The equity premium puzzle states that, given consumers who prefer to smooth consumption over a lifetime, the volatility of consumption, and the excess rate of return of volatile stocks to risk-free government bonds, the implied risk aversion of people must be astronomically, nonsensically high. But perhaps the problem isn’t that the return of stocks is too high, but rather than measured consumption volatility is too low. Savov, a PhD student at Booth, uses data from the USA and Europe of household waste – garbage – and finds that while garbage tracks consumption, it is much more volatile. When standard equity pricing models are estimated using garbage as a proxy for consumption, the implies risk aversion is significantly lower (though not low enough to fully resolve the equity premium puzzle). This result is robust to many different models, many different countries, and the exclusion of durable goods.
The point: economic data is poorly measured, and some economic puzzles may simply be measurement puzzles! Alwyn Young’s recent research on African incomes is in a similar vein.