Page 547 - The Principle of Economics

CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 561
But wait. There is a big difference. Profits grow over time. If that dividend should increase with profits, say at a rate of 5 percent annually, then, by the 30th year, your annual dividend payment will be over $800, or one-third more than the bond is yielding. The price of the stock almost certainly will have risen as well.
By this simple exercise, we can see that stocks—even with their profits growing at a moderate 5 percent—will return far more than bonds over long pe- riods. Over the past 70 years, stocks have annually returned 4.8 percent- age points more than long-term U.S. Treasury bonds and 6.8 points more than Treasury bills, according to Ibbot- son Associates Inc., a Chicago research firm.
But isn’t that extra reward—what economists call the “equity premium”— merely the bonus paid by the market to investors who accept higher risk, since returns for stocks are so much more un- certain than for bonds? To this question, we respond: What extra risk?
In his book “Stocks for the Long Run,” Jeremy J. Siegel of the University of Pennsylvania concludes: “It is widely known that stock returns, on average, exceed bonds in the long run. But it is lit- tle known that in the long run, the risks in stocks are less than those found in bonds or even bills!” Mr. Siegel looked at every 20-year holding period from 1802 to 1992 and found that the worst real return for stocks was an annual av- erage of 1.2 percent and the best was an annual average of 12.6 percent. For long-term bonds, the range was minus 3.1 percent to plus 8.8 percent; for T- bills, minus 3.0 percent to plus 8.3 per- cent.
Based on these findings, it would seem that there should be no need for an equity risk premium at all—and that the correct valuation for the stock mar- ket would be one that equalizes the present value of cash flow between stocks and bonds in the long run. Think of the market as offering you two assets, one that will pay you $1,000 over the next 30 years in a steady stream and
another that, just as surely, will pay you the $1,000, but the cash flow will vary from year to year. Assuming you’re in- vesting for the long term, you will value them about the same. . . .
Allow us now to suggest a hypothe- sis about the huge returns posted by the stock market over the past few years: As mutual funds have advertised the re- duction of risk acquired by taking the long view, the risk premium required by shareholders has gradually drifted down. Since Siegel’s results suggest that the correct risk premium might be zero, this drift downward—and the corresponding trend toward higher stock prices—may not be over. . . . In the current environ- ment, we are very comfortable both in holding stocks and in saying that pundits who claim the market is overvalued are foolish.
Source: The Wall Street Journal, Monday, March 30, 1998, p. A18.
(denoted as Y) is divided into four components of expenditure: consumption (C), investment (I), government purchases (G), and net exports (NX). We write
Y 􏰀 C 􏰁 I 􏰁 G 􏰁 NX.
This equation is an identity because every dollar of expenditure that shows up on the left-hand side also shows up in one of the four components on the right-hand side. Because of the way each of the variables is defined and measured, this equa- tion must always hold.
In this chapter, we simplify our analysis by assuming that the economy we are examining is closed. A closed economy is one that does not interact with other economies. In particular, a closed economy does not engage in international trade in goods and services, nor does it engage in international borrowing and lending. Of course, actual economies are open economies—that is, they interact with other economies around the world. (We will examine the macroeconomics of open economies later in this book.) Nonetheless, assuming a closed economy is a useful simplification by which we can learn some lessons that apply to all economies. Moreover, this assumption applies perfectly to the world economy (inasmuch as interplanetary trade is not yet common).