Jorda et al. are at it again. Over the past few years, they have constructed the most useful international macrofinancial dataset extending back to 1870 and covering 16 rich countries. The Policy Tensor has worked with the previous iteration of their dataset. I documented the reemergence of the financial cycle; the empirical law that all financial booms are, without exception, attended by real-estate booms; and that what explains medium-term fluctuations not just in real rates (a result originally obtained by Rey) but also in property returns, is the consumption to wealth ratio (equity returns on the other hand are explained by balance sheet capacity, not the consumption to wealth ratio).
There are two main findings in Jorda et al. (2017). First, they corroborate Piketty’s empirical law that the rate of return exceeds the growth rate. The gap is persistent and is only violated for any length of time during the world wars. Excluding these two ‘ultra-shortage of safe asset’-periods, the gap has averaged 4 percent per annum. That is definitely enough to relentlessly increase the ratio of wealth to income and drive stratification, as Piketty has shown.
The second finding is truly novel. Jorda et al. (2017) find that housing has dramatically outperformed equities over the long run. This is true not just in the aggregate but also at the country level.
Matt Klein over at Alphaville is truly puzzled by this failure of standard asset pricing theory. As he explains,
The ratio between the average yearly return above the short-term risk free rate and the annual standard deviation of those returns — the Sharpe Ratio— should be roughly equivalent across asset classes over long stretches time. There might be short periods when an asset class’s Sharpe ratio looks unusually high, especially in individual countries, but things tend to revert to their long-term average sooner or later.
More generally, the expectation of asset pricing theory is that Sharpe ratios should be roughly equal across not just asset classes but arbitrary portfolios as well. Deviations from equality imply the existence of extraordinary risk premia which ought to be eliminated through investors’ search for higher risk-adjusted returns.
This, of course, goes back to the hegemonic idea of Western thought. Competition serves as the organizing principle of evolutionary biology, economic theory, and international relations; as the cornerstone of America’s national ideology; and as the guiding star of modern governance and reform efforts. But there are some rather striking anomalies of this otherwise compelling broad-brush picture of the world—persistent sources of economic rents and the existence of substantial risk premia, eg on balance sheet capacity.
But I believe something much more elementary is going on with property. The next figure shows the global wealth portfolio. We see that housing constitutes the bulk of global wealth.
What explains the superior risk-adjusted performance of housing is the fact that housing assets are not, in fact, owned by the rich or market-based financial intermediaries like other asset classes, but quite broadly held by the small-fry. More precisely, the marginal investor in housing is your average homeowner who finds it extraordinarily hard to diversify away the risk posed by her single-family home to her balance sheet. Since it is so hard for her to diversify this risk away, she must be compensated for that risk.
Put another way, the risk premium on property is high because property returns are low when the marginal value of wealth to the marginal investor is high (ie, when times are bad for the average homeowner) and high precisely when the marginal value of wealth to the marginal investor is low (ie, when times are good for the average homeowner). This is as it should be given the relatively progressive vertical distribution of housing wealth.