Let’s Play a Game: Connect the Dots

Let us assume:

  1. That there is an equity premium ([PDF] UPDATE: Link modified to Brad De Long posting in which the PDF is embedded. Hat tip: Don Lloyd in comments.)
  2. That the equity premium can be derived from a linear relationship (y = ax(1) + bx(2) + ….) of the most significant variables.
  3. That equity premia are, to some not-insignificant extent, based on Wealth Inequality [PDF].
  4. That one of the primary variables contributing to the premium is the reliability and quality of the information provided

Given the above, should we expect the imminent weakening of U.S. accounting rules, discussed here and here, to produce a higher equity premium?*

If so, there are two possibilities. Either,

  1. the firms are perceived to have a higher present value, despite the change being one of accounting, not business flows or
  2. the stock prices decline in the face of greater uncertainty, leading to an increase in the premium due to a lowering of the price.

My instinctive answer—which I can probably be convinced is wrong, but it would take some effort**—is that the second would be the result. Leaving only one question:

Why does Christopher Cox (R-CA) hate the Securities Markets?

*Following from [3] above, we can assume that greater information tends to result in more optimal investment practices, and therefore a lower equity premium.

**The argument would have to show that the loosening of accounting practices will result in improvements to the company’s business processes that would not otherwise occur.

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