“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.