John Cochrane writes,

Most of macroeconomics focuses on variation in a single intertemporal price, “the” interest rate, which intermediates saving and investment. Yet in the recent recession…interest rates paid by borrowers (and received by any investors willing to lend) spiked up, while short-term government rates went down. Recessions are all about changes in credit spreads, about the willingness to bear risk and the amount of risk to be borne, far more than they are about changes in the desire for current vs. future certain consumption. Most of the Federal Reserve’s response consisted of targeting risk premiums, not changing the level of interest rates or addressing a transactions demand for money.

In the paper, he raises some really fundamental issues about finance theory, with some macroeconomics tossed in.

Here is what a lot of the paper is about, in my words (so I could be wrong). I go back to my rent vs. buy formula:

profitability (of buying) = rental rate + appreciation rate – interest cost

Note that for a stock, the “rental rate” is the ratio of dividend to price. Profitability should be close to zero in an efficient market.

Taking the interest cost as given, if the rental rate falls, the appreciation rate must rise. Thus, a sudden increase in an asset price should reflect future expected appreciation (this could be expected appreciation of rents, or dividends, or that have you).

Instead, Cochrane argues, when an asset price suddenly increases, this often reflects changes in the interest cost. Not so much in “the” market interest rate, but in the specific risk premium associated with the asset. So, when house prices shot up relative to rents, this reflected a lower risk premium in the housing market (which also coincided with a lower risk premium in the mortgage markets).

Some of this change in risk premium could be what many economists call “bubble.” Cochrane argues that some of the change is macroeconomic, although it is hard to say whether recessions cause risk premiums to rise, or vice-versa.

Anyway, Cochrane says that we have to get used to interpreting financial market events as changes in risk premiums rather than changes in expected cash flows (rents, in my formulation). Something to chew on.