See the schematic on page 32 here:
http://www.financialsense.com/editorials/bronson/2008_YearEnd.pdf

also explained in more detail here:
http://www.financialsense.com/editorials/bronson/2007/0927.html

Also, the difference between dividends and fixed interest (on government bonds) is a difference between risky and riskless income. It might be better to state your point as saying that there are two kinds of risk here – fluctuations in earnings (dividends + capital gains) and bankruptcy/default. For an individual security, these have very different effects on the distribution of returns. But for a portfolio, the effects are not so different.

John, I’m guessing you’re on the trail of something related to your earlier post entitled “the end of the cash nexus”.

I await with considerable interest your further findings.

But, except for the word “excess” in that sentence, this just explains (reiterates) why investment in equity is more risky than investment in bonds. It still doesn’t explain why the return is so much higher.

Part of the reason why the EPP is such a big issue is because it also ties into a lot of other “unsolved mysteries” in economics. A bit more specifically it goes right to the big discrepancies between micro and macro data and what they say about how people behave in all kinds of different ways. EPP, taken at face value implies crazy high levels of risk aversion at the macro level but micro studies estimate much lower levels of risk aversion, based on a multitude approaches. Basically, if you’re that risk averse that you need the 4% extra return on a risky investment, you wouldn’t get out of bed in the morning in the fear of the big bad world.
But it also matters for things like how costly are economic fluctuations. Again, micro studies estimates of risk aversion imply that the cost of fluctuations around a trend are nothing compared to the level of that trend. But, taking the EPP at face value – with the implausibly high levels of risk aversion – would imply that recessions and booms matter a lot more. So in a way it’s hard to say how much one should worry about fluctuations vs. how much one should worry about long term average growth, without solving the EPP first.
Another area where it becomes relevant is how much we value future, uncertain benefits. This blog has had some excellent discussions (thanks in large part to JQ) on the Stern Report and the costs of global warming. The central issue there is what is the proper social discount rate to use in estimating these costs. And a key parameter there is the intertemporal elasticity of substitution – which in this context is the same degree of risk aversion that makes the EPP the mess it is. Again, in a way, if we don’t know the answer to the EPP then we don’t know how to properly calculate (more precisely, how people in the economy calculate) these costs.

And another way that micro and macro data disagree with each other in a way that is relevant here is on the elasticity of labor supply – how much do desired hours of work change when the wage rate changes. It turns out to be the same parameter that is key to the EPP (essentially because both phenomenon have the same “substitution effect” vs. “income effect” aspect to them). Basically micro studies find that labor supply is elastic while (traditional) macro studies find that labor supply is not. This has implications for – well lots of stuff. For one if you’re gonna argue that most fluctuations in economic activity are due to productivity shocks (which a policy maker like the central bank or fiscal policy cannot do much about) then to make the explanation coherent you have to have an elastic labor supply. So you’re happy with the micro data but not the macro. But if you think it’s mostly Keynesian style demand side shocks, then that explanation works better with an inelastic labor supply. And what determines which one it is appears to be the same thing which causes the EPP.

The EPP also has implications for social choice theory (how much income redistribution is desirable, given that it has some cost), for consumption externalities (does “Keeping Up With the Joneses” make you save more or less?), for how saving behavior changes as an economy develops and for many other areas. It’s pretty much a big holy grail of a lot of economic research.

I can’t say I’ve studied this, but aren’t those all periods when high nominal interest rates were being used to bring inflation under control, at least at the beginning of each period? So maybe what you are seeing is a result of adaptive (as opposed to rational) expectations of inflation, so that bond-holders got higher real returns than they anticipated. At least that’s likely to be part of the story. I’d be surprised if there isn’t quite an extensive literature on this.

Hence the affinity between market trading and cocaine.

The big puzzle is, why are stocks so volatile.

I have to agree that it’s puzzling from some angles but perfectly sensible from others, and it’s not just the “info asymmetry” issue Kevin mentions. We think of stock exchanges as “normal” markets in which the products being traded just happen to be securities, but the real purpose of an exchange is to “amplify” signals from other markets rather than to discover new information. The idea behind the institution is to minimize the friction of reallocating capital, in the hopes that capital owners will quickly identify, exploit, and magnify tiny marginal differences in real productivity. So both excess volatility and a certain amount of noise (which offers the benefit of stochastic resonance) are really features, not bugs.

Cf. the Boydians, who very vocal about how performance always costs you in terms of stability and vice versa. Stock markets are supposed to overreact in preference to underreacting, just as sports cars are supposed to overreact rather than underreact, and for more or less the same reasons.