The Equity Premium Puzzle Solution: Incentives to Under-Report Inflation

Abstract

The biggest and most well-known unsolved problem in academic finance is famously referred to as the Equity Premium Puzzle. It refers to the unexplained phenomenon that for over 100 years the average return on a well-diversified portfolio of equities has far outperformed that of risk-free, short-term US treasuries. Although there have been countless proposed solutions, all have failed as these attempts implicitly assume perfectly-correct inflation statistics. Examining these assumptions, we discover that not only are the inflation numbers materially flawed, but more so, there are significant incentives for government entities to under-report inflation. With this, we find that to explain the Equity Premium Puzzle, inflation would only need to be under-reported by about 2-6% per year: an exceedingly likely scenario given the significance of these incentives.

Keywords: equity, premium, puzzle, inflation, CPI, interest rates, incentives, bias, BLS, tax, entitlement programs, political economy, debt, budget deficit, distortion

JEL Classification: D72, D73, E21, E31, E42, E43, E44, E51, E52, E58, E61, E62, G12, G18, G21, G51, H11, H62, H63, H81,