Hmm, my understanding is that the equity premium is the difference between equity returns and bond (treasury bill) returns.
Yes, that’s my understanding as well.
Does that tell us about the difference between equity returns and GDP growth?
I don’t know, my sense is not directly but I could be wrong. I think I was gesturing at this because I took it as evidence that we don’t understand why equities have such high return. (But then it is an additional contingent fact that these returns don’t just exceed bond returns but also GDP growth.)
A priori, would you expect both equities and treasuries to have returns that match GDP growth?
I don’t think I’d expect this, at least not with high confidence—but overall I just feel like I don’t know how to think about this because I understand too little finance and economics. (In particular, it’s plausible to me that there are strong a priori arguments about the relationships between GDP growth, bond returns, and equity returns—I just don’t know what they are.)
I thought about this for another minute, and realized one thing that hadn’t been salient to me previously. (Though quite possibly it was clear to you, as the point is extremely basic. - It also doesn’t directly answer the question about whether we should expect stock returns to exceed GDP growth indefinitely.)
When thinking about whether X can earn returns that exceed economic growth, a key question is what share of those returns is reinvested into X. For example, suppose I now buy stocks that have fantastic returns, but I spend all those returns to buy chocolate. Then those stocks won’t make up an increasing share of my wealth. This would only happen if I used the returns to buy more stocks, and they kept earning higher returns than other stuff I own.
In particular, the simple argument that returns can’t exceed GDP growth forever only follows if returns are reinvested and ‘producing’ more of X doesn’t have too steeply diminishing returns.
For example, two basic ‘accounting identities’ from macroeconomics are:
β=sg
α=rβ
Here, s is the savings rate (i.e. fraction of total income that is saved, which in equilibrium equals investments into capital), g is the rate of economic growth, and r is the rate of return on capital. These equations are essentially definitions, but it’s easy to see that (in a simple macroeconomic model with one final good, two factors of production, etc.) β can be viewed as the capital-to-income ratio and α as capital’s share of income.
Note that from equations 1 and 2 it follows that rg=αs. Thus we see that r exceeds g in equilibrium/‘forever’ if and only if α>s - in other words, if and only if (on average across the whole economy) not all of the returns from capital are re-invested into capital.
(Why would that ever happen? Because individual actors maximize their own welfare, not aggregate growth. So e.g. they might prefer to spend some share of capital returns on consumption.)
Analog remarks apply to other situations where a basic model of this type is applicable.
Yes, that’s my understanding as well.
I don’t know, my sense is not directly but I could be wrong. I think I was gesturing at this because I took it as evidence that we don’t understand why equities have such high return. (But then it is an additional contingent fact that these returns don’t just exceed bond returns but also GDP growth.)
I don’t think I’d expect this, at least not with high confidence—but overall I just feel like I don’t know how to think about this because I understand too little finance and economics. (In particular, it’s plausible to me that there are strong a priori arguments about the relationships between GDP growth, bond returns, and equity returns—I just don’t know what they are.)
Okay, sounds like we’re pretty much in the same boat here. If anyone else is able to chime in and enlighten us, please do so!
I thought about this for another minute, and realized one thing that hadn’t been salient to me previously. (Though quite possibly it was clear to you, as the point is extremely basic. - It also doesn’t directly answer the question about whether we should expect stock returns to exceed GDP growth indefinitely.)
When thinking about whether X can earn returns that exceed economic growth, a key question is what share of those returns is reinvested into X. For example, suppose I now buy stocks that have fantastic returns, but I spend all those returns to buy chocolate. Then those stocks won’t make up an increasing share of my wealth. This would only happen if I used the returns to buy more stocks, and they kept earning higher returns than other stuff I own.
In particular, the simple argument that returns can’t exceed GDP growth forever only follows if returns are reinvested and ‘producing’ more of X doesn’t have too steeply diminishing returns.
For example, two basic ‘accounting identities’ from macroeconomics are:
β=sg
α=rβ
Here, s is the savings rate (i.e. fraction of total income that is saved, which in equilibrium equals investments into capital), g is the rate of economic growth, and r is the rate of return on capital. These equations are essentially definitions, but it’s easy to see that (in a simple macroeconomic model with one final good, two factors of production, etc.) β can be viewed as the capital-to-income ratio and α as capital’s share of income.
Note that from equations 1 and 2 it follows that rg=αs. Thus we see that r exceeds g in equilibrium/‘forever’ if and only if α>s - in other words, if and only if (on average across the whole economy) not all of the returns from capital are re-invested into capital.
(Why would that ever happen? Because individual actors maximize their own welfare, not aggregate growth. So e.g. they might prefer to spend some share of capital returns on consumption.)
Analog remarks apply to other situations where a basic model of this type is applicable.
Ah, good point! This was not already clear to me. (Though I do remember thinking about these things a bit back when Piketty’s book came out.)