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January 23, 2008

Comments

Jim

"Wouldn't it be a nice idea if financial innovation were used to help ordinary people avoid risks, rather than help egomaniacs become rich?"

Yes it would. So why hasn't this happened?

Chris

Because egomaniacs are running the country, sadly

Jim

So it's a case of some required change in legislation or regulations, then, rather than market failure of some kind? Has this kind of thing been implemented in other countries? Genuine questions, I don't have any particular view on the subject.

chrisc

Long run returns for equities in the most successful democratic/capitalist economies have been high.
Not in those markets which disappeared!
Survivor bias I'm afraid.

chris

Chrisc - you're right that the equity premium for all markets including those that disappeared is low, as this paper shows:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=8156
But does this really explain the high premium in the US? Is this really a compensation for the risk of revolution or defeat in war?

reason

Chris,
the unequal distribution of the effects is more serious than you think. Think of young people entering the job market for instance. They will never catch up - they get no foot on the rung, get no on-the-job training and then have to compete with younger school leavers when the recovery starts. Think also of people unable to move because housing markets have become illiquid. Looking at averages can be very misleading (my favourite catchcry by the way).

reason

Also why do you think such markets would work.
1. How could we have confidence that the market would survive a downturn. Essentially you are asking for an art for catastrophe insurance (highly auto-correlated risks). But a private insurance market is likely to bid the price so low that bankrupcy in the event of a severe recession is almost certain. Even if it doesn't go bankrupt, the liquidity requirements of the re-insurer would almost certainly make the financial consequences of the recession even more severe. I can't see how you can avoid such systemic risks without considerable regulatory interference or having the re-insurance come from the central bank. If it is the latter, how is that different from standard anti-cyclical central banking?
1. The people most in need of that insurance (because their lack of financial assets makes them especially vulnerable to a downturn), can't afford it. This is the general problem of relying on markets to solve social insurance. Markets only serve those with resources.

spencer

Generally pre-recession periods are times of rising interest rates that reduces the present value of future earnings. So stock markets falling in a pre-recession period may not have anything to do with investors anticipating recessions, rather it is just a function of rising rates.

reason

Spencer...
I usually find your posts enlightening. In this case though, I don't believe you, please produce some evidence. Long term real rates (which surely what is relevant for discounting) are VERY low in the US. Or are you suggesting that the market is expecting deflation (surely TIPS would tell you that)?

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