Over at Grasping Reality: Flaws in the Rietz-Barro Explanation of the Equity Premium
: Flaws in the Rietz-Barro Explanation of the Equity Premium: I have an itch I need to scratch, ever since I found Ken Rogoff writing:
Robert Barro… has shown that in canonical equilibrium macroeconomic models… small changes in the market perception of tail risks can lead both to significantly lower real risk-free interest rates and a higher equity premium…. Martin Weitzman, has espoused a different variant of the same idea based on how people form Bayesian assessments of the risk of extreme events…
Rogoff, Barro, and Weitzman are all sharper than I am by substantial margins. But this seems to me to be wrong. I don’t think that what their papers mean is that the equity return premium is driven by fears of the rare event of a complete macroeconomic catastrophe. And it definitely does not mean what the math of Barro (2005) says: that high equity prices in 1929 and 2000 were driven by a much higher than normal expectation of such a complete macroeconomic catastrophe. Barro and Weitzman both work in a model in which safe assets are in zero aggregate supply…