Disasters and Recoveries Franois Gourio December 2007 1 Introduction Twenty years ago, Thomas A. Rietz (1988) showed that infrequent, large drops in consumption make the theoretical equity premium large. Recent research has resurrected this disaster expla- nation of the equity premium puzzle. Robert J. Barro (2006) measures disasters during the XXth century, and nds that they are frequent and large enough, and stock returns low enough relative to bond returns during disasters, to make this explanation quantitatively plausible. Xavier Gabaix (2007) extends the model to incorporate a time-varying incidence of disasters, and he argues that this simple feature can resolve many asset pricing puzzles. These papers make the simplifying assumption that disasters are permanent. Mathematically, they model log consumption per capita as following a unit root process plus a Poisson jump. However a casual look at the data suggests that disasters are often followed by recoveries. The rst contribution of this paper is to measure recoveries and introduce recoveries in the Barro-Rietz model. I nd that the e/ect of recoveries hinges on the intertemporal elasticity of substitution (IES): when the IES is low, recoveries may increase the equity premium implied by the model; but when it is high, the opposite happens. A second contribution of the paper is to study additional implications of the disaster model. I thank Robert Barro, Xavier Gabaix, Ian Martin, Romain Ranciere, Adrien Verdelhan, and participants in a BU macro lunch for discussions or comments. Contact information: Boston University, Department of Economics, 270 Bay State Road, Boston MA 02215. Email: fgourio@bu.edu. Tel.: (617) 353 4534. 1