Time may only move in one direction – but just like a faster than light neutrino, let’s ignore physics for a bit! Inspired by this comment from an anonymous author, we will take you to the years 1976 and 1989 and look at life through the eyes of a recent college graduate.
What explains the difference in returns between stocks and bonds?
One theory is that the difference in returns is due to the safety of bonds when consumption declines (the so called ‘risk premium’ is built into stock returns). One of the issues with testing this hypothesis is that the most commonly quoted measure of consumption, the National Income and Product Account, is too nonvolatile to explain the risk premium on its own. Alexi Savov, a grad-student at Chicago, has produced a fascinating look at using residential garbage production in order to take a closer look at the correlation between stock returns and consumption.
One of Milton Friedman’s most influential and revolutionary theories was his challenge to the traditional Keynesian consumption function, which includes simple after-tax income as a variable in the consumption. Friedman countered, however, that those who consume today take future taxes, price increases, salary increases, and other factors into account. This is summarized in his Permanent Income Hypothesis. More specifically, this counters that people consume based off of their overall estimation of future income as well as opposed to only the current after-tax income.