Sunday, October 02, 2005

Rational economic choice in the face of risk

Kevin Drum has a post that's a few days old regarding what is known as the equity premium. Brad DeLong discussed it too. Over the past century or so stocks have consistently returned higher yields than do bonds. This does not mesh with standard economic theory because if stocks are in fact a better deal that should drive up their price with respect to bonds until the two instruments are equal. The idea being beaten around lately is that the difference is because of a higher perceived risk in stocks. In short people are not making the rational choice because they perceive stocks to be relatively riskier than bonds.

This suggests to me that people overcompensate for risk. This in turn implies that it is very valuable for a nation, for an economy to minimize risk and to maximize stability. That is the benefit for minimizing risk is greater than can be expected based on the theory that people are making strictly rational choices.

This conclusion supports one of my strong reasons for supporting the federal programs that constitute our social safety net. I'm talking here about Social Security, Medicare, Medicaid, FDIC, unemployment insurance and the like. It is my opinion that maximizing economic stability and minimizing risk is primarily what the social safety net does.

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