A Secular Increase in the Equity Risk Premium

• Date: 01 June 2016
• DOI: http://doi.org/10.1111/infi.12085
• Author: Kevin Daly
• Published date: 01 June 2016

A Secular Increase in the Equity

Risk Premium

Kevin Daly

Goldman Sachs International.

Abstract

There is an increasing consensus that global ‘excess saving’has contrib-

uted to a reduction in equilibrium real interest rates. While economists

disputetheextentofthedecline,fewnowquestionthatadeclinehas

taken place or that excess saving has played a causal role. A key

implication of this narrative is a decline in yields of all assets, including

butnotrestrictedtogovernmentbondyields.Yet,sincetheturnofthe

century, yields on global equity have risen. A complementary explana-

tion is that there has been an increase in the global equity risk

premium (ERP), which has simultaneously pushed risk-free yield

curves lower and equity yields higher. Applying a sign restrictions

approach, I f‌ind that excess savings shocks were the predominant force

affecting global real bond yields between the mid-1980s and 2000 but

that ‘risk premium’shocks have accounted for more of t he decline in

real bond yields since 2000.

With special thanks to Ben Broadb ent and Philip Lane for their detailed comments and adv ice. Also

thanks to Alina Barnet t, Sharon Bell, Matthieu Droumaguet, Jan Hatzius, Matteo Leombroni, Ch ristian

Mueller-Glissmann, Peter Oppenh eimer, Huw Pill and two anonymous referees.

International Finance 19:2, 2016: pp. 179–200

DOI: 10.1111/infi.12085

© 2016 John Wiley & Sons Ltd

I. Introduction

There is a large body of opinion that excess sav ing –or, more precisely, an increase

in the global propensity to save relative to the propensit y to invest –has lowered

global equili brium real interest rates in the past 25 yea rs. Bernanke (2005) was

amongst the f‌irst to suggest that an emerging -world ‘savings glut’was responsible

for the decline in real lon g-term government bond yields w itnessed in devel oped

economies from the early 1990s onwards. Figure 1 plots ten-year real, ex ante

government bond yields for the United S tates of America, Japan, United K ingdom

and a euro area composite from 1975 onwards.

1

Initially viewed as a largely benign

development, this s avings glut is now consi dered by many to have played an

instrumental role in facilitating the credit boom that preceded the 2007–08 global

f‌inancial crisis.

In the years since the crisis , short- and long-te rm real interest rates have fallen

further, and the idea that excess sav ing has resulted in a secul ar decline in interest

rates has become more widespread. Summers (2014a) has argued that the global

economy has entered a pe riod of secula r stagnation, in which too much saving i s

chasing too few investment opportun ities, driving th e equilibrium real interest rate

below zero and curtai ling the effect iveness of monetar y policy in the proces s.

Although there are differences be tween the savings glut an d secular stagnat ion

theses, a common impl ication of both is that excess s aving has resulted in a

generalized de cline in yields across a ll assets, includ ing but not restricted to real

governmentbondyields(sometimesreferredtoasreal‘risk-free’rates).Yet,inthe

-2

-1

0

1

2

Yield (%)

3

4

5

6

7

US

Euro area

Japan

UK

Year

1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014

Figure 1: Real ex ante ten-year government b ond yields

Note: Author’s calculations, see Sec tion IV. Quarterly data to 2015Q4.

1

In Section IV, I describe how each of these series is cons tructed.

180 Kevin Daly

© 2016 John Wiley & Sons Ltd