“The Rate of Return on Everything“

This is the title of a new paper by Oscar Jorda, Katharina Knoll, Dmitry Kuvshinov, and Moritz Schularick (original paper, voxeu article). The paper is the result of a research project to calculate the rates of return on four major asset categories – equities, bonds, bills, and real estate – in 16 major developed economies going back as far in time as reasonable. (Quibble: Is that really everything? What about gold? currencies? commodities? paintings? vintage cars?)

The paper does nothing but compute long-run averages and standard deviations and draw graphs. No regressions, no econometric witchcraft, no funny stuff. Yet its findings are fascinating.

Bildschirmfoto 2018-01-08 um 09.46.21

Some of the results confirm what „everyone already knew, kind of“:

  1. Risky investments like equities and real estate yield 7% per year in real terms.
  2. The risk premium (equities/housing vis-a-vis short term bond rates) is usually between 4 to 5%.
  3. There is no clear long-run trend (either up or down) in rates of return. (Take this, Karl Marx!)

Some of the results are interesting, but not particularly puzzling:

  1. The return on total wealth (average of the rates of return on all assets weighted by their share in the economy’s aggregate portfolio) exceeds the rate of growth of GDP. This confirms Piketty’s claim that r > g. In terms of the Solow model it means we are living in a dynamically efficient regime: we cannot make both present and future generations better off by saving less. Perhaps the most interesting aspect of this finding is its robustness: it holds for every sub-period and for every country. It really seems to be a „deep fact“ about modern economies.
  2. The return on risk-free assets is sometimes higher, sometimes lower than the growth rate of GDP. For instance, before the two World Wars, the differential between the risk-free rate and growth was mostly positive, so that governments had to run primary surpluses to keep debt stable. Post-1950, the differential was mostly negative.
  3. Negative returns on safe assets are not unusual. Safe rates were negative during the two World Wars as well as during the crisis of the 1970s. In recent times safe rates went negative again in the aftermath of the global financial crisis. These findings don’t disprove the „secular stagnation“ hypothesis of Summers et al. but they do put it in historical perspective. It seems that rates were unusually high during 1980s and the recent downward trend could just be a reversion to the mean.

But some results are really puzzling – even shocking from the point of view of standard finance theory:

  1. The return on risk-free assets is more volatile than the return on risky ones. I haven’t yet digested this fact fully. Does this mean that “risk-free asset” is a total misnomer? No, because „risk-free“ refers to the unconditional nature of the payoff of an asset, not the variability of its return. A bond is „risk-free“ because it promises a fixed cash flow irrespective of the state of the economy. Stocks are called risky, not because their returns are volatile, but because the dividends they pay are conditional on the performance of the company. So does this mean that people’s time discount rate varies a lot? Why? It can’t be consumption growth variability – because consumption is quite smooth. What’s going on?
  2. Housing offers the same yield as equities, but is much less volatile. Jorda et al refer to this as the housing puzzle. I’m not sure how puzzled I should be by this. I surely found the high average yield of real estate assets surprising. However, from what I know about house price indices and the myriad measurement issues surrounding them, I feel that one should be very cautious about the housing returns. I definitely would like someone who knows more about this look carefully at how they calculated the returns (paging Dr. Waltl!). One potential solution to the puzzle I can see would be differences in liquidity. Housing is super illiquid, equities are quite liquid. Couldn’t the high return on housing just be an illiquidity premium?

There is much, much more in the paper, but those were the points that I found most striking. I’m sure this will be one of the most important papers of the past year and will be a crucial source for researchers in finance, growth, and business cycle theory. Plenty of food for thought.

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Market economy and private capitalism – two pairs of shoes!

Critics of our social and economic system often lack in accuracy when it comes to argumentation. At the same time defenders of the status quo sweepingly prejudge those critics and ignore the details of their argumentation in the first place. In order to advance the discussion it may be helpful or even necessary to capture and explain the most important institutions defining market economies and private capitalism in a metaphor about their evolving:

There was a tribe. Every year the eldest of the tribe decided about the roles of the individual members. In principal they spilt up the tribe into hunters and farmers. All food produced was collected by the eldest and then distributed equally among all members of the tribe.

Some members of the tribe were not quite satisfied with the mixture of meat and vegetables. Some of them preferred meat, others preferred vegetables. So they had the idea to exchange their goods in order to increase satisfaction. The institution called market was born and provided the possibility to bilaterally increase individual as well as total welfare. Every sensible economist has to acknowledge the basic potential trade principally offers to a society which is institutionalized by the markets thereby created.

The members of the tribe also acknowledged the improvement, but at the same time recognized that even after the goods were exchanged some still were not perfectly satisfied with their mixture of goods but perceived a shortage in meat. So these members asked the eldest, whether he may adapt the allocation of productive efforts in order to produce more meat. The eldest considered the request and reallocated some members from farmers to hunters. However, he overestimated the demand for meat and soon they observed a shortage in vegetables. Members preferring vegetables now asked the eldest to reallocate some hunters in order to increase the production of vegetables again. Members preferring meat, though, feared that the eldest once again fails to estimate correctly. So they proposed that the tribe votes about the aspired mixture of meat and vegetables. The eldest agreed and to some extent direct democracy was implemented in terms of indirect consumer sovereignty.

After having achieved two big reforms some of the members considered to go further. They proposed to also vote about the type of meat and vegetables. The eldest, though, declined and argued that the allocation would become far too complex considering an increased variety of goods. He neither had the capacities nor the information to centrally plan their production in such a detailed way.

The members however did not give up. Instead they proposed to delegate the allocation of effort to the individual members. They should know best about their preferences and skills. So why should they not decide individually whether and how they want to react when facing a shortage. Finally, the eldest agreed. He provided a sufficient amount of tools and then let the members of the tribe coordinate themselves. Following the argument of efficiency, from now on both consumption and production were decided decentrally.

The improvements in total as well as in individual welfare made the idea of self-organization well-accepted. At the same time the idea also sensitized the tribe with regard to productivity. Soon, some members started to complain about those that, in their opinion, contributed less to the output collectivized so far. So they proposed that it should not be equally distributed anymore. Instead, members should have the right to directly trade based on the output individually produced. The eldest was skeptical about such a big change but feared the dissatisfaction of the most productive and influential members. So he agreed again and the tribe finally headed towards a meritocratic market economy.

As their ambition increased further discussions evolved. All wanted to be the first when tools were allocated. Hunters argued about who has seen or shot an animal first. Farmers could not agree about who has sowed and groomed which acre of land. The fight about rights and resources had begun. Again some members came to the eldest for the sake of a proposal. They suggested to allocate the available resources to the members once for all. From then on, every member should have the property rights with regard to these resources as well as to all that is produced with, by or on them. Then the welfare of any member of the tribe should finally lie entirely in its individual hands. Everyone would have the incentive to make the best out of its own resources and thereby also the tribe in total benefits. The eldest had to admit the logic consistent to the previous reform and agreed. This is the point where private capitalism came on the board.

However, the eldest obviously did not consider that the consistency with previous reforms depends on the assumption of a stationary state. Once the resources are fixed on the individual level, the praised flexibility of members is at least partly lost. Threats and potentials implied by changes in preferences, changes in the variety of goods or changes in the set of available technologies are not shared equally or fairly any more. Instead, members are affected differently depending on the resources originally allocated to them. Some may benefit from changes which may imply losses for others. In contrast to the previous argumentation, the welfare of individual members does not entirely lie in their own hands but strongly depend on developments determined by all the others. In addition, this lack of self-determination is inherited to future generations. When born they face an allocation of resources as well as a distribution of output they so far could not determine at all. They may have the incentive to make the best of what they possess, but this may be not much or even nothing.

What this metaphor finally shows is that decentralized democracy, efficiency and meritocracy are not the result of the institution of private capitalism but may even be threatened by it. Therefore, critics of private capitalism are not necessarily critics of market economies, neither do they necessarily argue in favour of an equal distribution. They rather just address the lack of self-determination implied by the once and for all privatization of productive resources. Who dares to fundamentally contest this very liberal perspective?