Economic Growth and the Stock Market

Most financial commentators are of the view that increases in the stock market translate to an increase in economic growth. The reason is because the increase in stock prices lifts consumer and business optimism, which, in turn, boosts consumer and business demand for goods and services. This, in turn, strengthens the economy. But is it valid to hold that what drives the economy is the demand for goods and services?

Production and Consumption

If an individual in a market economy wants to secure consumer goods and services he wants, he must produce something useful that can be exchanged for those goods and services. In a market economy, every individual must be a producer first before he can exercise demand. Producers ultimately pay with goods and services in order to exchange them for other previously-produced goods and services they want. This is true even if they exchange money for goods since the money simply acts as a medium of exchange. It is an increase in the production of goods and services that sets in motion an increase in the demand. According to David Ricardo,

No man produces, but with a view to consume or sell, and he never sells but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.

An individuals’ demand is constrained by his ability to produce and exchange goods and services. The more goods and services an individual can produce, the more he can acquire. What enables the process of stable wealth-generation is production, saving, and capital investment. During the period of development of capital goods to hopefully make production more productive and efficient, saving is necessary to provide a “subsistence fund.” On this, Richard von Strigl wrote:

Let us assume that in some country production must be completely rebuilt. The only factors of production available to the population besides laborers are those factors of production provided by nature. Now, if production is to be carried out by a roundabout method, let us assume of one year’s duration, then it is self-evident that production can only begin if, in addition to these originary factors of production, a subsistence fund is available to the population which will secure their nourishment and any other needs for a period of one year…. The greater this fund, the longer is the roundabout factor of production that can be undertaken, and the greater the output will be.

It is clear that under these conditions the “correct” length of the roundabout method of production is determined by the size of the subsistence fund or the period of time for which this fund suffices.

The enhancement and the expansion of the infrastructure is what sets in motion economic growth. The enhancement and the expansion of the infrastructure, in turn, is possible as a result of the increase in the subsistence fund. This is only possible through saving. It is saving that supports various wealth-generating projects.

Stock Market and Economic Growth

When commentators suggest that a particular factor is an important driving force in economic growth, we have to look at the relationship to saving. Does this factor strengthen or inhibit saving and capital investment? Following this reasoning, does a rising stock market encourage saving and capital investment?

Again, according to much popular thinking, growth in the stock market makes people more optimistic about the future. This, in turn, it is alleged, boosts their demand for goods and services thereby strengthening economic growth. On the other hand, it is not a psychological disposition that determines whether an individual’s demand can be exercised, but the increase in the production of goods. This, however, requires an increase in saving, all other things being equal. An improved psychology as such can do very little to lift the economy if savings, production, and capital investment are not expanding.

Without the increase in production, it is not possible to accommodate the increase in the demand. The increase in the stock market, however, does not cause the increase in either production or savings. Hence, the stock market can’t set the platform for economic growth. Also, the prices of stocks reflect individuals’ evaluations of the facts of reality. However, evaluations cannot cause economic growth.

Central Bank Policies Cause Investors to Commit Erroneous Decisions

In the framework of the expanding “subsistence fund” and the market-selected money, such as gold, and in the absence of the central bank, the stock prices are likely to follow a generally rising trend. The increase in the stock market would reflect genuine economic growth—moving up and down relative to the success or failure of firms represented in the exchange. Economic growth is not because of increases in the stock market, but because of saving, capital investment, and greater production. The success of these things can be seen, in part, in an increase in the stock market. But this is assuming sound money, unhampered economic calculation, and no central bank.

It is the central bank’s policies of tampering with the financial markets that causes boom-bust cycles. This is also key for bull and bear markets. As a result of the central bank policies, investor’s ability to distinguish wealth-generating activities from non-wealth-generating activities (i.e., bubble activities are curtailed). By not being able to identify wealth-generators, investors become gamblers with the stock market—seen as a large casino.

Various theories, such as the Efficient Market Hypothesis (EMH), that emerged because of central bank policies that disrupt financial markets, hold that it is futile for investors to attempt to identify wealth-generators versus non-wealth-generators. In fact, one of the pioneers of the EMH, Burton Malkiel, has even suggested that, “...a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts.” A theory such as the EMH doesn’t explain, but only describes. Hence, it is not of much help to an investor. According to EMH, investors should give up sound thinking in favor of haphazard conduct.

Conclusion

The heart of economic growth is production, saving, and capital investment. Saving enables capital investment, which allows for greater production. Given that an increase in the stock market cannot strengthen these things, it follows that rising stock prices cannot strengthen economic growth, all other things being equal. Without improvement in the capital structure—irrespective of the state of the stock market—it is not possible to strengthen the economy. The disruptive fluctuations of the stock market—labeled as “bull”/“bear” markets are the result of the monetary policies of the central bank. These policies undermine stable production, genuine growth, saving and capital investment, and ultimately set in motion an economic impoverishment.

Courtesy of Mises.org

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