Brad DeLong has a piece linking to Rajnish Mehra’s survey of the literature on the equity premium puzzle, that is, the fact that the risk premium demanded by investors in private equity is much higher than seems reasonable on the basis of standard assumptions about individual preferences and capital market efficiency. My view is that no monocausal explanation can work but that the puzzle implies that the obvious gaps in financial markets (the absence of private unemployment insurance and the big wedge between borrowing and lending rates for individuals) have profound effects on the supply of equity capital.

To misquote Marx, the problem now is not to explain the equity premium but to derive its policy implications. To some extent, of course, the implications depend on the explanation. Still the framing of the problem as a puzzle has led to an excessive focus on puzzle-solving. Simon Grant and I have been looking at this question for a number of years. You can read our survey article here (PDF file).

Some of the implications reinforce common ideas. For example, the common view that recessions are socially very costly (compared to a stable rate of output growth with no booms and no recessions) is hard to sustain on a standard welfare analysis assuming efficient capital markets. Consideration of the equity premium implies that recessions are indeed socially costly.

Other implications are more surprising at least to those who have imbibed the current conventional wisdom. In this piece (PDF file), which just came out in Economica, we show that, if explanations of the equity premium based on market imperfections are accepted, the rate of return for public investments should be lower than the rate demanded by private investors in projects with similar risk characteristics. An immediate implication is that, other things (such as operational efficiency) being equal, privatisation will reduce welfare and nationalisation will increase it. Of course, other things are rarely equal, so the analysis supports a mixed economy with some services being provided by public enterprise and others

In this piece, which came out in the American Economic Review last year, we show that market failure explanations of the equity premium puzzle support the Clinton plan to invest some of the Social Security fund in stocks as opposed to the Bush plan of creating individual accounts.