Stock prices and the phony ‘wealth effect’

Gerard Jackson
BrookesNews.Com
Monday 4 June 2007

There’s an awful lot of sloppy economic ideas in our papers being passed off as economic analysis, one of which is the stock-prices-growth fallacy. This says that a stock market’s performance is driven by a net inflow of funds which in turn is driven by economic growth. It goes further by saying growth in turn is driven by investment, innovation and productivity; all of which influences corporate profits which in turn drive stock prices. Naturally, when these factors are positive GDP is growing.

It follows from this line of reasoning that rising stock prices in this environment are a healthy sign of an expanding economy. This line of reasoning has been used to describe the state of the US and Australian economies throughout most of the 1990s and up to the present. It is also argued that increased employment had the effect of raising household incomes, part of which was invested in shares. This triggered an economic chain reaction that goes like this:

The additional demand for shares boosts stock prices which then boosts household wealth. (The more you invest the richer you get). This increase in wealth encourages household borrowing which fuels consumption which then expands corporate earnings and the demand for labour which then boosts incomes which are in part invested in stock. . . . If this sounds to you like the economic equivalent of perpetual motion, you are dead right. Logicians have a term for this kind of reasoning: They call it begging the question.

Let’s get down to some economic basics. Savings (which equals investment) fuel an economy while entrepreneurship drives it. Now what exactly are savings? Saving is a process by which present goods are converted into future goods. Genuine savings mean that resources are being directed from current consumption (present goods) and invested in capital goods (future goods). This process will increase the future flow of consumer goods. Therefore cash balances are not savings, even though they are deferred consumption.

Every economy has a capital structure that consists of complex stages of production. The effect of increasing savings is to lengthen this structure by adding to it longer and more complex stages. These stages consist of heterogeneous capital goods embodying technology. This is the true nature of economic growth. It should also be clear that productivity is therefore the fruit and not the seed of economic growth.

In a progressive economy aggregate profits exceed aggregate losses. Hence, not only would a continual upward trend in the real value of stocks emerge but their returns would exceed the return on bonds, the difference being profit once risk had been accounted for. This brings us to productivity and profits. It’s shallow to argue that rising productivity generates profits. A firm’s physical and value productivity can still rise even as it goes broke. (There is no paradox here if one bears in mind that what matters here is demand for the product).

Profits are maladjustments between supply and demand, as are losses. This means that in a truly profitable firm or industry its factors are undervalued in relation to the value of their products. We can deduce from this that a sufficiently large switch in demand can bankrupt a firm whose productivity is rising and yet generate profits for another whose productivity is stagnant.

Of course, if an entrepreneur has sufficient forecasting skill he will invest in a way that lowers his costs of production, i.e., increases productivity, which in turn generates profits. But note, this is done by increasing the maladjustment between the supply of the product and the demand for the product, which will have the effect of attracting more competition which will squeeze the firm’s profits even as productivity continues to rise. A process that will be accelerated by the tendency of increasing productivity to lower prices. The point is that productivity per se is not the key to profits — entrepreneurial forecasting, or decision-making ability, is.

Looked at in this light two things emerge: (a) households that invest for the long term will certainly increase their wealth; (b) in this situation speculative booms will not emerge. The cause of these booms is easily detected and the culprit is credit expansion. Central banks allow credit to expand which raises nominal incomes and investment.

Eventually this credit begins to enter the stock market, laying the foundations of a speculative boom. Sure, as people think of themselves getting richer they borrow more to invest (or should I say gamble?) on the market. Thousands even engage in the risky practice of margin borrowing in the belief that economic gravity can be permanently defied. But where is all this credit coming from? The banking system is the answer.

So forget about the “wealth effect” or “margin borrowing” fuelling speculative frenzies: it’s a monetary illusion, a creation of credit expansion — nothing else

Gerard Jackson is Brookes’ economics editor