Post-Keynesian Observations

Understanding the Macroeconomy

5. THE STOCK MARKET: INDIVIDUAL FIRM ISSUES

with 4 comments

[NOTE: Be sure you have read part 4 before this one! This is part of a series of posts that explain the operation of the macroeconomy and the current crisis and they build on one another.]

For a part of the economy that really doesn’t have any direct effect on production, it sure grabs a lot of headlines. In fact, we could operate without a stock market. But, we have one, and it acts as a barometer of our animal spirits, and a determinant.

First, I want to clarify my comment that it has no direct effect on production. It does when the stocks are first sold, but not thereafter. Let’s say you start your own company making t-shirts for local concerts: Rock On Clothing Kompany, or ROCK. You go out and borrow the money to get started, the bank assigns a loan officer to you (who makes sure you follow the business plan you used to get the loan), you set up the company, and commence making t-shirts. Let’s further say that ROCK does well–very well–and so you decide to expand operations. You are going to need more money. But the bank will only let you borrow so much (particularly if you are already in debt to them) and those scheduled interest payments could turn out to be quite a burden if ROCK struggles, even if only for a few years. Would that there were a way that you could gets lots of money, never have to pay back the principle, and only make a payment when you your company has done well. But what fools would be willing to enter into such an agreement?

STOCKHOLDERS!

In exchange for a share of the ownership of ROCK, they never ask to be paid back other than quarterly shares of your profits. Of course, they are hoping that the latter will more than cover what they paid for your stock, but the glorious thing for you is that if ROCK has a bad quarter, you don’t have to pay out anything (of course, there had better be a nice note explaining why there weren’t any dividends and how you expect that to change!).

So that is the advantage to you of stocks. You will very likely get a lot more money than you could from a bank and you only pay back when you’ve done well. And you are not in debt in the traditional sense. The drawback is that you no longer own ROCK–now you are just the manager, and you could be replaced if the stockholders are not pleased. Damn them! Don’t they know that you built this company?! *sob*

Obviously, that did have an impact on production because it gave you the cash you needed to expand operations. But, such primary issues are a very small percentage of overall stock market activity. If one of the people who bought that primary issue decides to sell their share to someone else, you see exactly zero of that transaction. It’s just folks trading ownership of ROCK for cash, and that’s the overwhelming majority of stock market activity. So, if the value of the shares of ROCK fall, that doesn’t mean ROCK suffered directly (though they may indirectly–more on that below). Rather, ROCK’s owners, or all those who owned the stock whose value fell, suffered. There is no direct impact on ROCK whatsoever.

So why do we care? Several reasons. First, while ROCK won’t suffer directly if its shares fall, it does make it more difficult to raise cash in the future. If you decide to sell more stock, for example, you can’t sell it for as much. If you go to the bank to finance a new expansion, you can be damn sure they’ll look at those stock prices for an indication of how credit worthy you are. Since they’ve been falling, they’ll charge you higher interest rates. If you depend on raising cash every month for operating expenses (see part 1 of this series: Production Takes Time), then that interest rate may go up, too. None of that is very pleasant. Furthermore, the lower your stock price, the more you may have to look for a new job as stockholders replace you. So, as the manager, you do care about stock prices. In fact, in our economy today, you probably care too much–but that’s getting ahead of the story.

That’s why one firm cares about its stock price, but it does not explain the role the stock market as a whole plays in the macroeconomy. For that, I need to do a new posting: 6. THE STOCK MARKET: PSYCHOLOGY AND MACROECONOMIC IMPACTS. Stay tuned!

Advertisements

Written by rommeldak

January 10, 2009 at 11:20 pm

Posted in Uncategorized

Tagged with

4 Responses

Subscribe to comments with RSS.

  1. You mention in your first paragraph that we could operate without the stock market. However, based on your explanation above my mind is now stuck in the mode of how our economy relies on the stock market as an integral avenue to expand production when bank credit is not available.

    I see your next posting will be on the stock market – will you be covering how our economy could function differently/more effectively without the stock market?

    Is there an example in recent history of how an economy similar to ours functioned effectively without a stock market?

    nuk

    January 13, 2009 at 11:48 pm

  2. Yes, we could operate without a stock market, but we could not operate without someone giving credit to firms and consumers. So, any source of such funding would suffice, bank loans being the obvious one. But, the problem isn’t the stock market, per se, it’s the way it operates (which will be part 6).

    I don’t have an example of an economy without a stock market because we have all copied the US and UK. But I’ll leave you with this teaser, one of Keynes’ comments about the US stock market:

    “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

    I’ve got part 6 started but likely won’t finish until tomorrow!

    rommeldak

    January 14, 2009 at 9:18 am

  3. I wish we didn’t have The Stock Market. Something about disconnected share/stockholders making money off the work of and employment decisions for hundreds, thousands, even tens of thousands of people with whom they have no contact, knowledge, or (seemingly) respect for whatsoever just doesn’t sit right with me.

    SicPreFix

    January 18, 2009 at 6:52 am

  4. It would be relatively easy, if controversial, to make it work. Something as simple as a sliding scale of taxes on sales of stock. Say, for example, that if you sold a stock within a month of buying it then you had to pay 50% of the sale price as a tax. From one to two moths, 40%; two to four, 30%; and so on. After, say, a year, it drops to 0%. This would properly discriminate between those we don’t want participating in this market (those who are transacting on market sentiment) and those we do (long-term investors). The former would be discouraged while it would have zero effect on the latter.

    rommeldak

    January 20, 2009 at 12:32 am


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: