Free exchange

Body of evidence
Is a concentration of wealth at the top to blame for financial crises?
Mar 17th 2012 | from the print edition
IN THE search for the villain behind the global financial crisis, some have pointed to ine!alit" as a
c!lprit# In his 2010 boo$ %&a!lt 'ines(, )agh!ram )a*an of the +niversit" of ,hicago arg!ed that
ine!alit" -as a ca!se of the crisis, and that the .merican government served as a -illing accomplice#
&rom the earl" 1/00s the -ages of -or$ing .mericans -ith little or no !niversit" ed!cation fell ever
farther behind those -ith !niversit" !alifications, he pointed o!t# +nder press!re to respond to the
problem of stagnating incomes, s!ccessive presidents and ,ongresses opened a flood of mortgage
credit#
In 1//2 the government red!ced capital re!irements at &annie Mae and &reddie Mac, t-o h!ge
so!rces of ho!sing finance# In the 1//0s the &ederal Ho!sing .dministration e1panded its loan
g!arantees to cover bigger mortgages -ith smaller do-n2pa"ments# .nd in the 2000s &annie and
&reddie -ere enco!raged to b!" more s!bprime mortgage2bac$ed sec!rities# Ine!alit", Mr )a*an
arg!ed, prepared the gro!nd for disaster#
,entral ban$ing
Mr )a*an3s stor" -as intended as a narrative of the s!bprime crisis in .merica, not as a general theor" of
financial dislocation# 4!t others have noted that ine!alit" also soared in the "ears before the
5epression of the 1/60s# In 2007 26#78 of all .merican income flo-ed to the top 18 of earners9their
highest share since 1/2/# In a 2010 paper Michael :!mhof and )omain )anci;re, t-o economists at the
International Monetar" &!nd, b!ilt a model to sho- ho- ine!alit" can s"stematicall" lead to crisis# .n
investor class ma" become better at capt!ring the ret!rns to prod!ction, slo-ing -age gro-th and
raising ine!alit"# <or$ers then borro- to prop !p their cons!mption# 'everage gro-s !ntil crisis
res!lts# Their model absolves politicians of responsibilit"= ine!alit" -or$s its mischief -itho!t the help
of government#
Ne- research hints at other -a"s ine!alit" co!ld sp!r crisis# In a ne- paper> Marianne 4ertrand and
.dair Morse, both of the +niversit" of ,hicago, st!d" patterns of spending across .merican states
bet-een 1/00 and 2000# In partic!lar, the" foc!s on ho- changes in the behavio!r of the richest 208 of
ho!seholds affect the spending choices of the bottom 008# The" find that a rise in the level of
cons!mption of rich ho!seholds leads to more spending b" the non2rich# This %tric$le2do-n
cons!mption( appears to res!lt from a desire to $eep !p -ith the ?oneses# Non2rich ho!seholds spend
more on l!1!r" goods and services s!pplied to their more affl!ent neighbo!rs9domestic services, sa",
or health cl!bs# Had the incomes of .merica3s top 208 of earners gro-n at the same, more leis!rel"
pace as the median income, the" rec$on that the bottom 008 might have saved more over the past
three decades9@700 per ho!sehold per "ear for the entire period bet-een 1/00 and 2000, or @000 per
"ear *!st before the crisis# In states -here the highest earners -ere -ealthiest, non2rich ho!seholds
-ere more li$el" to report %financial d!ress(#
The paper also reveals ho- responsive government is to rising income ine!alit"# The a!thors anal"se
votes on the credit2e1pansion meas!res cited in Mr )a*an3s boo$# <hen s!pport for a bill varies, the
a!thors find that legislators representing more !ne!al districts -ere significantl" more li$el" to bac$ a
loosening of mortgage r!les#
Ine!alit" ma" drive instabilit" in other -a"s# .ltho!gh sovereign borro-ing -as not a direct
contrib!tor to the crisis of 2000, it has since become the principal danger to the financial s"stem# In
another recent paper Marina .AAimonti of the &ederal )eserve 4an$ of Bhiladelphia, Eva de &rancisco of
To-son +niversit" and CincenAo D!adrini of the +niversit" of Eo!thern ,alifornia arg!e that income
ine!alit" ma" have had a tro!bling effect in this area of finance, too#
The a!thors3 models s!ggest that a less e!itable distrib!tion of -ealth can boost demand for
government borro-ing to provide for the lagging average -or$er# In the recent past this demand -o!ld
have coincided -ith a period of financial globalisation that allo-ed man" governments to rac$ !p debt
cheapl"# .cross a sample of 22 FE,5 co!ntries from 1/76 to 2007, the" find s!pport for the notion that
ine!alit", financial globalisation and rising government debt do indeed march together# The idea that
ine!alit" might create press!re for more redistrib!tion thro!gh p!blic borro-ing also occ!rred to Mr
)a*an, -ho ac$no-ledges that stronger safet" nets are a more common response to ine!alit" than
credit s!bsidies# 'iberalised global finance and rising ine!alit" ma" th!s have led to s!rging p!blic
debts#
)easonable do!bt
Fther economists -onder -hether income ine!alit" is not -rongl" acc!sed# Michael 4ordo of )!tgers
+niversit" and ,hristopher Meissner of the +niversit" of ,alifornia at 5avis recentl" st!died 1G
advanced co!ntries from 1/20 to 2000 to test the ine!alit"2ca!ses2b!sts h"pothesis# The" t!rn !p a
strong relationship bet-een credit booms and financial crises9a res!lt confirmed b" man" other
economic st!dies# There is no consistent lin$ bet-een income concentration and credit booms,
ho-ever#
Ine!alit" occasionall" rises -ith credit creation, as in .merica in the late 1/20s and d!ring the "ears
before the 2000 crisis# This need not mean that the one ca!ses the other, the" note# In other cases, s!ch
as in .!stralia and E-eden in the 1/00s, credit booms seem to drive ine!alit" rather than the other
-a" aro!nd# Else-here, as in 1//0s ?apan, rapid gro-th in the share of income going to the highest
earners coincided -ith a sl!mp in credit# )ising real incomes and lo- interest rates reliabl" lead to credit
booms, the" rec$on, b!t ine!alit" does not# Mr )a*an3s stor" ma" -or$ for .merica3s 2000 crisis# It is
not an iron la-#
Combating climate change
Net benefits
The idea of pulling carbon dioxide out of the atmosphere is a beguiling one.
Could it ever become real?
Mar 17th 2012 | ,.'H.)I | from the print edition
THFEE -ho -orr" abo!t global -arming have a simple ans-er to the problem# Eimple in theor", that isJ
stop p!mping carbon dio1ide into the atmosphere# In practice that is rather hard to do# 4!t there is
another approach# Having p!t the st!ff into the air, ta$e it o!t#
Fne proven -a" of doing this is photos"nthesis# Meas!res to n!rt!re and e1pand the -orld3s forests
come high on the agenda of environmental proposals# 4!t ne- forests ta$e !p a lot of land# Ho- abo!t
a high2tech alternativeJ capt!ring the ,F2 from air b" artificial means and t!c$ing it a-a" in the Earth3s
cr!stK
:la!s 'ac$ner, a ph"sicist at ,ol!mbia +niversit", started tal$ing abo!t this a decade ago# Beter
Eisenberger, also of ,ol!mbia, and 5avid :eith, !ntil recentl" of the +niversit" of ,algar", in ,anada, and
no- at Harvard, have ta$en !p the idea as -ell# .ll three have formed companies aimed at doing it, -ith
the help of some intrig!ed billionaires# 5r 'ac$ner -as patronised b" the late Har" ,omer, fo!nder of
'ands3 End, a large clothing compan"# 5r Eisenberger3s bac$er is Edgar 4ronfman, -hose fort!ne came
from Eeagram, a no- def!nct distiller# .nd 5r :eith has 4ill Hates#
4!t there is a limit to -hat even an enth!siastic green billionaire can afford9and man" observers thin$
that air capt!re lies -ell be"ond it# . report p!blished last "ear b" the .merican Bh"sical Eociet" L.BEM
p!t the cost of e1tracting and storing carbon dio1ide !sing an air2capt!re s"stem based on $no-n
technolog" at bet-een @N00 and @000 a tonne# That is abo!t 00 times the c!rrent price of E!ropean
carbon credits# .t s!ch prices it -o!ld ta$e tens of trillions of dollars to deal -ith a "ear3s -orth of
carbon2dio1ide emissions# .nd some thin$ the .BE3s estimates of costs are on the lo- side#
It -as in large part to arg!e abo!t that estimate that air2capt!re enth!siasts and their critics met in
,algar" on March 7th20th# The disc!ssions -ere detailed, mostl" civil, sometimes heated# The" did not
arrive at a meeting of minds, b!t the" did demonstrate that the -a" people thin$ abo!t air capt!re is
shifting# <hat -as once seen as a -a" of t!c$ing ,F2 a-a" for good is no- increasingl" tho!ght of as a
-a" of pac$aging it !p for people -illing to pa" for it9incl!ding oil companies eager to sell more oil#
The billionaire bo"s3 cl!b
.ir2capt!re schemes revolve ro!nd a process of reversible absorption# &irst, a stream of air is r!n over
the absorbing material in !estion, -hich p!lls ,F2 o!t of it# Then the absorber is processed to release
the ,F2, allo-ing the device to go bac$ to -or$ and the ,F2 to be disposed of#
5r 'ac$ner3s version !ses la"ers of Teflon or paper covered -ith a resin that absorbs carbon dio1ide
-hen dr" and gives it !p -hen moist# 5r Eisenberger3s proposal emplo"s ceramic bloc$s similar to those
fo!nd in a car3s catal"tic converter# These, li$e 5r 'ac$ner3s sheets, are coated -ith chemicals that ta$e
in and release carbon dio1ide according to the circ!mstances# In 5r Eisenberger3s case, tho!gh, the
cr!cial circ!mstance is temperat!re# The bloc$s absorb ,F2 -hen the" are cool and re2emit it -hen
the" are hot#
5r :eith3s version of the technolog", -hich he hopes to commercialise thro!gh a compan" called ,arbon
Engineering, based in ,algar", !ses a li!id to s!c$ !p the ,F2# This is similar to the -a" a po-er
station3s cooling to-er -or$s# . film of li!id tric$les over corr!gated pac$ing material inside the to-er,
b!t instead of giving !p heat to the s!rro!nding air the li!id absorbs carbon dio1ide from it#
The fig!re in the .BE report applies to a s"stem similar in spirit to ,arbon Engineering3s# 5r :eith thin$s
he can do things for m!ch less# His s"stem has a design that ma$es it easier to get the air thro!gh it,
!ses cheaper materials and does not dra- electricit" from the grid, -hich adds to costs and red!ces the
net amo!nt of carbon stored Lsince grid electricit" comes -ith carbon emissions attached, from the f!el
!sed to ma$e itM# .n assessment prod!ced for ,arbon Engineering b" cons!ltants sees a price of @660 a
tonne as possible# The compan" is aiming for @170#
That is still higher than an" carbon mar$et is li$el" to pa"# 4!t the idea of simpl" getting carbon credits
for storing ,F2 in the gro!nd, -hich air2capt!re enth!siasts !sed to see as the nat!ral !se for the
technolog", is no longer pla!sible# &or air capt!re to -or$ it needs to find people -ith a real economic
need for the carbon dio1ide it prod!ces#
5r :eith thin$s he has done so# Enhanced oil recover" LEF)M technologies get e1tra petrole!m o!t of
depleted fields b" s!eeAing ,F2 into them# Normall", -here that ,F2 comes from -o!ld not matter9
and there are m!ch cheaper so!rces than air capt!re# 4!t ,alifornia no- has a lo-2carbon f!el standard
that ta$es acco!nt of the amo!nt of carbon dio1ide released in the deliver" of a barrel of oil to mar$et#
4eca!se an EF) s"stem !sing atmospheric carbon dio1ide removes, rather than emits, carbon dio1ide,
the f!el it prod!ces -o!ld co!nt as ver" lo- carbon indeed !nder ,alifornia3s r!les# That means it might
command a premi!m -orth the costs of air capt!re#
. giant s!c$ing so!nd
The other companies also have plans for !sing ,F2 to ma$e f!els, b" feeding it to algae# .nd Ned 5avid,
chief e1ec!tive of :iliman*aro, the firm that !ses 5r 'ac$ner3s technolog", -a1es l"rical abo!t the long2
term possibilities of EF) in a -orld in -hich oil sta"s e1pensive and depleted fields are ever more
common# If air capt!re -ere cheap eno!gh to pla" a role there, -ide2scale deplo"ment might p!sh its
costs do-n f!rther still, ma$ing it directl" applicable to the climate problem# 4!t a lot of oil -o!ld get
p!mped !p first#
.nd there is another problem# If getting ,F2 o!t of the air can be done cost2effectivel", getting it o!t of
the chimne"s of po-er plants and oil refineries, -here it is m!ch more concentrated, -ill be a lot easier#
The .BE report estimates that this technolog", $no-n as carbon capt!re and storage L,,EM, sho!ld be a
tenth as costl" as air capt!re# .nd serio!s plans for ,,E in .merica, s!ch as E!mmit Bo-er3s proposal for
a coal plant in Ean .ntonio, Te1as, depend on the reven!es e1pected from selling the ,F2 to oil
companies for EF)#
,arbon capt!re and storage is not a s!re thing# Its development has been a lot slo-er than advocates
-o!ld have -ished# 4!t if air capt!re can be made economical, then ,,E -ill s!rel" be made even more
so, and -ill be able to sell more carbon dio1ide cheaper# If air capt!re has an"thing to offer it -ill be in
niches -here ,F2 is needed onl" for a short -hile, or in a remote location# L4oeing is loo$ing at !sing
the technolog" to help the armed forces ma$e s"nthetic f!els in -ar Aones#M &irst, tho!gh, the !estions
of cost have to be settled9not thro!gh arg!ment, b!t b" act!all" b!ilding things -hich either fail or p!ll
off tric$s that fe- o!tside the companies involved deem possible# .nd that, it appears, is -hat
billionaires are for#
The world economy
Can it bethe recovery?
The outloo! for the world economy is better than it was" but there are still big
ris!s out there
Mar 17th 2012 | from the print edition
THE)E are tantalising signs of good ne-s in the -orld econom"# In .merica firms are hiring more and
cons!mers are spending more# The e!ro Aone3s recession is proving milder than e1pected# Hreece3s debt
restr!ct!ring, the first sovereign defa!lt in a developed econom" for N0 "ears, has passed off -itho!t a
hitch# ,heered b" the signs of recover", and relieved that disaster has been avoided Lpartic!larl" in
E!rope, -hich to-ards the end of last "ear seemed on the brin$ of a calamit" of 'ehman2li$e
magnit!deM, financial mar$ets have been climbing steadil" higher# The ME,I global share inde1 is !p b"
almost /8 since the beginning of the "ear and b" 208 since its lo-s last Fctober#
.fter so m!ch gloom, it is hardl" s!rprising that the -orld3s animal spirits are beginning to leap again#
Iet there are good reasons to be -ar" of all the optimism# Hlobal gro-th, dragged do-n b" less
eb!llient emerging economies as -ell as recession in E!rope, is still li$el" to be slo-er this "ear than it
-as in 2011#
,hinese econom"
.nd there are still big ris$s o!t there# Too often since the 2000 financial crisis investors3 hopes for strong
and lasting gro-th have been dashed9-hether b" bad l!c$ Lsoaring oil pricesM, bad polic" Ltoo m!ch
b!dget a!sterit" too fastM or the painf!l realisation that recoveries after asset b!sts are generall" -ea$
and fragile# If tensions -ith Iran over its n!clear programme spi$e, for instance, an oil2s!ppl" shoc$
co!ld once more ca!se havoc# M!ch co!ld "et go -rong#
'ess gloom, b!t no boom
,onvenientl" eno!gh for a president -ho is see$ing re2election in November, the clearest signs of
recover" are in .merica# The good ne-s is both c"clical, as stronger emplo"ment f!els income and
spending, and str!ct!ral, as evidence mo!nts that the drags from the ho!sing b!st are -aning Lsee
articleM# E1cl!de the temporar" -or$ involved in carr"ing o!t .merica3s 2010 cens!s, and more *obs
have been created in the three months since November than in an" three2month period since 200N#
+nemplo"ment and !nderemplo"ment are both falling# Ho!se prices contin!e to drift lo-er, b!t both
constr!ction and home sales have started to rise# ,ons!mer credit is gro-ing and the fiscal s!eeAe has
loosened, than$s to an easing of state2level b!dgets and ,ongress3s e1tension of temporar" ta1 c!ts
!ntil the end of the "ear#
None of this is the st!ff of boom times# &or the "ear as a -hole .merica3s econom" -ill probabl" gro-
aro!nd its trend rate of aro!nd 2#78# That3s a lot lo-er than might be e1pected after a normal
recession= b!t after financial crises, -hen cons!mers are -eighed do-n b" debt, recoveries tend to be
anaemic# That level of gro-th -ill not bring the *obless rate do-n fast, b!t it -o!ld be an improvement
on 2011 and, more important, it co!ld be the first step to-ards a self2s!staining recover", than$s to the
virt!o!s circle of stronger *ob gro-th leading to higher cons!mer spending, -hich in t!rn sho!ld
generate more *obs#
E!rope, b" contrast, remains a long -a" from recover"# There the good ne-s is simpl" that things are a
lot less bad than the" might have been# Than$s to the massive provision of li!idit" to ban$s b" the
E!ropean ,entral 4an$ LE,4M !nder Mario 5raghi3s ne- management, both a financial collapse and a
nast" credit cr!nch seem to have been averted# The res!lt is a shallo- recession -hich Herman" ma"
escape altogether# &or others, ho-ever, it3s still not clear -here gro-th -ill come from# Most E!ropean
co!ntries, partic!larl" those on the e!ro Aone3s peripher", are imposing a!sterit" on their economies to
get their deficits do-n# The str!ct!ral reforms the" are introd!cing to help boost gro-th -ill ta$e time
to have m!ch effect#
4!t as long as it remains shallo-, a E!ropean recession -ill do limited damage on the rest of the -orld#
.nd that is an important reason -h" the o!tloo$ for man" emerging economies is better than it -as a
co!ple of months ago# To be s!re, gro-th has slo-ed mar$edl" in man" emerging economies, from
,hina to 4raAil, as tighter monetar" polic" has dampened domestic spending# 4!t a collapse in E!rope
ris$ed a far deeper slo-do-n in the emerging -orld, as e1ports pl!nged and foreign capital fled# <ith a
e!ro2Aone catastrophe off the table, at least for no-, capital flo-s to the emerging -orld are rising and
e1port2oriented economies Lpartic!larl" in .siaM are starting to accelerate again#
,hina is the e1ceptionJ its recent trade fig!res -ere s!rprisingl" grim Lsee articleM# 4!t even there, the
o!tloo$ for the rest of this "ear is better than recent ne-s s!ggests# That3s beca!se a -elcome fall in
inflation leaves room for the ,hinese government to ease monetar" and fiscal polic", even if c!rbs on
propert" spec!lation -ill remain# The government -ill not allo- too sharp a slo-do-n, since this "ear3s
change of leadership in ,hina p!ts a premi!m on maintaining social stabilit"#
.dd !p this disparate evidence and the case for modest optimism is solid# 4!t m!ch more needs to be
done to b!ild a more d!rable recover"#
The last cr!sade
E!ropean co!ntries need to stop foc!sing so intentl" on a!sterit" and instead do more to generate
gro-th# The E,43s li!idit" in*ections have s!ccessf!ll" bo!ght time for indebted governments, b!t for
permanent relief the e!ro Aone needs to b!ild instit!tions that allo- *oint liabilit" for government debts
balanced -ith fiscal discipline#
.merica3s priorit" sho!ld be to craft a medi!m2term plan -hich p!ts the b!dget deficit on a do-n-ard
path -itho!t sn!ffing o!t the recover"# There is, !nfort!natel", not a chance that it -ill do that before
November3s presidential election# ,hina3s econom" remains too reliant on investment rather than
domestic cons!mption# )ather than enco!rage the b!ilding of roads and rail-a"s, an" stim!l!s this "ear
sho!ld p!sh cheap ho!sing and higher -ages, as -ell as pensions and health spending#
The reasons for optimism are real# 4!t if polic"ma$ers get it -rong again, the recover" co!ld "et t!rn to
d!st#
#reece$s default
The wait is over
The biggest sovereign default in history" and the most anticipated
Mar 17th 2012 | from the print edition
Hree$ creditors on a da" trip
MFET came !ietl" in the end# .fter a tort!o!s process, the ma*orit" of private holders of Hree$
government bonds had agreed b" March /th to trade in their bonds for ne- longer2dated ones -ith less
than half the face val!e of the old ones and a lo- interest rate# The biggest sovereign2debt restr!ct!ring
in histor" allo-ed Hreece to -ipe some O100 billion L@160 billionM from its debts of aro!nd O670 billion#
It -ill also be the first test of the resilience of the financial s"stem to the pa"ment on sovereign bonds of
credit2defa!lt s-aps L,5EsM, a form of ins!rance against bad debts#
Holders of O172 billion of the O177 billion of sovereign bonds iss!ed !nder Hree$ la- signed !p to the
s-ap# The rest9those -ho did not respond to the bond2e1change offer or the holders of aro!nd O/
billion of bonds -ho opposed it9-ere forced to accept the deal# The Hree$ government invo$ed a
recentl" enacted la- that bo!nd all private bondholders to the bond2s-ap if more than t-o2thirds of
them consented to it# .ro!nd O20 billion of the O2/ billion of Hree$ bonds iss!ed !nder foreign la- also
agreed to the s-ap# The r!mp -ere given !ntil March 26rd to come aro!nd to the deal#
The threat of coercion might e1plain -h" big holders li$e ban$s and pension f!nds chose not to contest
the terms of the s-ap# 4!t Hreece needed to achieve close to 1008 participation in the bond2s-ap to
!nloc$ its second bail2o!t pac$age from international lenders# That meant it had to force the small
gro!p of malcontents to s-allo- the deal, -hich in t!rn meant it co!ld no longer be seen as vol!ntar"#
That triggered a %credit event( and started a process that -ill lead to a pa"o!t of ,5E ins!rance on
Hree$ bonds later this month#
&inancial mar$ets too$ the ne-s -ith a shr!g, even tho!gh for months E!ropean officials have loo$ed
-ith horror at the prospect of a sovereign2credit event in the e!ro Aone# Their angst stemmed partl"
from earlier official pledges that Hreece -o!ld not defa!lt or restr!ct!re its debtsJ a %vol!ntar"( loss2
ta$ing b" private investors -o!ld have allo-ed that fiction to be !pheld# E!ro2Aone polic"ma$ers ma"
also have been an1io!s not to trigger pa"o!ts to amoral %spec!lators( -ho had bet against a co!ntr"
going b!st#
Their dis!iet also had deeper roots# ,orporate defa!lts that lead to pa"ment of ,5E ins!rance are
ro!tine b!t a sovereign credit event is a novelt"# There -as nat!ral an1iet" abo!t ho- it -o!ld go#
Nat!ral b!t misplaced# The notional val!e of Hree$ sovereign bonds ins!red b" ,5Es is aro!nd @N/
billion, according to 5T,,, a data repositor"# 4!t ban$s and hedge f!nds have offsetting e1pos!res,
having iss!ed some ,5E ins!rance contracts and bo!ght others# Fnce these -ash o!t, the net e1pos!re
to a Hree$ defa!lt is a more modest O6#2 billion# The losses inc!rred b" ins!rers on Hree$ ,5Es -o!ld
have to be heavil" concentrated to threaten the financial s"stem# .nd since the ne- Hree$ bonds iss!ed
in the s-ap have some mar$et val!e Ltho!gh the" are alread" trading at a deep disco!ntM, the mone"
changing hands after the precise pa"o!t is determined on March 1/th -ill be some-hat less than that
fig!re# The real problem -o!ld have been if the Hree$ bond s-ap had not triggered pa"o!ts on ,5Es,
r!ining their credibilit" as a so!rce of protection against f!t!re sovereign defa!lts, and raising
government2borro-ing costs#
Fther aspects of the restr!ct!ring are more tro!bling# Fne is that the E!ropean ,entral 4an$ LE,4M -as
able to sidestep a coercive -rite2do-n of its Hree$ bonds, ac!ired as part of a programme to stabilise
bond mar$ets in tro!bled e!ro2Aone co!ntries# That -ill !ndermine its po-er to stop f!t!re mar$et
panic thro!gh bond p!rchases, since investors no- $no- that the larger the E,4 holding of a co!ntr"3s
bonds is, the bigger the -rite2do-n private investors -o!ld s!ffer in a restr!ct!ring#
The E,4 co!ld instead resort to providing !nlimited amo!nts of cheap long2term loans to ban$s to stem
an" f!t!re panic, as it did so s!ccessf!ll" -ith its a!ctions of three2"ear mone" in 5ecember and
&ebr!ar"# 4!t that s!ccess comes at a cost# The healthier sort of ban$, -ith an e1cess of deposits over
loans, is no- less li$el" to lend its spare cash to other ban$s for fear that the" have alread" pledged their
best collateral to the E,4 in e1change for long2term li!idit"# ?ens <eidmann, the head of Herman"3s
4!ndesban$, -orried o!t lo!d this -ee$ that some ban$s -ill become dependent on cheap E,4
li!idit"# That fear ma" alread" have come to pass#
%&uity mar!ets
'hares and shibboleths
(ow much should people get paid for investing in the stoc!mar!et?
Mar 17th 2012 | from the print edition
I& THE)E is a sacred belief among investors, it is that e!ities are the best asset for the long r!n# 4!" a
diversified portfolio, be patient and re-ards -ill come# Holding cash or government bonds ma" offer
safet" in the short term b!t leaves the investor at ris$ from inflation over longer periods#
E!ch beliefs sit oddl" -ith the performance of the To$"o stoc$mar$et, -hich pea$ed at the end of 1/0/
and is still 778 belo- its high# Fver the 60 "ears ending in 2010, a %long r!n( b" an" standards,
.merican e!ities beat government bonds b" less than a percentage point a "ear#
In the developed -orld, the period since the t!rn of the millenni!m has been a partic!lar
disappointment# Eince the end of 1/// the ret!rn on .merican e!ities has been 7#N percentage points
a "ear lo-er than that on government bonds Lsee chart 1M# That has left man" corporate and p!blic
pension f!nds in deficit and man" people -ith private pensions facing a dela"ed, or poorer, retirement#
+nderstanding -h" e!ities have let investors do-n over the past decade -ill help them -or$ o!t -hat
to e1pect in the f!t!re#
The long2term faith in e!ities is based on the theor" that investors sho!ld be re-arded for the ris$iness
of shares -ith a higher ret!rn, $no-n as the %e!it" ris$ premi!m( LE)BM# That ris$ comes in t-o forms#
The first is that shareholders get paid onl" -hen other claimants on a compan"3s cashflo-, s!ch as
-or$ers, the ta1man and creditors, have received their d!e# Brofits and dividends are th!s highl"
variable and can disappear altogether -hen times get to!gh# The second ris$ is that share prices are
volatile, more so than bond prices# Eince 1/2N there have been seven calendar "ears -hen .merican
e!it" investors have s!ffered a loss of more than 208= investors in Treas!ries have s!ffered no s!ch
calamito!s "ears#
The big !estion, ho-ever, is ho- large that e1tra ret!rn sho!ld be# Here it is important to disting!ish
bet-een the e1tra ret!rn investors act!all" achieved for holding e!ities L-hat co!ld be called the e1
post n!mberM and the ret!rn the" e1pected to achieve -hen the" bo!ght them Lthe e1 ante fig!reM#
.cademics started to foc!s on this problem in the mid21/00s -hen a paper b" )a*nish Mehra and
Ed-ard Brescott indicated that the e1 post ret!rn of .merican e!it" investors had been remar$abl"
high, at aro!nd seven percentage points a "ear# It seems !nli$el" that investors e1pected to do so -ell#
Bremi!m p!AAle
There are a n!mber of possible e1planations for these ver" high e1 post ret!rns# Fne is s!rvivorship bias
in the n!mbers# .merica, -hich is the benchmar$ for E)B meas!rements, t!rned o!t to be the most
s!ccessf!l econom" of the 20th cent!r", b!t it might not have been# 4efore the first -orld -ar investors
do!btless had high hopes for .rgentina, ,hina or )!ssia9onl" to be disappointed#
Elro" 5imson, Ba!l Marsh and Mi$e Eta!nton of the 'ondon 4!siness Echool L'4EM have anal"sed the
data for 1/ co!ntries from 1/00 to 2011 and fo!nd that the E)B relative to Treas!r" bills Lshort2term
government debtM ranged from *!st over t-o2and2a2half percentage points a "ear in 5enmar$ to si12and2
a2half points in .!stralia# The" fo!nd a premi!m for .merica of five percentage points#
.nother e1planation for the high ret!rns is a parado1ical oneJ that e!ities have become less ris$"# In
the earl" part of the 20th cent!r" corporate acco!nts -ere more opa!e and less reliable Ltho!gh
shareholders in Enron, a b!st energ" compan", ma" disagreeM# Most stoc$s -ere o-ned b" private
investors -ith onl" a handf!l of individ!al shares# This left them more e1posed to the ris$ of a single firm
failing, -hich meant the" p!t a lo-er val!e on shares9or, to p!t it another -a", the" demanded a
higher premi!m for o-ning them#
Toda" most e!ities are o-ned b" instit!tional investors -ho can assemble a diversified portfolio# Even
small investors can o-n an inde1 f!nd at lo- cost# The impact of one compan" failing is th!s far smaller#
This red!ced ris$ has prompted investors to pa" higher prices for shares= in other -ords, to accept a
lo-er dividend "ield# That ma" -ell have increased the e1 post ris$ premi!m Lother things being e!al, a
fall in the dividend "ield from G8 to 28 means investors do!ble their mone"M#
The siAe and persistence of the E)B led some commentators in the late 1//0s to come !p -ith an
ingenio!s, if fla-ed, arg!ment# In their boo$ %5o- 6N,000(, for instance, ?ames Hlassman and :evin
Hassett arg!ed that the reliable o!tperformance of shares over bonds meant that e!ities -ere not
ris$ier at all# .s a res!lt, there need be no e1 ante ris$ premi!m#
This time is not different
If this belief -ere correct, e!it" investors sho!ld have been -illing to accept a lo-er earnings "ield#
LThis is the inverse of the price2earnings ratio= if the pPe is 70, the earnings "ield is 28#M In the co!rse of
moving to the lo-er earnings "ield, the mar$et -o!ld have soared to the 6N,000 level of the boo$3s title#
. lo-er e1 ante ris$ premi!m implies higher ret!rns in the short term# The a!thors -ere proved right in
one sense# Investors -ho bo!ght shares in 1/// did not earn a ris$ premi!m# 4!t that -ill be of scant
consolation to those -ho believed the boo$, since 16 "ears later the 5o- is at aro!nd 16,000, not
6N,000#
Fne obvio!s problem -ith their reasoning -as that, altho!gh e!ities might have beaten bonds over
most long periods, the horiAon of the average investor is m!ch shorter# There have been man" e!it"
bear mar$ets in histor" and investors are e1posed to the real ris$ that the" -ill have to sell in the middle
of one# Most shares are o-ned b" professional f!nd managers, -ho have to report to their clients ever"
three months# If a big bet on e!ities goes -rong the" cannot -ait 20 "ears to be proved right# ,lients
-ill have deserted them long before then#
The late21//0s debate ill!strated a familiar pattern at the top of b!ll mar$ets# <hen share prices have
alread" risen a lot, commentators scramble for reasons -h" the" sho!ld rise even f!rther# In the 1/00s
those -ho !eried -hether the ?apanese stoc$mar$et -as e1pensive on a minimal dividend "ield and a
s$"2high price2earnings ratio -ere told that %<estern val!ation methods( did not appl" in To$"o# .t the
t!rn of the cent!r" man" ass!med that, beca!se the achieved E)B had been high in the past, it -o!ld be
so in the f!t!re# 4!t investors had their reasoning bac$-ards# <hen share val!ations are high, f!t!re
ret!rns are li$el" to be lo- and vice versa#
Hiven the histor" of the ris$ premi!m, -hat -ill the f!t!re re-ard for e!it" investors beK This !estion
is disc!ssed in a ne- set of papers> iss!ed b" the ,hartered &inancial .nal"sts Instit!te# The collection is
a follo-2!p to a similar e1ercise !nderta$en in 2001, -here the range of estimates of the premi!m
varied from Aero to seven percentage points a "ear#
The first step is to define the e!it" ris$ premi!m more e1actl"# Mssrs 5imson, Marsh and Eta!nton
brea$ it do-n into the follo-ing componentsJ the dividend "ield, pl!s the real dividend gro-th rate, pl!s
or min!s an" change in the pricePdividend ratio Lthe inverse of the dividend "ieldM, min!s the real ris$2
free interest rate#
In the period 1/0022011, the average -orld dividend "ield -as G#18= real dividend gro-th -as *!st 0#08=
and the rerating of the mar$et added 0#G8# That comes to a real e!it" ret!rn of 7#G8 Lthe calc!lation is
geometric, not arithmeticM# Etripping o!t the ris$2free interest rate, the E)B -as G#G8 vers!s short2term
government debt and 6#78 vers!s longer2term government bonds Lsee chart 2M#
The dividend "ield comprised the vast b!l$ of the ret!rn# This -as tr!e across all the co!ntries st!died
b" the a!thors# Had investors consistentl" bo!ght the highest2"ielding !intile of e!it" mar$ets over
the past 112 "ears the" -o!ld have earned an average nominal ann!al ret!rn of 16#68 compared -ith a
ret!rn of *!st 7#G8 for those b!"ing the lo-est2"ielding !intile# High2dividend mar$ets have also
performed best so far this cent!r"#
The importance of the dividend "ield is ironic, given the lac$ of foc!s on the meas!re in most modern
investment commentar"# Man" anal"sts arg!e that the dividend has been s!perseded b" the share b!"2
bac$ -hich Lpartic!larl" in .mericaM is a more ta12efficient -a" of ret!rning cash to shareholders# 4!t
)obert .rnott of )esearch .ffiliates points o!t that, altho!gh b!"2bac$s red!ce share capital, companies
are also finding -a"s to add to it# &irms iss!e shares to pa" for ac!isitions, for e1ample, or to re-ard
e1ec!tives thro!gh incentive schemes# Historicall", net share iss!ance has been aro!nd 28 of total
e!it" capital a "ear# This dil!tion of e1isting shareholders is part of the reason -h" real dividend
gro-th has been so lo-, -ell belo- H5B gro-th#
.s a starting point for estimating the f!t!re E)B, this is not enco!raging# The c!rrent dividend "ield on
stoc$mar$ets is lo-er Lat 2#78 in the co!ntries covered b" the '4E dataM than the historical average#
5ividends tend to gro- Lat bestM no faster than H5B, and !s!all" slo-er beca!se of the dil!tion effect#
Nor is there m!ch hope of a boost from a reval!ation of the mar$et# Eince the "ield is lo-, relative to
histor", it is more li$el" that an" reval!ation -ill s!btract from ret!rns# In another paper, ,liff .sness of
.D) ,apital, a hedge2f!nd gro!p, !ses his estimates of dividend "ield and li$el" dividend gro-th to
come !p -ith a forecast for f!t!re real e!it" ret!rns in .merica of aro!nd G8 a "ear#
&!t!re imperfect
.ltho!gh this fig!re is lo-er than the historical average, it still means that e!it" investors -ill earn a
ris$ premi!m# The real "ields on short2 and long2term debt are Aero, or negative in some cases# Nominal
"ields are close to historic lo-s# If the ris$2free ret!rn is Aero, then the entire ret!rn from e!ities -ill
co!nt as a ris$ premi!m# .nd a G8 premi!m -o!ld be onl" a little belo- the long2term average for
.merica#
That still -o!ld not be high eno!gh for man" pension f!nds# In .merica, local2government pension
f!nds base their contrib!tions on the ass!mption that the" -ill earn 08 Lin nominal termsM on their
investment portfolios# Treas!r" bonds "ield 28 at the moment, so a G8 ris$ premi!m s!ggests a nominal
ret!rn of N8 on e!ities# That means pension f!nds -ill fall -ell short of their targeted ret!rn#
Bension providers have t-o optionsJ increase contrib!tions or c!t benefits# ,!tting benefits -ill be
diffic!lt for man" .merican states since pension rights are legall" or constit!tionall" g!aranteed# Eo
ta1es -ill have to go !p or other services -ill have to be c!t# ,ompanies that have offered pensions
lin$ed to final salaries ma" have to divert mone" into their pension schemes, cash that co!ld have been
invested to boost the econom"# Individ!als -ho rel" on private pensions Lor on so2called defined2
contrib!tion benefits, -here the compan" does not promise a pa"o!tM face the same problem#
E!ities are not a miracle asset that -ill t!rn measl" contrib!tions into a genero!s pension# Those -ho
-ant to retire in comfort sho!ld save more#