Post-Keynesian Observations

Understanding the Macroeconomy


with 4 comments

[NOTE: Be sure you have read part 5 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.]

I explained in part 5 how selling stock affects an individual firm, but not how the stock market affects the economy as a whole. First, if you’ve been reading along, you know that the initial sale of stock is done to raise money. Thereafter, sales simply transfer ownership from one economic entity to another–the firm does not benefit directly. However, there are important indirect effects. In general, firms with high stock prices are rewarded with managerial stability and cheaper funding of future activities.

Here comes a key point so play close attention!!! As a society, our hope is that the firms with the best management teams, marketing plans, products, machinery, workers, etc. are also those with the highest stock prices. If they are truly best, then we want them to have cheaper access to funding so that they can grow faster than their less-efficient competitors. Otherwise, we are rewarding the wrong people and the best firms don’t have easiest access to resources. So here’s what we want to see happen:

more efficiency => higher stock price => cheaper access to funds => faster growth

We can be pretty sure that the last three really do happen, so the question is, do the most efficient firms really end up with the highest stock prices? And therein lies the problem.

Ideally, before someone buys a share of stock they do lots of research into company. They should examine its history, its plans, its directors, its competition, the general market conditions, etc., etc. It should be a pretty rigorous undertaking. Then, once purchased, they’d hang on to that stock through short-term ups and downs, secure in the knowledge that over the long haul, their background research shows that these jokers know what they are doing. If this was the norm in the market for stocks, then, on average, more efficiency would, indeed, lead to higher stock prices.

But that’s not what happens. The ease with which one can simply dump a bad decision means that in general, comparatively little research is done. In fact, rather than focusing on issues specific to the firm, stock market participants are far more likely to zoom in on psychological factors. It’s more “what do I think the other people in the stock market are thinking?” than “what do I think about this firm?” That breaks the all-important first link between more efficiency and higher stock price.

Some economists are quick to argue that if you are one of the people who does look at the firm rather than the psychology that your “smart” money will drive out the others and thereby rebuild that link. But this is not true if you are in the minority. The majority money drives the prices and determines who wins and who loses–you will find yourself in the latter group if you don’t play their game and so it is actually the smart money that is punished. Under these circumstances, there is simply no mechanism forcing those buying and selling stocks to focus their attention on what would be most important for the economy: the long-term profitability of the firm itself. Keynes half jokingly suggested that when you buy a share of stock, you would have to keep it forever–can you imagine how much research you’d do then?! Of course, we also wouldn’t sell many stocks.

What I described above has multiple consequences but I’ll just give you a couple here. First and already mentioned is that the link is broken. More efficiency isn’t creating higher stock prices, psychological factors are. Therefore, the wrong firms are getting easier access to funds. Second, the domination of the stock market by psychological factors leads to much shorter time horizons for the decision making of firms. Ideally, when you are thinking of building a new factory, you are planning around events that will occur 5 to 10 years in the future. Short-term variations in market conditions should not impact your long-term plans. But, when the stock market is so oriented toward short-term psychology and your funding and managerial stability depend on your stock price, you find that you are forced to react to factors that you know darn well are not worth worrying about past next month. This is a serious problem in the US economy and has been growing since the 1980s. Our preoccupation with finance and the stock market has superimposed on US industry a dangerously short-term view of the world. It’s like a football team that thinks in terms of plays rather than drives. What if the coach was forced to think that his team had to try to score a touchdown on every single offensive play, rather than being free to try to string together a series of plays (i.e., a drive) to accomplish that purpose? He might get lucky now and then, but I guarantee that the latter would actually score more points.

Hang on tight as we are now getting enough background to finally start entering into what’s happening now! In the coming days, look for…

Part 7: Minsky’s Financial Instability Hypothesis or, How People Go Crazy with Debt!


Part 8: Financial Crises.


Written by rommeldak

January 14, 2009 at 10:06 am

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4 Responses

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  1. awesome, please keep it coming!!


    January 14, 2009 at 10:41 pm

  2. Thanky, Brian! Working on the next installment right now.


    January 14, 2009 at 10:47 pm

  3. I recently told a 40ish friend to pick a well-managed, well-captialized car company to invest part of his retirement savings in. My reasoning (which is always prescient when yoked to someone else’s money) was that it’s a good idea to invest in a well-managed company that has a bright future and a dismal present. I noticed in the the early 90s, when I worked at Tandy, that whenever Circuit City struggled, both Tandy’s and Best Buy’s stocks would tank, regardless of their performance. Then if one or the other did well, Circuit City’s price would go up.

    I think well-run car companies (ones in no danger of going out of business soon) have a bright future. And their stock is cheap.

    My friend teases me because he bought Ford (he couldn’t afford Toyota) and the stock immediately went down. But it won’t stay there.

    Charles Flemming

    January 27, 2009 at 11:51 pm

  4. That reminds me of the age-old advice to buy into utilities–people need electricity and heat! Eventually, they should recover (only drawback is if you happen to retire right after the market crashes!!!).


    January 27, 2009 at 11:54 pm

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