By Prashansa Srivastava
A new paper titled “The Rate of Return on Everything, 1870–2015” by Jorda, Knoll, Kuvshinov, Schularick, and Taylor seeks to answer the fundamental questions that have formed the basis of modern economic thought since the 18th century, using absolute raw data. The paper uses a new and comprehensive set of data spanning 145 years and covering 16 advanced economies. The data set analyses total returns on government bonds, stocks and the often ignored but extremely important component of household wealth, to reveal many new insights.
The question about the real return in an economy is as old as the profession of economics itself. The movement of the return as compared to the growth rate in an economy and long-run returns of assets sheds light on a multitude of classic questions in macroeconomics, investment and finance. The paper also raises questions about the evolution of the risk premium, the role of capital in leading to the rise of inequality, fears that modern economies face negligible or no economic growth, and how unusual today’s low-interest environment is by historical standards.
Housing- An underrated source of wealth
One of the most surprising findings of the paper is that residential real estate, not equity, has been the best long-run investment over the course of modern history. Housing was less than half as volatile and historically a better investment than stocks. With the exception of World War I, housing returns have been remarkably stable. With only a couple of exceptions, the return has been between five percent and eight percent year in and year out. Equities do about as well on average, but are far more volatile, ranging from zero percent to 15 percent depending on the strength of the economy. The UK is one of the few countries where stocks have significantly outperformed housing over the long run. In most countries, the returns are comparable, and in some places such as France and Japan, housing has done much better being less volatile but also less liquid. This can be explained by the fact that the rental income returns have been greater than the stock dividend returns.
However, there are caveats to the research as well, housing as an asset is difficult to measure, with its price differing from unit to unit and city to city. Housing also involves a number of maintenance and physical costs. Thus, it doesn’t mean that housing is now the best investment in the long run. Lack of liquidity, high property taxes, less global interrelation and difficulty to diversify a real estate portfolio all indicate that investors should not completely turn to housing as an investment. However, an internationally diversified portfolio of real estate holdings would be a good idea considering the new findings of this research.
Risky assets and safe assets
Returns on safe assets such as government bonds and bills have been surprisingly volatile. In wartime and times of inflation, returns have plummeted. Even in peaceful times, they range from minus three percent to eight percent. The real safe rate was at a high during gold standard times, in the interwar period, and in the mid-1980s fight against inflation. Low returns and high volatility have thus offered a poor risk-return trade-off to investors.
The evolution of risk premium
The findings about safe and risky assets can also help to understand the evolution of risk premium over time. Risk premium refers to the return of a risky asset over and above the risk-free rate of return that an asset is expected to yield so as to compensate for the additional risk. With the exception of the huge change during the Depression and World War II, the trend is fairly clear. From 1870 to 1970, the risk premium gradually increased from about four percent to seven percent. With safe rates rising, risk premiums fell and ever since the mid-80s the risk premium has been between 2-4 percent.
Thus, for the better part of a century, investors required a premium of 4-7 percent to entice them to invest in risky equities instead of comparatively safe treasury bonds. But following the collapse of the Bretton Woods regime in the 70s and the global financial deregulation of the 80s, investors have required a premium of only 2-4 percent. Risk premiums thus fluctuate more due to the volatility of safe returns rather than risky returns which tend to be more stable and smooth. Studying the trends, the paper also suggests that when risk premiums are low, financial crises become more likely.
Piketty’s Puzzle
According to the noted economist, Thomas Piketty, if the return to capital exceeds the rate of economic growth, that is if r>g, the already rich would be able to accumulate wealth faster than the pace of economic growth and inequality would skyrocket in the coming decades. The paper by comparing returns to growth or ‘r minus g’ suggests that r is greater than g for more years, more countries and more dramatically than predicted by Piketty. The exceptions occur only in or around wartime. In the pre-WW2 period, r minus g was on average 5% per annum. Currently, this gap is still quite large—in the range of 3%–4%. It narrowed to 2% during the 1970s oil crises, before widening in the years leading up to the financial crisis of 2008. On a global level and across most countries, the weighted rate of return on capital was twice as high as the growth rate in the past 150 years. This striking finding that r is greater than g in peacetime can have numerous implications. However, interestingly r minus g does not fluctuate systematically with growth rate. This finding poses many more questions in the field of distribution and substitution of income.
Thus the historical economic study of the rate of return and compilation of a vast data set spanning a century and a half provides new insights and answers many questions. However, most importantly it leads to the possibility of the postulation of many more such fundamental economic questions that can form the basis of future research in the years to come.
Featured Image Source: Flickr
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