Risk premiums for equity: the puzzle and the bezzle
Another note to myself post: an idea I thought I’d blog quickly rather than trying to work through in detail.
One of the big unsolved problems in economics is to explain the risk premium for equity, that is, the fact that the historical average rate of return to equity investment (shares) is much higher (about 6 percentage points) than the average rate of interest on high grade (government or genuinely AAA corporate) bonds, whereas the standard economic model of these things (the consumption-based capital asset pricing model or CCAPM) suggests that the premium should be no more than 0.5 percentage points. The basic idea is that the reason for the premium is that the market portfolio of equity represents a claim on aggregate consumption, so the risk premium must arise from the variability of the growth rate of aggregate consumption and this is small (the growth rate ranges from about 4 per cent in a boom to -3 per cent in a moderately severe recession).
One possible explanation for the puzzle is that equity investment has its own special risks in addition to the riskiness of aggregate consumption. But not any kind of risk will do: the risk has to be correlated with fluctuations in aggregate consumption, that is with the business cycle.
Observation of the current crisis phase reminded me of JK Galbraith’s idea of the bezzle. The bezzle is the amount of undetected corporate fraud. As a boom continues, and everyone does well, people realise they can siphon off money and use it to make even more money. If they are threatened with detection, the original amount stolen can be returned to the till, and thye are still ahead. But, in a crisis, this can’t be done and, in any case, outside accountants are all over the books. So, embezzlers are caught and the bezzle shrinks. It stays small in the early stages of recovery when most decisions are being made by the cautious types who survived the crisis. But as the boom continues, hungrier and less-risk averse types come to the fore and the bezzle begins to grow again.
What this means is that recorded profits (and therefore dividends, capital gains and so on) will be higher than true profits in booms, while hidden losses will emerge in recessions, just when investors need their money. This would imply a larger risk premium.
The bezzle seems to work nicely as an explanation (at least partial) for both the equity premium puzzle and the apparent excess volatility of stock prices (a quick Google search suggests that this idea is not entirely new as regards excess volatility – Eden and Jovanovich had a similar idea a long time ago, but didn’t connect it to the equity premium, and they assumed that the problem was good and bad firms rather than a cyclical fluctuation in badness).