A drag on the economy?

In my previous post, I called George Osborne an obnoxious prat. I was wrong. He's an obnoxious prat who knows nothing about economics. His claim that welfare payments are a " drag on the British economy" might be the precise opposite of the truth. Perhaps what's really expensive isn't the generosity of our welfare system, but its meanness, the fact that it doesn't provide anything like sufficient insurance against unemployment.
To see why, start with the equity premium puzzle, first pointed out (pdf) by Rajnish Mehra and Edward Prescott back in 1985, which says that long-term equity returns are far higher than they should be in theory.
Theory tells us that the average excess return on an asset should be proportional to its covariance with consumption growth*. This is because a major motive for having assets is to see us through rainy days, when our consumption would otherwise fall. An asset that does badly in bad times is especially risky, and so requires high expected returns.
This predicts that the Sharpe ratio on shares should be equal to the product of: the standard deviation of consumption growth, the correlation between consumption and share prices, and a coefficient of risk aversion**.
Now, in the last 40 years, the standard deviation of UK consumption growth has been 0.025 (2.5%), and the correlation between this and annual equity returns has been 0.07. We don't know what the coefficient of risk aversion is, but  10 would be on the high side. Multiplying through gives us 0.018.
But since 1900 the Sharpe ratio for UK shares has been 0.22.
Theory is out by a factor of more than 10. It predicts that equities should out-perform safe assets by around 0.4 percentage points a year. In fact, they've out-performed by 4.4 percentage points.
Why? There are numerous possibilities - of which survivorship bias is one. But the interesting possibility is raised here (pdf) by George Constantinides.
The equity premium is high, he says, partly because individual households' actual consumption is much more  volatile than average households' consumption. Individuals don't think: "my consumption volatility is 0nly 2.5% a year, so I can take on equity risk against that background." Instead, they think: "I could lose my job and so lose  80%  of my income. I don't want even the small chance of losing money on shares if this happens." The upshot is that they stay out of the market. Share prices are therefore low, and expected returns are high.
In other words, the lack of income insurance causes share prices to be low. It is this that is a huge drag upon the economy. If we had better ways of pooling idiosyncratic risk, background risk would be less. People would be more willing to buy shares, and their prices would be higher.
Let's roughly quantify this. The dividend yield on the All-share is now 3.7%. If we assume dividend growth of 5% a year (likely money GDP growth), this implies an expected return of 8.7% a year. This is 4.2 percentage points more than we could get on safe nominal assets. But theory says the premium should be only 0.4 percentage points. We're out by 3.8 percentage points.
If only one quarter of this were due to the inadequacy of income insurance, the dividend yield would be 0.9 percentage points lower. Which would mean that share prices would be £583 billion higher.
In other words, the lack of an adequate welfare system - which of course needn't be run by the state - costs us over half a trillion pounds. This is much more than the cost of paying people to stay on the dole or incapacity benefit, which is small.
So, how might Osborne be right? You could argue that very little (almost none) of the equity premium is due to idiosyncratic consumption risk. Or you could argue that the cost of providing better insurance, by reducing work incentives, would be prohibitive - though Shiller's proposals for insuring  industrial or occupational risks seem to avoid this problem.
I suspect, though, that these are unpromising avenues.   
* John Cochrane's great book, Asset Pricing, explains. Here's the introduction (pdf).
** This pdf by John Cochrane  derives this.

Comments

[Luis Enrique]

Interesting stuff... this may just be a quibble but, how is the economy improved by asset values being revised upward? Does it make sense to weigh that against the cost of keeping people on the dole? Even if it is a gain, it's static isn't it? The word 'drag' sounds dynamic to me - perhaps the cost of keeping people on the dole is not captured by the funding cost.

[GeoffH]

Yeah, and lazy sods idling their lives away on welfare paid for by the likes of me is OK by you, I suppose?

I'm drawing my company pension. About 1/8th goes on income tax and a further 1/8th goes on Council tax. That's a quarter of an income of less than £15k - paid for by a lifetime of savings while in work. And you're still content that welfare should be doled out to lazy scroungers who can't and won't shift the butts off the sofa - except to grab another can of lager.

And when I do freelance work to boost my income, the taxman takes more half of every additional pound I earn.

Can't you see your posturing on behalf of the workshy - and all so you can mouth off at Osborne about his upbringing - makes we taxpayers angry?

[reason]

GeoffH
Your emotional problems are nothing to do with the rightness or wrongness of Chris's argument.

I'm just a bit wary of the logic on two points thought.
1. Surely intermediaries should close the gap
2. I'm not convinced it is so easy to calculate the real equity premium (survival bias, transaction costs etc).

[GeoffH]

I'm sorry you think my arguments 'emotional', reason, but until they are not only answered but satisfactorily assuaged by changes in the tax system by tough and deep reductions in public spending and real measures against scrounging, then wittering on about 'survival bias' mean nothing.

I'll give you another example of our iniquitous tax system.

My mother was recently taken into hospital. She lives 150 miles away. In visiting her several times over the past fortnight - surely the right thing to do - I had to drive many more miles than usual.

It was an additional expense I did not begrudge. Except that additional expense of app £250 yielded over £200 to the exchequer in fuel duty and VAT.

You think it right that indirect taxes on fuel are so high that the Chancellor can 'profit' so much from my mother's misfortune?

And why so high? Because government attempts to do too much, wastes too much and featherbeds wastrels, that our host regards so highly.

[GeoffH]

"In other words, the lack of income insurance causes share prices to be low. It is this that is a huge drag upon the economy. If we had better ways of pooling idiosyncratic risk, background risk would be less. People would be more willing to buy shares, and their prices would be higher"

And while I'm at it; this is just bollocks. The British generally are averse to buying shares because they've swallowed the leftist line that they should leave everything to the State.

How much 'income insurance' do you think I should buy? Even in my semi-retired state, I'm required to give over £4k a year in NI contributions. For a very poor return; no unemployment benefit, as I'm self-employed, and bugger all by way of State Pension.

Get the State off my back and £4k in proper insurance premiums would buy a hell of a lot.

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“But the interesting possibility is raised here (pdf) by George Constantinides.
…In other words, the lack of income insurance causes share prices to be low. It is this that is a huge drag upon the economy. …Let's roughly quantify this. …If only one quarter of this were due to the inadequacy of income insurance, the dividend yield would be 0.9 percentage points lower. Which would mean that share prices would be £583 billion higher.
In other words, the lack of an adequate welfare system - which of course needn't be run by the state - costs us over half a trillion pounds. This is much more than the cost of paying people to stay on the dole or incapacity benefit, which is small.”

I am suspicious about arguments that raise an “interesting possibility”, move to a flat assertion, assume a magnitude for the effect, and conclude that they have proven something. Especially when they start with claims that someone is an “obnoxious prat”.

Since nationalised industries are notoriously inefficient, I suggest that inefficiencies in the welfare system are caused by its control by the state. So does Chris think we should privatise it?

[reason]

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"Since nationalised industries are notoriously inefficient, I suggest that inefficiencies in the welfare system are caused by its control by the state."

Surely this is a non-sequitur - was the welfare system once a private business?

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Yes.

Or rather, it was private enterprise.

Building societies, friendly societies etc.

http://www.amazon.co.uk/Welfare-State-Were-James-Bartholomew/dp/1842751611

You must have taken out insurance, asked for help from family and friends etc? That is the vestigial remnant.

[cjcjc]

Chris's argument should rather be, not that share prices would be higher (though they would be) but rather the corollary, ie that the cost of capital (the other side of the expected equity market return) would be lower, thus leading to greater investment thus leading to higher long term growth?

Of course if government were to grow to provide these greater welfare payments this might offset the above?

[Luis Enrique]

Aha - cjcjc - that's it