“No One Can Borrow” – Reassessing the “Junior Can’t Borrow” Equity-Premium Puzzle Resolution

“Junior Can’t Borrow,” Constantinides, Donaldson, and Mehra’s (CDM) three-period exchange model, eliminates borrowing by the young, and, consequently, all generations to resolve the equity premium puzzle. This paper examines CDM’s resolution in an 80-period, OLG model with capital, fiscal policy, macro shocks and steeply rising borrowing costs. Imposing such costs on all generations and, thereby, eliminating the bond market produces, as in CDM, a large premium. But permitting even one generation to sell bonds without transactions costs dramatically raises the safe rate, restoring the puzzle. Hence, “No One Can Borrow” not “Junior Can’t Borrow” is CDM’s real message. Since zero or low marginal-cost borrowing is commonplace – be it via secured borrowing or friends and family loans, CDM’s “solution” isn’t plausible. As in representative-agent RBCs, macro risk is low in OLG-RBCs – not because aggregate shocks are small, but because they can be hedged via self-insurance (saving) and largely average out over agents’ lifetimes. Indeed, absent high marginal borrowing costs, agents, even older ones, are close to indifferent between holding shares and holding bonds, rendering their net bond demand (supply) curves highly elastic. This explains why even a single generation is willing to supply significant amounts of bonds at a low price (high yield).