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Does inflation exaggerate theequity premium?

Kyriacos KyriacouBrunel Business School, Brunel University, Uxbridge, UK

Jakob B. MadsenInstitute of Economics, EPRU and FRU, University of Copenhagen,

Copenhagen K, Denmark, and

Bryan MaseBrunel Business School, Brunel University, Uxbridge, UK

Abstract

Purpose The aim of this paper is to identify why the historically observed equity risk premium islarger than most researchers believe is reasonable. Whilst equity is undoubtedly riskier thangovernment issued securities, the extent of the realised premium on equity has been characterised as apuzzle.

Design/methodology/approach This paper measures the equity premium for a number ofcountries over the past 132 years, and then uses a pooled cross-section and time-series analysis toinvestigate the relationship between the equity premium and inflation.

Findings This paper shows that the equity premium over the past 132 years has been significantlypositively related to the rate of inflation and, therefore, has resulted in an equity premium that issubstantially higher in the post 1914 period than before. This effect results from the relativeperformance of bonds and stocks during inflationary periods. The relatively poor performance ofbonds during periods of inflation drives much of the equity premium.

Research limitations/implications Counterfactual simulations in the paper show that the

average equity premium post 1914 would have been 4.61 per cent and not 7.34 per cent had the rate ofinflation been zero. This is much closer to theoretically derived estimates.

Practical implications The size of the equity premium has implications for investorsasset allocation decision. The importance of inflation suggests that in a low inflation environment, theexpected equity premium will be considerably lower than the historically realised equity premium.

Originality/value This paper establishes a clear link between the rate of inflation and the equitypremium.

Keywords Equity capital, Inflation

Paper type Research paper

1. IntroductionThe equity premium (the difference between stock returns and risk-free returns) is

central to many aspects of finance, in particular investors asset allocation decision.Ever since Mehra and Prescott (1985) argued that the extent of this premium was apuzzle, academics have proposed a number of alternative explanations. Mehra andPrescott measured the average US equity premium between 1889 and 1978 atapproximately 6 per cent. A more recent estimate by Siegel (1998) puts the US equitypremium at 4 per cent between 1802 and 1997. Whilst there is no dispute that stocksare relatively riskier, Mehra and Prescotts evaluation that such a premium constitutesa puzzle is based on an analysis in which the premium is determined by the covariance

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q Emerald Group Publishing Limited

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DOI 10.1108/01443580610706573


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of asset returns with the marginal utility of consumption. Given the low correlationbetween stock returns and consumption (or other important risks faced by individualssuch as labour income or house price risk[1]), a large equity premium could initiallyonly be justified by an excessively large coefficient of risk aversion.

As a result of the formulation of the size of the equity premium as a puzzle, the focusof much of the existing research has attempted to resolve the puzzle by justifying alarge premium. This paper takes a different approach. Rather than try and resolve thedisparity between the theoretically implied premium and the realised premium, weinvestigate whether there are factors, or variables, that can explain the extent of therealised equity premium. We find that inflation has a consistent, and significant,positive impact on the equity premium realised by investors. Further, we show thatthis relation appears to be caused by the relative performance of stock and risk-freereturns in the presence of inflation. More specifically, bonds have proved to be asignificantly poorer hedge against inflation than stocks. To the extent that inflation isunlikely to have been anticipated by investors, the equity premium realised byinvestors must have been greater than expected. Moreover, we identify a clear break inthis relative performance around 1914, coinciding with the partial collapse of the goldstandard[2]. This finding is consistent with Siegel (1999, p. 11), who argues thatperhaps the shift from a gold standard to a paper monetary standard had a negativeeffect on these real (bond) returns until investors fully adjusted to the inflationary biasinherent in the new monetary standard. We therefore provide an insight into theimportance of inflation as a risk factor that was not incorporated appropriately intoexpectations of the equity risk premium.

2. LiteratureThe overwhelming research focus on the equity premium has attempted to resolve thepuzzle by justifying the size of the premium. At one end of the spectrum are attempts

that allow for alternative preferences, thereby enabling investors to have the requiredhigh levels of risk aversion. These range from the incorporation of narrow framing(Barberis et al., 2003) and habit formation (Constantinides, 1990) to the application ofgeneralised expected utility in Bansal and Yaron (2004). Alternatively, Constantinideset al. (2002) propose a friction-based explanation. The equity premium would be lowerif the young were not liquidity constrained from investing in equity. Instead olderinvestors for whom equity is not a desirable asset determine the premium.

At the other end of the spectrum are approaches that do not attempt to justify alarge expected premium, but focus on explaining why investors have historicallyrealised a larger premium than they might have required. Rietz (1988) argues that theequity premium incorporates the probability of a substantial crash in output orconsumption. If this crash had occurred, the realised premium would have been

considerably smaller. A related approach is that of Brown et al. (1995), who suggestthat the equity premium is biased upwards because it is measured from markets thathave survived over long periods of time. Incorporating the probability of a market notsurviving reduces the expected premium[3]. Fama and French (2002) note the dramaticreduction in the dividend price ratio since 1950, and infer that this has induced asignificant unanticipated capital gain into the realised equity premium.

Empirical research by Jorion and Goetzmann (1999) implied initially that there wassome support for a survivorship bias. They show that the rate of capital appreciation

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(capital return in excess of inflation) in US stocks since 1921 has been considerablygreater than the median. However, Dimson and Marsh (2001) and Dimson et al. (2002)show that the equity premium realised in the US does not differ from that of a numberof other countries during the twentieth century. There is however stronger evidence for

a substantial variation in the equity premium over time. Siegel (1998) shows that theequity premium in the USA has increased from 1.9 per cent between 1802 and 1870 to6.6 per cent between 1926 and 1997. There is also consistent evidence that post-1950equity premia are significantly larger than pre-1950 (Dimson et al., 2002; Fama andFrench, 2002). That this increased premium may not have been anticipated isreinforced by Jagannathan et al. (2001), who argue that between 1970 and 1999, theexpected US equity premium was below two percent[4].

The evidence that the realised equity premium varies substantially over timeconforms to the possibility that it may be affected by underlying macroeconomics. Forexample, Stultz (1999) suggests that changes in the degree of market globalisation mayimpact on expected returns. Alternatively, there are aspects of financial developmentand market integration that have undergone significant variations over time, andwhich may be consistent with fluctuations in the unconditional equity premium.Bordo et al. (1998) suggest that international market integration did not reach the levelsseen prior to 1914 until the 1990s[5]. Similarly, Makin (1995) notes the increasinginternational financial liberalisation since the early 1980s. Rajan and Zingales (2002,p. 3) argue that countries were more financially developed in 1913 than in 1980,whilst Basu and Taylor (1999) note that the dispersion of real interest rates is only nowreturning to pre-1914 levels. Lettau et al. (2004) argue that the recent decline in theequity premium is related to a sustained fall in macroeconomic risk, specificallyconsumption volatility. Consistent with this, consumption volatility is stronglycorrelated with long-run changes in the dividend-price ratio.

Our research extends this approach by focusing on the impact of economic

variables, and principally inflation, on the equity premium. The Fisher effect statesthat nominal returns should accommodate expected inflation to preserve the real returnearned by investors. In theory, this should apply equally to stock and bond returns,implying that the equity premium will not be influenced by inflation. For the equitypremium to be influenced by inflation requires a differential impact of inflation onstock and bond returns, respectively. Moreover, for inflation to impact positively on theequity premium means that bond returns need to be a poorer hedge against inflationthan stocks. Whilst the existing research has not focused explicitly on the relativehedging performance of stocks and bonds, there is consistent evidence that stocks donot do well when inflation is high, particularly over the short term (Nelson, 1976; Famaand Schwert, 1977). These results have also been confirmed by Al-Khazali (2004) for anumber of Asian stock markets. Extending this to an analysis of long-horizon five-year

holding periods, Boudoukh and Richardson (1993) obtain a positive but less thanone-for-one relation between stock returns and inflation[6]. More importantly, if stockreturns do not comove in line with inflation, then it is likely that the equity premiumwill also vary with inflation. This will almost certainly be the case if the respectivecomovement between stock returns and inflation, and bond returns and inflation, isdifferent. This implication is also implicit in Boyd et al. (2005), who suggest that thedifference in the short-term response of bond and stock prices to unemployment shocksmay be consistent with variations in the equity risk premium.

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3. Data analysisWe estimate the equity premium using the arithmetic mean since this most accuratelyproxies what investors might expect to earn in any particular year[7]. In Table I wecalculate the arithmetic equity premium using both short and long risk-free rates.

The equity premium is normally measured using short rates since these most closelyapproximate risk-free investments. In particular, they expose investors to less inflationrisk, which is not the case with longer-term bonds. Long bond returns are riskier thanshort bond returns by virtue of their greater volatility, and are sensitive to unexpectedinflation. We present results for premia measured from 1871 (the starting point of ourdata), and from 1900 (to enable comparison with previous research)[8].

Several points emerge from Table I. First, the country equity premia areconsistently large in magnitude. The short rate means are 6.23 and 7.04 per cent, whilstthe long rate means are 5.56 and 6.23 per cent, respectively. Second, irrespective of therisk-free rate used, the equity premium for the USA is consistent with that for anumber of other countries. Since 1900, the realised premium for the US is 6.88 and6.15 per cent relative to bills and bonds, respectively. This compares with 5.23 and

4.96 per cent for the UK. Since 1871, the premia are 5.69 and 5.63 per cent for the USA,and 5.03 and 4.77 per cent for the UK. Overall, the US premium is marginally below themean equity premium irrespective of whether we use short or long rates, or start at1871 or 1900. There is therefore no evidence to suggest that the historically observed

Short rates Long ratesCountry Equity premium Std. dev. Equity premium Std. dev.

1871-2002France 8.49 29.4 7.42 29.2Germany 5.26 27.7 3.86 27.4

Ireland 6.67 22.4 6.13 22.0UK 5.03 19.7 4.77 19.0USA 5.69 18.5 5.63 18.1Mean 6.23 23.5 5.56 23.1Median 5.68 22.4 5.63 22.01900-2002Australia 6.93 16.7 6.44 16.7Canada 6.22 18.1 5.17 17.9France 9.92 33.0 8.85 32.7Germany 5.18 30.0 3.36 29.7Ireland 7.59 25.0 6.91 24.5Italy 8.68 34.5 8.40 34.2Netherlands 6.81 23.6 5.39 23.4Spain 4.06 23.2 3.92 23.1

UK 5.23 22.0 4.96 21.2USA 6.88 19.5 6.15 19.3Mean 6.74 24.6 6.00 24.3Median 6.88 23.6 6.57 24.4

Note: This table presents arithmetic equity premia for up to ten countries with data available duringthe periods 1871-2002 and 1900-2002. These are calculated using both bills and bonds. Std. dev. is thecorresponding standard deviation. The mean and median are the equally weighted averages,respectively. The data for Germany excludes 1922-1923

Table I.Equity premia 1871-2002


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USA equity premium is significantly greater than that for the other countries in oursample. This contrasts with the results presented in Jorion and Goetzmann (1999), whoestimate the real capital appreciation for a large number of countries over a comparableperiod, and argue that the US has experienced a higher risk premium than elsewhere.

Third, the difference between the respective mean equity premia obtained usingshort and long rates is small. Starting at 1871 the difference between the means is0.67 per cent, whilst it is 0.81 per cent starting at 1900. This difference is small giventhe inherently greater risk associated with bonds.

In Table II we split our sample into two, representing pre World War I andpost-1914, respectively. Table II shows there is a marked difference in the premiaobserved during the two periods. Prior to World War I, the equity premia averaged alittle over 3 per cent. From 1914 onwards, the mean equity premium has beenaround 7 per cent. Fama and French (2002) contrast a realised US equity premium of4.4 per cent between 1872 and 1950 with one of 7.43 per cent between 1951 and 2000.They suggest that the expected and the realised equity premia have de-coupled since

1950[9]. Our results suggest that 1914, rather than 1950, may represent a natural breakbetween periods of relatively low and high equity premia. This would militate againsta fluctuating dividend-price ratio being the cause. Instead, we will argue that inflation,and specifically unanticipated inflation, is a possible determining factor.


1871-1913France 3.26 6.7 2.39 6.6Germany 4.29 15.5 3.81 15.3

Ireland 2.54 7.1 2.63 7.0UK 3.89 5.8 3.87 5.5USA 2.18 15.4 3.99 14.8Mean 3.23 10.1 3.34 9.8Median 3.26 7.1 3.81 7.01914-2002Australia 6.67 17.8 6.10 17.8Canada 5.71 18.5 4.52 18.3France 11.02 35.3 9.86 35.1Germany 5.75 32.2 3.88 31.9Ireland 8.66 26.7 7.83 26.2Italy 10.01 36.8 9.66 36.5Netherlands 7.37 25.2 5.68 24.9Spain 5.22 24.6 5.06 24.5

UK 5.58 23.6 5.21 22.8USA 7.38 19.6 6.43 19.5Mean 7.34 26.0 6.42 25.8Median 7.37 25.2 6.10 24.9

Note: This table presents equity premia for up to ten countries with data available for the periods1871-1913 and 1914-2002. These are calculated using both bills and bonds. Std. dev. is thecorresponding standard deviation. The mean and median are the equally weighted averages,respectively. The data for Germany excludes 1922-1923

Table II.Equity premia for tencountries 1871-1913,1914-2002

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Our respective estimates of the equity premium, and principally the similarity betweenthese derived from short and long rates, would be consistent with the impact ofunanticipated inflation on bonds. Unanticipated inflation reduces realised bond returnsrelative to expected returns, whereas its impact on the returns to bills will be smaller.

Siegel (1999, p. 11) provides support for the poor performance of bonds over longperiods of time, noting:

. . . it is not well understood why the real rate of returns on fixed-income assets was so lowduring the 1926-1980 period. The bursts of unanticipated inflation following the end of WorldWar II and during the 1970s certainly had a negative effect on the realised returns fromlong-term bonds.

For inflation to have an impact on the equity premium, the comovement between therisk-free rate and inflation needs to be different to that between stock returns andinflation. Put another way, given Boudoukh and Richardsons (1993) findings that longhorizon stock returns do not adequately accommodate inflation, stock returns need tobe affected less adversely by inflation than risk-free returns.

In Table III, we measure the real stock return over comparable periods to theestimates of the equity premium in Table II. This shows that the real stock return hasbeen relatively stable over the equivalent periods. From 1871-1913, the mean real stockreturn was 6.68 per cent, whereas it was 7.25 per cent from 1914 onwards. There istherefore no evidence of a significant difference in the real stock return between the preand post-1914 periods, despite the evidence of substantial variation in the equitypremium in Table II. This means that the variation in the equity premium we find musthave been driven by the risk-free rate.

Country Real stock return Std. dev.

1871-1913France 5.86 7.6Germany 6.96 15.2Ireland 5.60 6.2UK 7.00 5.92USA 7.96 15.81Mean 6.68 10.11914-2002Australia 8.12 17.9Canada 7.24 18.1France 6.67 29.8Germany 5.81 32.3Ireland 8.67 24.7Italy 6.34 30.4

Netherlands 7.22 23.0Spain 4.51 23.3UK 6.67 21.2USA 8.24 20.1Mean 6.98 24.1

Note: This table presents real stock returns for up to ten countries with data available for the periods1871-1913 and 1914-2002. Std. dev. is the corresponding standard deviation. The mean is an equallyweighted average. The data for Germany excludes 1922-1923

Table III.Real stock returns for ten

countries 1871-1913,1914-2002


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4. Empirical estimatesThis section tests the hypothesis in this paper that the equity premium increased in thepost 1914-period because inflation reduced the real returns on bonds more than stocks.To investigate the nexus between the equity premium and inflation the following three

models are estimated using pooled cross-section and time-series analysis:

epit a0 a1pit 11;it; 1

rit b0 b1pit 12;it 2

erit c0 c1pit 13;it 3

where ep is the equity premium measured in percentage points as share returns minusthe nominal interest rate on long or short government bond, r is the nominal interestrate on long-term and short-term government bonds in percentage points, er is thenominal equity return in percentage points, p is the rate of consumer price inflation inpercentage points, and 1 is a disturbance term. Dummies are included in the

hyperinflation period and the surrounding years for Germany (1922-1926).The models are estimated using annual data over the period from 1871 to 2002 for

USA, the UK, Ireland, France, and Germany (Group I) and additionally for Canada,Australia, Italy, the Netherlands, and Spain over the period from 1900 to 2002 (GroupII). Country-dummies were excluded from the estimates because their estimatedcoefficients were both individually and jointly insignificant at conventionalsignificance levels.

To gain efficiency the model is estimated allowing for the correlation of theerror-terms between countries. The covariance matrix is weighted by the correlation ofthe disturbance terms using the following variance-covariance structure:

E 12

ijn o s2

i

; i 1; 2; . . .N;

E{1it; 1jt} sij; i j;

where s2i the variance of the disturbance terms for country i 1, 2, . . . , N,sij the covariance of the disturbance terms across countries i and j; and 1 is thedisturbance term. The variance s2i is assumed to be constant over time but to varyacross countries and the error terms are assumed to be mutually correlated acrosscountries, sij, as random shocks are likely to impact on all countries at the same time.The terms s2i and sij, are estimated using the feasible generalized least squaresmethod.

The results of estimating equations (1)-(3) are reported in Table IV. R2 is notreported since it is driven to one by the German hyperinflation dummies. The nullhypothesis of cross-country coefficient homogeneity across countries cannot berejected at conventional significance levels for any of the estimates. Nor do the tests forfirst-order serial correlation and ARCH effects give evidence against the modelspecification. These results indicate that the models are well specified.

The estimation results suggest that inflation is a highly significant determinant ofthe equity premium regardless of estimation period, country sample and whether theshort or long bond rate is used. The estimated coefficients of inflation in the models ofthe equity premium vary between 0.43 and 0.61, which suggests that inflation increase

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Shortrate

Longrate

Equityp

remium

Bondyields

Sharereturns

Equitypremium

Bond

yields

I

II

I

II

I

II

I

II

I

II

pt

0.59(5.93)

0.43(5.10)

0.00(1.32)

0.00(0.94)

0.47(5.58)

0.29(4.17)

0.59(5.93)

0.43(5.10)

0.00(0.62)

0.00(1.67)

Con.

4.02(3.06)

3.93(2.80)

4.44(7.22)

4.01(7.27)

6.84(5.70)

7.59(6.27)

3.43(2.67)

3.10(2.37)

4.89(7.30)

5.03(5.78)

Est.Per.

1873-2002

1903-2002

1873-2002

1903-20

02

1873-2002

1903-2002

18

73-2002

1903-2002

1873-2002

1903-2002

NT

650

1000

650

1000

650

1000

650

1000

50

1000

DW(m)

2.02

1.99

2.00

1.99

1.98

1.93

F(i,j)

0.88

1.55

0.91

1.31

1.55

1.22

0.55

1.44

0.41

1.11

ARCH

0.00

0.02

0.00

0.03

0.04

0.27

0.11

0.01

1.20

1.02

Notes:Thecoefficientestimatesarethesumofalllags.Absolutet-statisticsaregiveninparenthes

es.

NT

numberofobservations,w

hereNisthe

numberofcountries,Tisthetime-period.

DW(m)

modified

Durbin-Watsontestforfirstorders

erialcorrelationinfixedeffectpanel

datamodels

(Bhargavaetal.,1982).F(i,j)

F-testforcross-countrycoefficien

tconstancy,andisdistributedasF(N(k-1),NT-Nk)underthenullhypothesis

ofcoefficient

constancy,andkisthenu

mberofregressors(19).A

RCH

fixedeffectmodelARCHtest,basedonwithinindividualresiduals,andisdistributedasx21

underthenullhypothesis

ofhomoscedasticity.ThefollowingfivecountriesareincludedinGroupI:TheUSA,theUK,Ireland,France,andG

ermany.The

followingtencountriesa

reincludedinGroupII:TheUSA,th

eUK,Ireland,France,Germany,Canada,Australia,Italy,theNetherlands,andSpain.

Impulsedummiesareinc

ludedintheestimatesovertheperiodfrom1922to1926forGermany

Table IV.Parameter estimates of

equations (1)-(3) using theshort rate


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the equity premium by about half of the rate of inflation. Given that inflation reacheddouble digits during and immediately after the World Wars and the 1970s in almost allOECD countries, the inflationary periods in the past century have been partlyresponsible for the large equity premium that has been observed.

The estimated constant terms in the equity premium estimates give importantinformation about the equity premium when the influence of inflation is accounted for.The estimated constant terms are about 4 per cent in the estimates, whereas they are onaverage 6 per cent when inflation is excluded from the equity premium regression(not shown). This result suggests that approximately 2 percentage points of theestimated equity premium is due to inflation over the entire estimation period.As shown in the next section the inflation-induced equity premium has variedsubstantially over history and, as argued above, increased substantially after 1914.

To check the source of the inflation-induced equity premium the nominal interestrate and nominal stock returns are regressed on inflation and the results are alsoreported in Table IV. The nominal bond rate is not significantly related to inflationregardless of estimation period, country sample and whether the short or the long rateis used. Nominal stock returns, by contrast, are significantly related to the rate ofinflation. Although the estimates show that stocks are only fractionally hedged againstinflation they have, nevertheless, been a better hedge against inflation than bondssince 1870.

5. SimulationsHow would the equity premium have behaved if the rate of inflation had been zeroduring the past century? To investigate this issue we undertake counterfactualsimulations in this section to estimate the path of the equity premium if the rate ofinflation had been zero and compare it with the actual equity premium. Following theestimates in the previous section, we assume that inflation increases the equity

premium by half its magnitude, which means that if inflation was 10 per cent, then theequity premium without the impact of inflation would be 5 per cent lower.The simulations are presented in Table V.

Comparing the results in Tables II and V it is evident that thereis no inflation-inducedeffect on the premia pre 1914. The mean for short rates changes from 3.23 to 3.25when the inflation effect is incorporated. The corresponding figures are 3.34 and3.35 for the long rates. However, post 1914, we obtain means of 4.61 and 3.79 per cent forshort and long rates, respectively. This compares with the corresponding estimatesfor the realised premia in Table II of 7.34 and 6.42 per cent. These inflationadjusted estimates of the equity premium are more in line with those derived fromfundamentals.

Considering individual countries the estimates give further credibility to the

hypothesis that inflation has been partly responsible for the post 1914 risk premium.In Table II there was a large cross-country discrepancy in the equity premium in thepost 1914 sample. Using short rates, the equity premium without the inflationcorrection was double digits in Italy and France. However, they were also the countriesthat experienced the highest post 1914 inflation (we have excluded the hyperinflationperiod in Germany). Correcting for inflation brings the equity premium for thesecountries more in line with the other countries. The inflation-corrected equity premiumis 6.75 per cent for France and 5.06 per cent for Italy.

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6. Concluding remarksIn this paper, we have argued that inflation has predominately been responsible for thehigh equity premium observed in the past century. Using over a century of datafor the most important industrialised countries, we have shown that the equitypremium has been significantly associated with inflation. As a consequence, theequity premium has been particularly high in the inflationary periods such asthe periods around the world wars and the two oil price shocks in the 1970s.

Counterfactual simulations show that the mean post 1914 equity premium wouldhave been 4.61 per cent and not 7.34 per cent if the rate of inflation had been zero. Thisis consistent with our analysis that implies inflation has added approximately 2 percent to the realised equity premium. This impact of inflation comes from the relative

poor performance of bonds during inflationary periods.In providing an insight into the importance of inflation for the realised equity

premium, our findings raise the issue of whether the equity premium has been reducedto a permanently low level. Current estimates of the equity premium fromfundamentals suggest that it lies between 2 and 4 per cent. For these estimates toprove realistic, we would require either that the rate of inflation be kept permanentlylow, perhaps as a result of monetary targeting, or for bond owners to be bettercompensated for inflation if it were to increase in the future.


1871-1913

France 3.19 7.0 2.31 6.9Germany 3.98 15.5 3.50 15.2Ireland 2.63 6.6 2.71 6.5UK 3.98 5.9 3.96 5.5USA 4.65 13.2 4.27 15.2Mean 3.25 10.2 3.35 9.8Median 3.98 7.0 3.50 6.91914-2002Australia 4.52 18.3 3.94 18.3Canada 4.13 18.7 2.94 18.4France 6.75 34.5 5.59 34.3Germany 3.42 33.0 1.53 32.7Ireland 6.03 26.9 5.20 26.4

Italy 5.06 35.9 4.72 35.6Netherlands 5.69 24.7 4.00 24.5Spain 1.40 24.6 2.19 24.5UK 3.41 23.6 3.05 22.8USA 5.74 20.1 4.79 20.0Mean 4.61 26.0 3.79 25.8Median 4.79 24.7 3.97 24.5

Note: This table presents simulated equity premia, adjusted for the impact of inflation, for up to tencountries with data available for the periods 1871-1913 and 1914-2002. The numbers are the realisedequity premium minus half of the rate of inflation. Std. dev. is the corresponding standard deviation.The mean and median are the equally weighted averages, respectively. The data for Germanyexcludes 1922-1923

Table V.Simulated equity premia

for ten countries1871-1913, 1914-2002


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Notes

1. See, for example, Heaton and Lucas (2000).

2. The gold standard was first abandoned worldwide in the mid 1930s. However, mostcountries abandoned the gold standard at the onset of WWI and the reestablishment of the

gold standard in the 1920s only lasted a few years. See Eichengreen (1992) for a morecomplete discussion of these issues.

3. Li and Xu (2002) however suggest that the induced bias is not large, even if the probability ofa market not surviving the twentieth century is just one half, the historic average.

4. Consistent with this, Welch (2000, 2001) surveys financial economists and finds theirexpectations of the equity premium have declined substantially.

5. The principal factor contributing to the earlier period of market integration was the goldstandard. Associated factors include the absence of currency risk, very substantial capitalflows and the convergence of government bond yields.

6. One possible reason for this is that increased inflation predicts lower output growth andtherefore lower dividend growth. Mallik and Chowdhury (2002) also examine the linkbetween inflation and real incomes.

7. The arithmetic mean exceeds the geometric mean by approximately one half the variance.

8. Existing research has also used long data histories to examine characteristics of the businesscycle (Garcia-Ferrer and del Rio, 1999) and bond yield volatility (Zhu, 2001).

9. Fama and French (2002) argue that the high realised equity premium in the US since 1950may have been induced by a significant, but unanticipated, reduction in the dividend-priceratio and with it an associated capital gain.

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Appendix Accumulated share indexThe data are updated from 1970 using Morgan Stanleys accumulated index. The followingsources are used before 1970. Canada. 1900-1924: Dimson, Elroy, Paul Marsh and Mike Staunton,

2000, The Millennium Book, A Century of Investment Returns, London Business School, ABN,AMRO, 1924-1999: Panjer, Harry H and K P Sharpe, 2001, Report on Economic Statistics1924-1998, Canadian Institute of Actuaries. USA. Jack W Wilson and Charles P Jones,2002, An analysis of the S&P 500 index and Cowles extensions: price indexes and stockreturns, 1870-1999, Journal of Business, 75, 505-533. Japan. Global Financial Data.

Australia. Global Financial Data. France. 1870-1900: NBER Macroeconomic Data Base,1900-1970. Global Financial Data. Germany. Gregor Gielen, 1994, Konnen Aktienkurse NochSteigen?, Wiesbaden: Gabler Verlag. The index is multiplied by 10 before 1948 to take account ofthe money reform that changed the old Reismark to a new DEM at the ratio of 1:10. Ireland.S F Whelan, 1999,From Canals to Computers: The Friends First, Guide to Long Term Investment.Dublin: Friends First,. Italy. Panetta, Fabio and Robert Violi, 1999, Is there an Equity PremiumPuzzle in Italy? A look at Asset Returns, Consumption and Financial Structure Data over the LastCentury, Termi di Discussione 353, Bank of Italy (data received by personal correspondence with

Fabio Panetta). Netherlands. Eichholtz, Piet, Kees Koedijk and Roger Otten, 2000, De Eeuw vanHet Aandeel, Economisch Statistische Berichten, January (data received by personalcorrespondence with Piet Eichholtz and Roger Otten). Spain. The data are kindly provided bySantiago Fernandez Valbuena, Universidad Complutense. Madrid. United Kingdom. 1870-1913:Richard S Grossman, 2002, New Indices of British Equity Prices, 1870-1913,Journal of Economic

History, 62, 121-146. 1913-1970. Barclays Capital, 2001, Equity Guild Study, Barclays Capital.

Consumer pricesB. R. Mitchell, 1983, International Historical Statistics: Americas and Australasia, Macmillan:London, B. R. Mitchell, 1975, European Historical Statistics 1750-1975, Macmillan: London, andB. R. Mitchell, 1982, International Historical Statistics: Asia and Africa, Macmillan: London. Thedata are updated using OECD, Main Economic Indicators.

Nominal interest rates on short and long term government bondsCanada. F. H. Leacy (ed.), 1983, Historical Statistics of Canada, Statistics Canada: Ottawa. USA.S. Homer and R. Sylla, 1991, A History of Interest Rates, London: Rudgers University Press.Corporate and municipal long-term bond yields are used over the period from 1900 to 1918.

France, Germany, Netherlands, Spain and UK. Homer and Sylla, 1991, A History of InterestRates, London: Rudgers University Press, where the official discount rate is used for Spain before1940. Italy. Fratianni, M, Spinelli, F, 1997, A Monetary History of Italy, Cambridge: CambridgeUniversity Press. Ireland. Whelan, 1999, From Canals to Computers: The Friends First, Guide to

Long Term Investment. Dublin: Friends First. The data are updated using OECD, Main Economic Indicators.

Corresponding author

Kyriacos Kyriacou can be contacted at: [email protected]

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