More from the recent working paper by Oscar Jorda, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan Taylor (“The Rate of Return on Everything, 1870–2015“). (Previous blog post about the return on residential real estate.)
- Return data for 16 advanced economies over nearly 150 years …
- …on the income and capital gains (and thus, total returns) from equities, residential housing, government bonds, and government bills.
- Real returns average 7% p.a. for equity, 8% for housing, 2.5% for bonds, and 1% for bills.
- Housing returns are much less volatile than equity returns.
- Real interest rates have been volatile over the long-run, sometimes more so than real risky returns. Real interest rates peaked around 1880, 1930, and 1990. Current low real interest rates are “normal.”
- Risk premia have been volatile, but at lower than business cycle frequencies.
- r − g is rather stable in the long run and always positive. The difference rose during the end of the 19th and 20th century.
On Alphaville, Matthew Klein discusses recent work by Oscar Jorda, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan Taylor (“The Rate of Return on Everything, 1870–2015“) according to which
Residential real estate, not equity, has been the best long-run investment over the course of modern history.
… but they didn’t calculate the returns most homeowners actually experience. Most people borrow to buy housing and most people live in their properties without renting them out. This makes a big difference.
… Net rental income has historically accounted for half of the total returns from owning housing. It’s also far less volatile, dramatically boosting the Sharpe ratio compared to what you would get just by looking at changes in house prices.
Housing has beaten stocks since 1950 because rental income has been better than dividend income, not because house prices have grown more than stock prices.
In BPEA, Natasha Sarin and Larry Summers argue that bank stock has not:
… we find that financial market information provides little support for the view that major institutions are significantly safer than they were before the crisis and some support for the notion that risks have actually increased. …
… financial markets may have underestimated risk prior to the crisis … Yet we believe that the main reason for our findings is that regulatory measures that have increased safety have been offset by a dramatic decline in the franchise value of major financial institutions, caused at least in part by these new regulations.
This table is taken from their paper:
However, their finding need not be as bad as it sounds. After all, bank regulators intended to insulate taxpayers against bank failure and to render the financial system more shock proof, not bank equity.
On VoxEU, Torben Andersen and Jonas Maibom point out that empirical findings of a positive correlation between efficiency and equity need not contradict elementary theoretical predictions.
The trade-off [between efficiency and equity] applies at the frontier of the possibility set of combinations of economic performance and income equality available to policy makers. If policies and institutions are ‘well-designed’, the country is at the frontier. There is no free lunch and a trade-off inevitably arises.
However, there may be many historical, institutional and political reasons why countries are not at the frontier. … in which case there is scope for improvements in both economic performance and income equality.
This insight leaves one important message. In cross-country comparisons … differences in the distance to the frontier should be accounted for …
In his blog, John Cochrane points to SoFi, a FinTech company, as proof that banking services can be delivered by institutions without the traditional characteristics of a bank.
SoFi finances loans by selling equity. The loans are securitized and the cash is reinvested in loans. As John points out:
- A “bank” (in the economic, not legal sense) can finance loans, raising money essentially all from equity and no conventional debt. And it can offer competitive borrowing rates — the supposedly too-high “cost of equity” is illusory.
- There is no necessary link between the business of taking and servicing deposits and that of making loans. Banks need not (try to) “transform” maturity or risk.
- To the extent that the bank wants to boost up the risk and return of its equity, it can do so by securitizing loans rather than by borrowing. (Securitized loans are not leverage — there is no promise of your money back when you want it. Investors bear any losses immediately and without recourse.)
- Equity-financed banking can emerge without new regulations, or a big new Policy Initiative. It’s enough to have relief from old regulations (“FDIC-free”).
- Since it makes no fixed-value promises, this structure is essentially run free and can’t cause or contribute to a financial crisis.
In jusletter.ch, Corinne Zellweger-Gutknecht argues that the legal status of central bank reserves is more equity- than debt-like—at least as far as the Swiss National Bank (SNB) is concerned. According to Zellweger-Gutknecht, reserves constitute debt only if the SNB is legally obliged to redeem them in exchange for central bank assets.
If the SNB purchases dollars against Swiss Francs in an open market operation, it creates reserves which are equity-like. But if it acquires dollars against Swiss Francs and is committed to engage in a reverse transaction in the future (a swap), then it (temporarily) creates reserves which are debt-like.
The Economist reports about a proposal by Jeremy Bulow and Paul Klemperer for equity recourse notes (ERNs) that could bolster a bank’s equity after negative shocks. While contingent convertible bonds (CoCos) are converted into equity when bank capital falls below a defined threshold, ERNs would convert when the share price fell below a trigger price. Moreover, the new shares would be valued at the trigger price even if the share price had fallen much lower. Low share prices thus would trigger both a conversion and a partial default.