Saturday, September 6, 2008

An explanation for the Equity Premium Puzzle that I haven't seen in the literature

With regard to Brad DeLong's September 6th post, "The U.S. Equity Premium: Past, Present, and Future":

I have an explanation for the equity premium puzzle that I haven't seen in the literature, but it seems to me to be a potentially very strong one. It's related to the supply of equity, rather than as with all of the other major explanations I have seen, the demand for equity.

It's simply because of the great decrease in restrictions on a firm's profit maximizing activity when financing with equity rather than fixed methods (bonds, bank loans, etc.), especially when it comes to high NPV projects that have payoffs far in the future, firms can create more wealth when they finance with equity, so they will therefore be willing to pay a higher expected return. Thus, graphically the supply curve for equity is simply higher than the supply curve for fixed instruments.

If the supply curve for equity is very long and flat, or even increasing, as we would expect if there were a great deal of constant and increasing returns to scale opportunities, and if it were consistently enough higher than the supply curve for fixed instruments, then this could for the most part or completely explain the puzzle of why equity returns have been so much higher than fixed instrument returns, even when adjusting for risk.

Moreover, if the equity supply curve is long and flat (or increasing) enough, then we could expect equity returns to be as good in the future as they have been over the long run in the past, or even better.

For more details, please see my working paper, "Estimate of Risk of Privatized Social Security Should be based on Far More Information than Just Historical Stock and Bond Returns", pages 3-5.