returns of risky securities vs riskless ones can change, and so can the relative returns of risky securities vs corporate assets (Tobin’s Q).
The more difficult arbitrage, Tobin’s Q, consists of two parts:
1. There’s the real economic difference between the market price of liabilities and the cost of assembling the assets. That part is fairly arbitrageable, which is the job that’s done by MBOs, LBOs, merchant banks and some hedge funds. I remember, for example, hedge funds building sheet rock factories while short selling the stocks of sheet rock companies when there were building supply shortages during the housing bubble.
2. Then there’s the other part, which you are talking about, which is simply the marginal cost of skilled management. This cost, which depends both on the supply of managers and their aversion to risk, can be very high. Having to pay them is what closes the gap between the low return on the liabilities and the high return on assets (not including management). To an arbitrageur, management needs to be thought of as just another (possibly expensive) asset.
But either way, arbitraging tobin’s Q should not have any impact on the returns of liquid securities which are determined by investor preferences. It will just reduce the rents that flow to management and reduce the returns to the non-management corporate assets.
Thanks, K, but I don’t understand the argument in part 2. If managers are risk averse when making individual investments because their own wealth is disproportionally exposed to the returns of the firms that they are running — including their future labor income — how is paying them more going to help? It seems it would hurt, as you are increasing the stakes.
The only thing that would help would be to hedge them from the consequences of their investment decisions, that is, from whether they perform well or not in their jobs. You would need to include assurances that whether they are deemed to be skilled or unskilled is independent of the outcomes of their investment choices. I guess you could pay them solely on their educational credentials and years of experience. That wouldn’t be much different than having the government buy up all the capital and appoint unionized civil servants to make strategic decisions about which projects the firm undertakes.
“It seems it would hurt, as you are increasing the stakes.”
I don’t think so. You’re only increasing the upside. The downside is zero (in case of default). If I pay you more in some states of the universe and never pay you less that’s an unequivocal good (it’s actually a definition of you doing arbitrage).
..and the point being that in the long run — if managers just don’t undertake a return unless it yields the risk-free rate +P%, on average — then who gets the P%? The managers can pocket it, equity investors in the secondary market can pocket it, or the VCs that sell firms to the secondary market can pocket it.
I think, in the real world, none of these arbitrages are perfect and there is a tug of war as to who earns the rent. I think the case can be made that in the last 20 years or so, it was the insiders (e.g. managers) who pocketed the bulk of the premium, as equity investors have not been doing too well. VCs have been doing OK.
K, I missed your post.
OK, basically you are saying that “paying them more” means letting them earn the entire rent, or a large portion of it.
I don’t think so. You’re only increasing the upside. The downside is zero (in case of default). If I pay you more in some states of the universe and never pay you less that’s an unequivocal good (it’s actually a definition of you doing arbitrage).
Hmm, if you don’t need to eat, or you don’t mind your next job being flipping burgers, then it is an unmitigated good. Others would would use their current salary/position as a baseline of zero, and think of how they can marginally improve or reduce from their baseline when evaluating risk.
From my experience with management, most of them are definitely risk averse and interested in protecting their position. They would never undertake a risky project whose expected payout is just the risk free rate. And that is certainly true of small businessmen.
In the world of rock-star CEOs, I think they are driven by non-monetary considerations to a large degree. It could be legacy, ambition, whatever. It’s hard to say in that case. Nevertheless, they wont undertake a risky project with the expected payoff only the risk-free rate. They would rather buy a bond.
Finance, of course, is a different world. There, sure, you are picking up nickels in front of a steam roller to get a 1% spread.
But you don’t do that in the non-financial world.