Equity Premium: Product of Monetary Policy Interventions

In our previous article Why Stocks Could Outperform Bonds Over The Next Decade

However, Mr. Gerald Jackson of Brookesnews has an excellent theoretical dissertation underpinning this so called equity premium debate, (bold highlights mine)

we laid the case why I think stocks could outperform bonds (mostly from the inflation perspective)Let me quote Mr. Jackson,

``However, we live in the real world of uncertainty where markets exist because we do not have perfect foresight. Therefore the role of the market is to coordinate and distribute expectations and masses of incomplete knowledge to market participants who will then act according to their own expectations and experience. The world of uncertainty brings us to the nature of profit and its effect on shares. In a progressing economy — one that enjoys rising per capita investment — aggregate profits will always exceed aggregate losses."

``Obviously, if firms consistently make profits then the value of their shares must steadily rise. This means that equity returns must exceed the return on bonds. The reason is the nature of profit. Ludwig von Mises explained that profits are maladjustments between supply and demand. Hence factors become underpriced in relation to the value of their products whenever a genuine profit appears."

``Let us assume a general equilibrium position where all returns have been equalised. There would be no profits or losses and uncertainty would have disappeared. Let us now introduce uncertainty and losses but not profit into our model. Obviously a risk premium would now emerge. It should be equally obvious that the difference between the return on bonds and equities would be pure risk.

``The final step takes us into the real world of profits and losses where economic progress is the order of things. We would now find that the difference between bonds and equities has widened further because we now have to account for aggregate profits exceeding aggregate losses. Therefore profit equals any return over the rate of interest plus any attendant risk. In a progressing economy new ideas, inventions, techniques, innovations, etc, are being constantly applied through new capital combinations. This process constantly renders older capital combinations obsolete and leads to their dissolution thereby creating profitable opportunities."

In short, the fundamental difference between stocks and bond is profit. And by nature stocks, due to its claim on capital goods or earning streams, should outperform bonds.

But the so-called equity premium is the attendant volatility emanating from government policies from which Mr. Jackson defines as the ``gross monetary mismanagements distorts markets and inflates share prices. Sooner or later unavoidably painful corrections have to be made. When this happens the market gets the blame and calls are made on politicians to take action. This invariably results in highly damaging interventionist policies. All because basic truths about how shares are truly valued and how bad monetary policies cause financial crises have been forgotten."