Robert Waldmann: Robert Waldmann: "The wedge comes from 2 types of irrationality. Poor portfolio diversification means the portfolio held by actual investors has high risk per return compared to the market portfolio. And also irrational loss aversion...
...But I also don't think the source of the wedge matters much.
The crude Mehra-Prescott calculation is interesting. It could be that the equity premium is high because of irrationality, and it could be that it is high because of liquidity constraints and other frictions. But in either case, considering the return a rational representative agent would accept is interesting. The premium minus what it would be if there were a rational representative agent describes the welfare effect of a sovereign wealth fund on welfare. This is John Quiggin's point and it is very important. That is the 64 trillion dollar question.
Why the policy would cause a huge increase in welfare is less important than the fact that such a policy exists, is simple, and can be implemented.
So next step is we look at a state which issued debt and buys the risky asset. The math is fairly simple and works for an OLG model with rational agents in the same way it works for a model of a representative but very stupid agent.
Notice that the leveraged state doesn't have to worry about interest rate spikes. If its debt is short term, it can respond to a loss of public confidence by liquidating its portfolio. In simple models, there aren't multiple equilibria.