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December 26, 2004

Kevin Drum's Head Spins...

All that's solid melts into air as he confronts the fact that right-wing economists aren't what they used to be. He suspects a serious right-wing line wobble:

The Washington Monthly: I'll admit that I haven't kept up with recent thinking about the equity premium, and I haven't kept up with the recent thinking of Martin Feldstein either. But even so, here's why I'm puzzled. The United States is the biggest and most dynamic capitalist country in the world. Likewise, the U.S. stock market is the biggest and most dynamic stock market in the world. It is, in fact, practically a shrine to free market capitalism. And yet Brad would have me believe that conservative economist Martin Feldstein believes that:

The U.S. stock market is the victim of a massive, persistent, and inexplicable market failure,


The best cure for this is an immense government program that forces its citizens to invest in the stock market.

Either conservative economics has taken a turn I'm not aware of, or else Brad is misrepresenting Feldstein's views. But which is it?

Wassamatta U? Hasn't Kevin ever heard of Equity-Primiumism in one country before?

Posted by DeLong at December 26, 2004 05:41 PM

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The problem with Kevin is that he likes the idea of getting a response from you as opposed to catching up on feldstein. It makes him feel important and questioning you allows him to be the good little centrist so as to appease his conservative followers.

Posted by: Erik at December 27, 2004 08:29 AM

My impression is that our real purpose is redistributive (i.e. we want higher inequality). Market failure means that an (infinitely wise) social planner could find a Pareto-dominant solution to whatever one is happenin' under the market failure. A society with increased (or, for that matter, reduced) inequality does not Pareto-dominate one with lower (or higher) inequality. So re-designing Social Security to increase inequality does not redress a market failure, but it does achieve the equity goal of increasing inequality. Good thing? Bad thing? Well, I'd say bad, to be honest, but market failure isn't the real issue here. The equity premium DOES suggest that maybe the government should buy stocks and sell T-bills, but the choice plan supplants insufficient investment in the stock market relative to other financial instruments with excessive investment there.

Posted by: Julian Elson at December 27, 2004 01:20 PM

“But if the stock market were working well, the marginal investor would be a 40-year old in his or her peak earning years looking out to retirement spending 40 years in the future--an investor much less averse to risk than the 62-year old.”

It looks like DeLong believes in time diversity—that the market gets less risky the longer the time horizon. If this is the case, then I think we need to debate this point. As pointed out by Samuelson and Bodie, the reverse is true. Properly defined, investment risk increases with increasing time horizon.

Posted by: A. Zarkov at December 27, 2004 11:28 PM

Just as a control on theoretic hubris in the equity premium argument, let's look other areas in which economists try to explain the behavior of large complex markets, and fail. It is by now a routine matter for international finance specialists, Treasury professionals (and hired guns, like Rubin), IMF staff, to win the last war when it comes to international financial crises. Professor DeLong admits himself baffled at the divergence of productivity and hourly wages. Professor DeLong and many of his colleagues once long ago favored reducing barriers to capital flow because it would mean capital would flow to capital poor areas, but it has not. So far, Professor DeLong's apparent favorite reason for thinking that partial privatization of Social Security might do good is that there is an equity premium. The equity premium, however, is just a theoretical construct. You can't see it. You can't measure it. You can only guess it exists, guess at its magnitude and guess how it will respond in the face of privatization.

Posted by: kharris at December 29, 2004 10:18 AM