The psychology of the equity risk premium

There is a huge literature on the equity risk premium that probably could sustain its own journal, trying to document it or explain it. But somehow, people keep finding new ways to look at the equity risk premium, so it sometimes worth checking out what they last came up with.

Georges Prat looks at the equity risk premium at various horizons and studies how and why they evolve differently. The study highlights that there is a time-varying term structure of equity risk premia, and that it depends on interest rates (expectedly) and a hidden state variable that the author attributes to psychological factors. Now, it is easy to blame changes in tastes for anything one cannot explain, but this is hardly convincing, here or elsewhere. The study uses the S&P 500 index and Treasury bonds and calculates premia at one and ten year horizons. If taste shocks make that risk tolerance of some people changes, they may get completely out of particular maturities. Looking at big aggregates is then not appropriate to measure how risk-averse they are. For example, if I find that long term risk is getting too high for me, for example because I am approaching retirement, I will get out of the blue chip stocks I was holding and into ten-year government bonds. Blue chips will then be priced by a different demand. There is thus a composition effect, that is, the risk tolerance of those holding these stocks is different, but it is because these are different people. That is not psychological, this is demographic.

Are wars rational?

There are few circumstances where wars are globally welfare enhancing. One can imagine that wars can be individually optimizing, for example when we consider the old land-taking or enslaving war. But casual empiricism indicates that quite often fools engage in wars, like minnows tickling obviously overpowering giants (Irak, North Korea) or others who have little objective chance of winning (South Ossetia, Caprivi, Falklands). Is it because some belligerent are poorly informed or even irrational?

Clara Ponsati and Santiago Sanchez-Pages use Markov games with fully rational players to characterize wars, and even chronic wars. A country can lay a claim on another country, leading to bargaining or war, and it can only end if one surrenders. The problem is that parties do not know their relative strengths and can only learn about them by engaging in war. Add a dose of optimism, and you have a recipe for war. Were one to add some political economy (or populism) to this model, outcomes would be really depressing and worrisome. But I still have some faith in humanity.

Interest-only mortgages and house price bubbles

Bubbles are annoying. First because they are difficult to identify, second because they indicate that prices do not reveal the "proper" information, and third because they lead to misallocation of real resources and much hardship when they burst, which they inevitably do. You want to prevent bubbles from happening, but again they are really difficult to identify, especially in real time.

Gady Barlevy and Jonas Fisher may have figured out a clever way of identifying bubbles in house prices. Using some theory, they find that interest-only mortgages should only be used if there is a bubble. Turning to data, they find that the use of such mortgages is rather sparse through time and space, and when it is used, it corresponds pretty closely to episodes where we suspect bubbles could be happening. In particular, interest-only mortgages mere mostly used in areas with inelastic housing supply, which are more prone to bubbles.

Is there really no selection bias in laboratory experiments?

Whenever you read about a survey or an experiment, the first worry one should have is whether there is some selection bias in the studied example. As I have argued before, experimental economics is almost exclusively on a sample from a minority of the world population. But assuming that we are only interested in this minority (and unfortunately we are), is there still some selection bias.

Blair Cleave, Nikos Nikiforakis and Robert Slonim did some experiments in the classroom with over 1000 students, and then invited them for more experiments in a laboratory setting. Those that followed the experiment did not have different characteristics, which is reassuring. However, this only partially alleviates my worries. Indeed, students are only a small minority of the current population, one that is more educated, coming from a richer background, younger, etc. I am looking forward to a broader study...

Time for an agricultural revolution in Africa?

When you think about income differences across the world, Africa is really depressing. It seems nothing is making a lasting impact in terms of policy for it to catch up with the others, and seeing how Asia managed to transform itself makes you wonder what is fundamentally wrong. While one may think this has to do with misguided policies, so much has been tried that something ought to have stuck. But no. One thing that helped Asia is that evolution in rice brought an agricultural revolution that freed human resources for manufacturing, so could such a revolution also happen in Africa?

Donald Larson, Keijiro Otsuka, Kei Kajisa, Jonna Estudillo and Aliou Diagne claim that several areas in Africa are suitable for rice, but local diets and tastes are too diverse for rice to have the success it had in Asia. The productivity of other crops needs to improve as well. So it does not look like there is a ready-made solution that will kick-start the agricultural revolution soon, despite some very localized successes.

That said, why insist of improving agriculture on a continent that is visibly not appropriate for this? Much like telecommunications in Africa jumped over landlines directly to mobile telephony, why not bypass agricultural development straight to manufacturing? One argument against this is the large transportation costs that make local agriculture essential and manufacturing away from the ports unprofitable. But why insist on keeping the population on the countryside? Why not develop coastal cities and take advantage from returns to scale there, like Singapore and Hong Kong did, and

An analysis of the oldest auction in history

Homo economicus is not a recent phenomenon. Not only that, he design market mechanisms early in history that appear to be very subtle. The oldest known auction was designed by Illyria in Babylonic times. This is a marriage markets in its true sense, as it is about auctioning off potential brides. All eligible girls are assembled, and an auctioneer offers them to the highest bidders, starting with the one expected to fetch the highest price. Proceeds are used to sell the least attractive brides to the poorest men assembled.

Michael Baye, Dan Kovenock and Casper de Vries analysis this auction in a two-player environment and claim that there is something paradoxical. Assume complete information, which means the auctioneer will always earn zero profit. Then is appears players can earn a much larger surplus by playing a mixed strategy than with a pure strategy. And there a continuum of these mixed strategies, and the expected payoff for both players is arbitrarily high, but finite. The problem is the solution procedure used to solve for symmetric mixed strategies breaks down here, because it selects strategies that are not part of Nash equilibria. We should learn from that to be very careful when applying standard theorems. A similar reasoning applies to incomplete information where the bidders do not know how much the other player values the potential brides.

There is no recent literature on this auction. However, it was mentioned on the back cover of the August 2006 issue of the Journal of Political Economy. I suspect this is what inspired the authors to work on this. They could have mentioned this and acknowledged the submitter, Costas Meghir.

Markets under-value fuel economy for new cars

Is it worth it to buy a fuel efficient car? If you ask an economist, he will look at the fuel consumption, the cost of gasoline, and calculate the cost benefit of a fuel efficient car, probably also factoring in a resale value and a discount rate. But a non-economist customer?

David Greene says the literature is really unclear, as customers seem to be under-valuing and over-valuing fuel efficiency depending on how you look at the data. Surveys seem to indicate that car buyers consider a very short horizon for the payback, 1.5 to 2.5 years. That makes it very difficult for fuel efficient cars, hence the need for subsidies, or better taxes on the inefficient cars (see why). But this provides little theoretical insight where car buyers differ from the economist I described above. Greene thinks this has to do with risk aversion about future gasoline prices, or loss aversion (being afraid of having taken a poor decision). But clearly, this requires more research.

Having said this, I am puzzled at how little hybrid cars have been adopted in Europe, in particular compared to the United States. The cost of European gasoline is very significantly higher, and the environmental consciousness is also more pronounced. Is it because the alternatives to hybrid cars, the small fuel efficient sedans, are much better than in the US?