Accounting for Macro-Finance Trends: Market Power, Intangibles, and Risk Premia

Paper Martin Sandbu mentioned

"....Real risk-free interest rates have trended down over the past 30 years. Puzzlingly in light of this decline, (1) the return on private capital has remained stable or even increased, creating an increasing wedge between public and private rates of return; (2) stock market valuation ratios have increased only moderately; (3) investment has been lackluster....Our main empirical result here is that the rising spread between private and public capital is driven mostly by a confluence of two factors: rising market power and rising macroeconomic risk. This rising macroeconomic risk in turns implies that the equity premium, which previous researchers have argued fell in the 1980s and 1990s, may have risen since 2000.Moreover, we show how previous researchers, who have used models without risk, have attributed too big a role to rising market power. We also find little role for technical change. Our estimates offer a better understanding of the drivers of investment, profitability, and valuation ratios. Finally, stepping outside of the model, we provide further independent corroborative evidence of the increase in the equity premium using simple reduced-form methods. When we incorporate intangibles, we see that a significant increase in their unmeasured component can help explain the rising wedge between the measured marginal product of capital and the risk-free rate. Interestingly, we find that intangible capital reduces the estimated role of market power in our accounting framework, while preserving the role of risk.... Table 1 shows that the average one-year rate falls from around 2.8% in the first half of our sample (1984-2000) to -0.3% in the second half of our sample (2001-2016). The long-term rate similarly falls from 3.9% in the first half to 1.1% in the second half....We provide a simple accounting framework that allows decomposing the changes observed over the past 30 years in some key macro-finance trends into “semi-structural”parameters using a fairly clear identification. We say “semi-structural” because, allowing these parameters to vary over time flexibly suggests they are not microfounded and invariant to policy. Yet we find the results useful because deeper explanations have to be consistent with the changes of parameters implied by our approach. We find that about half of the increase in the spread between the return on private capital and the risk-free rate is due to rising market power, and half due to rising risk. Technical change plays little role. Higher savings supply and higher risk are the prime proximate contributors to the decline of the risk-free rate. Rising market power help explain the evolution of the capital share, profitability, and capital accumulation, but its contribution is substantially overstated if the model is estimated using a macro approach that abstracts from risk. Finally, taking into account intangibles reduces further the estimated increase in the market power. One limitation of our approach is that we treat the parameter changes as independent causal factors, but they might actually be driven by common causes; for instance, higher market power might reduce innovation and hence productivity growth, but we treat these as independent. Our analysis also does not incorporate some factors which could help explain the evolution of some of the big ratios that we study. In particular, we abstract from taxes and from agency issues (e.g. external finance or corporate governance frictions) or market incompleteness, that could also give rise to wedges that might vary over time. Our study of transitional dynamics is only scratching at the vast possibilities. Finally, it would be interesting to study these issues taking into account the specific open economy considerations or at least to study these same facts for a variety of countries...."

Emmanuel Farhiy and FranÁois Gourioz, " Accounting for Macro-Finance Trends: Market Power, Intangibles, and Risk Premia," Brookings Papers on Economic Activity, September 13, 2018, https://www.brookings.edu/wp-content/uploads/2018/09/BPEA_Fall2018_Accounting-for-Macro-Finance-Trends.pdf