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Source link: http://archive.mises.org/13748/how-the-stock-market-and-economy-really-work/

How the Stock Market and Economy Really Work

September 1, 2010 by

The stock market does not work the way most people think, writes Kel Kelly. One commonly held belief is that a stock-market boom is the reflection of a progressing economy. Not so: it mostly reflects money creation. FULL ARTICLE

{ 79 comments }

Phoenix September 1, 2010 at 8:17 am

What is most needed during recessions is for the economy to be allowed to get worse…

Most here know what is trying to be said with this line, but it’s pretty disingenuous. The boom (the good times, to the naive) is when the economy is getting worse. The recession itself is the economy getting better. So, what is most needed during recessions is for the economy to be allowed to get better, i.e., liquidate malinvestments and realign the structure of production. It only superficially seems to be getting worse.

Kel Kelly September 1, 2010 at 10:32 am

Phoenix, there was no disingenuousness intended. On the contrary, I was trying to be straightforward. To let the economy heal itself does in fact consist of letting it get worse before it gets better. A recession is not the economy getting better necessarily, since it does get worse during that time. But getting worse is what’s needed in order to achieve a permanent — as opposed to a temporary (i.e., 2003-2008) — healing. So any way you look at it, the economy — both GDP and the real economy — get worse before they get better during recessions. That is what I was trying to relay.

Allen Weingarten September 1, 2010 at 12:26 pm

Phoenix, I appreciate your insight. The addict is getting worse as he takes his drugs (while feeling better), but is getting better when he stops taking drugs (while feeling worse). I would not use the term ‘disingenuous’ to discuss the way things are described, but would prefer to employ the objective measure of the amount of drugs used.

Steven Farrall September 1, 2010 at 9:21 am

Brilliant. Send a copy to every politician and central banker in the Western World (especially USA, UK and Europe) and make them copy it out 100 times each. Then set a test.

Christian Entrepreneur April 15, 2011 at 5:09 pm

Love the idea! In Canada we have free postage to politicians.

fundamentalist September 1, 2010 at 9:31 am

Excellent analysis! Thanks! Mises and Hayek, as well, always emphasized that the effect of credit expansion depends upon where the money enters the market. If it enters via business loans it inflates asset prices; if it enters through the guv borrowing and spending it drives up consumer goods prices. This is outstanding investment advice!

Kel Kelly September 1, 2010 at 1:49 pm

Thanks fundamentalist!

fundamentalist September 1, 2010 at 9:38 am

PS, Frank Shostak had a graph of his AMS last fall showing a decline in year-over-year money. It was a pretty good predictor of this year’s correction in the stock market.

matt September 1, 2010 at 10:17 am

” The most important economic and financial indicator in today’s inflationary world is money supply.”

you should put that line not just in the summary but in the top and middle. good article.

Ryan September 1, 2010 at 10:34 am

It’s wonderful to see Kelly quote Fritz Machlup’s book The Stock Market, Credit, and Capital Formation. The work elucidates most of Kelly’s points and goes much further. It ought to be near the top of most people’s reading list on this site.

Victor September 1, 2010 at 10:36 am

Deflation, falling prices, would be calamitous. During deflation, the nominal value of debts stay the same while nominal income continues to fall. As households and firms recieve less income, they would find it more difficult to discharge their debts. The inevitable result, of course, is bankruptcy and a widespread collapse of our banking system.

One must remember that most exchanges are made by means of credit. Should our economy suffer widespread bankruptcy, as it would under deflation, the ability of households and firms to get short-term credit to meet basic expenses would be destroyed. Firms could not meet payrolls, retailers could not buy goods from manufacturers, and importers could not pay for their imports. How can this possibly be seen as desirable?

Richard September 1, 2010 at 11:21 am

Ok, so a bunch of people go bankrupt. This does not destroy the capital goods that already exist. New owners will take them over. Their prices and rents will be based on the expected discounted value of the future goods that they produce, and this discount will include expected year over year deflation.

David September 1, 2010 at 12:53 pm

That’s only a problem when deflation is unexpected, just as unexpected inflation harms creditors. If it’s relatively expected or predictable it can be factored into the interest rate charged. There are periods in American history which saw deflation and rapid growth.

fundamentalist September 1, 2010 at 1:35 pm

Victor, you’re right. There might be widespread bankruptcy if the deflation was unexpected. However, most businesses take out loans with variable rates. That’s why we haven’t experienced a lot of bankruptcies or loan defaults in commercial real estate as we have with home mortgages. So under deflation the interest rate would drop dramatically. Also, many businesses would simply refinance at the lower rates. But the main benefit would be that businesses would save more and depend less on loans. The banking and financial services sector would shrink as a percentage of the economy and savings would increase.

Ouroboros September 1, 2010 at 2:51 pm

I don’t think this is correct, Victor, because real deflationary pressure creates a natural interest rate as well. Just as loans have an interest rate on them now, real deflationary pressure would simply be an interest rate.

Craig September 1, 2010 at 5:31 pm

Victor:

Let’s be clear that a constant money supply would not induce deflation. It couldn’t by definition — deflation is a decrease in the amount of money. A constant money supply would see price decreases as more capital lengthened the production process, but that would result in growing productivity causing nominal wages to remain roughly constant (though increasing in purchasing power) or even growing.

The debt-bugaboo is not a justification for inflationary monetary policy.

Bill Miller September 1, 2010 at 11:04 am

Victor:
Nothing about falling prices in and of themselves necessitates bankruptcy, or a lack of credit.Prices fell for most of the nineteenth centure, and plenty of credit was extended during that time (mass industrialization and such), while output grew at a rate that would be enviable today. Nominal interest rates merely have to fall to reflect the increase in the value of money. While this could not go below zero, having the money appreciate in value at that rate would require a significantly higher level of economic growth than we have now. Indeed, it would be an enviable problem to have, that economic growth could be high enough that the currency appreciated at such a rate as to have nominal interest rates fall close to zero. That said, I don’t consider it a very likely occurrence.

DD5 September 1, 2010 at 12:37 pm

Learn the fucking difference between monetary deflation and price deflation.

Beefcake the Mighty September 1, 2010 at 12:50 pm

Well said.

Allen Weingarten September 1, 2010 at 12:43 pm

“An improving economy neither consists of an increasing GDP nor does it cause the overall stock market to rise.”

I concur with the analysis by Mr. Kelly, but think that we ought to be able to measure GDP intrinsically, rather than subject it to the impact of prices. Consider his illustration where the supply of goods & services rises, but the money is unchanged. Suppose arguendo, in 1900 there are 1 million widgets produced, and sold for $2 apiece, resulting in a contribution to GDP of $2 trillion. Then in 1901, there are 2 million widgets produced, and sold for $1 apiece. By Kelly’s analysis the GDP is unchanged. However, if we measure the GDP in 1901 using 1900 dollars, the GDP has doubled to $4 million.

Isn’t this what we really want to measure, not the influence of the money supply, but the objective change in the amount of goods & services?

Kel Kelly September 1, 2010 at 1:08 pm

Allen,Indeed, that’s what we want to measure, but we can’t in reality. In your scenario, production doubled, but in reality, prices could not double. As you pointed out, they would halve. Conversely, we could produce the exact same amount of widgets in 1901, double the money supply, add a GDP deflator which deflates half of the money growth, and prices would still be 50% higher (100% higher if no deflator was used). If deflators were accurate, then in this scenario, ALL of the increase in price would be accounted for, and prices would remain where they were the year before. The point is that prices (GDP) could rise just by more money existing, so it would not tell us about real production. We do want to account for the increase in production, but we can’t add up oranges, trucks, and movie tickets sold. The best we could do is try to aggregate the rate of increase of the physical units produced.

Allen Weingarten September 1, 2010 at 2:37 pm

Kel, you say that we cannot measure GDP in reality, but you have not shown why in 1901 we cannot use the dollar values of 1900 to calculate the change in GDP. I think we can calculate the change in “oranges, trucks, and movie tickets”, or sample whatever changes are deemed important. My example was widgets, but it could have been cars or houses. Perhaps you are saying that we cannot ascertain whether more or less of any item is produced in a year? Please clarify.

Gerard D. January 15, 2011 at 11:57 am

I agree with Allen, and was confused on this point throughout your article. Deflating GDP (aggregate spending) by the commensurate rise in prices cancels the effect of new money on prices, leaving one with just the change in the amount of goods produced, i.e. a real GDP comparison.Kel, I just can’t see how a GDP deflator doesn’t accurately account for rising prices, allowing for an apples to apples comparison. If Allen and I are wrong could you please provide a concrete example of exactly what you mean?

Bruce September 1, 2010 at 1:29 pm

You said, “capital gains (the profiting from the buying low and selling high of assets) could be made only by stock picking — by investing in companies that are expanding market share, bringing to market new products, etc., thus truly gaining proportionately more revenues and profits at the expense of those companies that are less innovative and efficient.” That is the essence of efficient capital markets.

The rest of your article talks about certain factors which, for the most part, affect ALL stocks the same way. All will rise or fall roughly equally based on these effects. You still have to pick winners to make more than the average. I may make a little (like an average investor) but because of the factors you cite, I really made nothing, and I agree with your premise. I’m just pointing out that you can make REAL gains in the market regardless of what the overall economy does if you are picking the winners, those that make best use of their resources for efficient production and distribution of goods and services.

fundamentalist September 1, 2010 at 1:32 pm

What’s wrong with a gdp “inflater” during natural deflation? We use a gdp “deflater” to measure real growth under inflation.

fundamentalist September 1, 2010 at 1:36 pm

The stock market has slumped as the growth in money faltered, but the Feds are gearing up for more QE, so this would be a good time to get into the stock market.

newson September 2, 2010 at 10:01 pm

are you talking your book? ☺

Sean September 1, 2010 at 2:11 pm

I’m confused as to why the examples of (a) increased net savings; and (b) reduced tax rates would result only in TEMPORARY stock price increases. Would not these hypothetical changes—ceteris paribus—result in continual flows of money into the market?

iows: in P = D/S, I can’t wrap my brain around the idea that the increase in D would be a one-time increase. Ugh, I’m so bad at economics

Sean September 1, 2010 at 2:21 pm

Well, in retrospect, I can see that if D1 = 5 and D2 = 10, then P would have a ceiling. Nevermind, I’ve answered my own question. I’m SO used to the stock market index going UP in price, it’s hard to imagine a scenario where it wouldn’t do so. Like I said, ugh. :-)

edit: Also, it’s not a “temporary” increase in price, it’s a “one-time” increase. My confusion.

Rosemary Ley September 1, 2010 at 3:13 pm

I have read a great many theories about what the stock market represents and this is yet another funamental justification for what I have personally come to believe is far beyond fundamentalism. I believe that the waves represent both macro and micro struggles of mankind. I am sure that if we could trace these waves back to the beginning of time we may indeed have a better understanding of ourselves.

In fact if one applies basic wave theory philosophically to just about every aspect of humanity, even religion, it is facinating what it reveals. Indeed it may be that in a few hundred years time humanity views our current obsession with growth (greed) which pervades absolutely every aspect of our lives from macro policy based GDP to the human desire ‘to own’ as the darkest times in humanity.

Rosemary

Russ the Apostate September 1, 2010 at 3:54 pm

Our “obsession” with economic growth (real economic growth, that is) is not about “greed” at all. It’s about prosperity for everybody. Economic growth is the only thing that can lift everybody out of poverty. What is so wrong with wanting this?

mpolzkill September 1, 2010 at 3:57 pm

Someone once said around the turn of the century (19th/20th) that half the misery ever suffered by mankind up to that time had emanated from their own teeth. Dark.

Sean September 1, 2010 at 9:00 pm

equality of opportunity vs. equality of outcome

you take as self-evident the moral superiority of the latter

Smack MacDougal September 1, 2010 at 3:26 pm

The great, invariant Law of Prices drives the whole of economics — Winning bids of demand in the face of supply set the price.

Whenever anyone makes exception to this great law to justify their false beliefs about economics, their claims fail.

In authentic understanding of economics, money is mere notes and coins. All else are contracts that get settled in money.

Stocks are goods, the same as any other goods and thus stock prices fall under the governance of the great, invariant Law of Prices.

No great mystery exists as to why stock prices rise. In short, prices rise when more money gets bet through time than money gets cleared away. Simply, persons buying stocks, which are mere goods, prefer these goods to other goods being offered for sale in marketplaces everywhere.

It is the frequency of higher bids in the face of supply that drives prices and nothing more.

Often, ever more money can get bet at stock exchanges because such money gets borrowed under contract as long as the return to sales of stocks bought on borrowed cash exceeds the debt service on such borrowed cash. Sustained lending, hence borrowing, can happen only when lenders receive timely payments for debt service.

Unfortunately, Kel’s article is riddled with false beliefs and fallacy about all things economics. Worse, his article drips with conspiracy theory paranoia.

Kel’s claim that “the volume of spending in the economy” is the source of price rises in stock markets or any market is false. Kel pushes a fallacy of “aggregate prices” as many others have in the past, including Irving Fisher, a man who made a career from it.

Consumer preferences change all the time, especially owing to technological effects that give rise to innovation (invention that leads to a change in behavior) and to improved methods.

For innovation, anyone need only think of new products replacing old, e.g., iPods and MP3s replacing CDs and radio or Netflix replacing Blockbuster, to see invention changing behavior. For improved methods, one need only see how increased transistors on computer die and their manufacture have lead to lower prices.

More spending has arisen for such entertainment, yet prices have fallen considerably. Why? Supply has increased faster than the winning bids of demand.

The great, invariant Law of Prices — winning bids of demand in the face of supply — is the sole source for prices.

While a rise in the quantity of money results in a rise in prices, it does nothing to change the amount of wealth anyone and all have.

Say that $1 Million is all the money in an economy and that exactly 1 million persons exist. Say further than 10% of the persons hold 90% of the money. Let’s assume that money distribution falls equally in both groups. This means 100,000 shall have $9 each, while 900,000 shall have a mere 11 cents each!

If we assume that persons do not change their preferences, then doubling the quantity of money, to $2 million, does nothing but give 10% of the persons $18 and 90% of the persons 22 cents. Only nominal (named) prices change. Buying power for each person in the economy remains exactly the same.

Even with the same quantity of money, prices can rise when money gets into the hands of ever more persons in the economy, faster. The same sum of money does more work as more participants can express their preferences. It’s the frequency of bidding that counts.

Kel falls off the deep end when he claims that “new money increases sales revenues of companies before it increases their costs.”

In fact, the opposite happens. Again, the great, invariant Law of Prices rules.

Costs rise ahead of revenue as new money holders bid up the prices of capital goods needed to make their finished products. Typically, this is what sows the seeds of impending crisis, destruction and recession.

Worse, Kel reveals Conspiracy Theory fueled paranoia when he writes, “The whole system of inflation is solely for the purpose of theft and wealth redistribution. ”

Fed Res bankers purposefully seek inflation — an expansion of bankers’ revolving and non-revolving credit — because that’s how member bankers of the Federal Reserve system earn revenues and hopefully profits. If bankers don’t sell credit contracts, bankers do not earn revenues.

Matthew Swaringen September 1, 2010 at 5:42 pm

“If we assume that persons do not change their preferences, then doubling the quantity of money, to $2 million, does nothing but give 10% of the persons $18 and 90% of the persons 22 cents. Only nominal (named) prices change. Buying power for each person in the economy remains exactly the same.”

Since when do we live in the magic world where the increase in funds goes directly to every single person in the economy at the same time? Individuals may well not have changed their preferences, but since the money created goes to different individuals who received loans at lower rates than they otherwise would they bid away resources from those who would otherwise get them. Preferences don’t change, but the allocation of funds has changed.

So your scenario is wrong because you look at the money distribution as even when it’s definitely never like that. It’s interesting that you also talk about prices doubling due to preferences staying the same, seemingly contradicting yourself on the point that “bids” is what drives prices and not money supply inflation.

The second problem you have with the “winning bids” idea, is seeming to have no good explanation as to why the winning bids do occur for higher and higher amounts? You seem to just accept at face value that.. the amounts go up because.. they are being bid up (in fact, you say.. that’s the only reason they go up is preference, and it has nothing to do with inflation of the money supply).

But if there is a fixed supply of money, the amount of dollars available is fixed. You run out of money to bid up the price when there is no more funds. Once you start inflating though, you’ve destroyed that control and the bidding can continue beyond the point it otherwise would.

“Fed Res bankers purposefully seek inflation — an expansion of bankers’ revolving and non-revolving credit — because that’s how member bankers of the Federal Reserve system earn revenues and hopefully profits. If bankers don’t sell credit contracts, bankers do not earn revenues.”
So without a Federal Reserve inflating the money supply banks can never make money? So you are saying banks can’t operate without this, despite the fact that they have in the past?

Smack MacDougal September 1, 2010 at 11:17 pm

You amuse, Matthew Swaringen.

Of course, we do not live “in the magic world where the increase in funds goes directly to every single person in the economy at the same time”. Yet, Kel blathered on about the quantity of money. My example shows what happens if the sum of money gets doubled in an economy, ceterus paribus.

Nothing about my presentation is wrong. However, your failing to see the words, “If we ASSUME, ..” makes you wrong.

I have no problems, you do. The great, invariant Law of Prices undergirds the whole of economics — winning bids of demand in the face of supply sets the price.

The economy does not get into a state where it “runs out of money”. As long as the transaction rate accelerates, prices can increase without a corresponding increase in the quantity of money.

If more persons gain intelligence about skills offered for hire, products offered for sale, more persons can transact under compressed time using the exact same quantity of money. Prices can rise as more persons become aware of products that many of them prefer simultaneously.

Your beliefs are false, because you can see only from a static nature, In your distorted view, money exchanges hands once, from one buyer to one seller. Yet, in a real economy, money changes hands often.

Under a real economy, money is mere medium of exchange. In the end, wealth must swap for wealth.

When persons say “money supply” what they mean is bankers’ credit. For wherever you have money supply, you have money demand. The clearing price of such is interest paid — the rate of future money to pay for now money rented. In authentic understanding of economics, money is mere notes and coins. All else are contracts that get settled in money.

A commercial banker is a trader whose business consists in buying money and debts by creating other debts. A banker BUYS money and SELLS credit. The depositor SELLS his or her money and BUYS credits. When a banker takes a deposit, that banker creates and issues credits payable on demand.

Bankers are in the credit business. That’s how they make money.

Matthew Swaringen September 2, 2010 at 6:49 am

“You amuse, Matthew Swaringen.”
You’re funny too. I’m glad we amuse each other.

“Yet, Kel blathered on about the quantity of money. My example shows what happens if the sum of money gets doubled in an economy, ceterus paribus.”
Yeah, which had nothing at all to do with Kel’s argument, since he wasn’t arguing ceterus paribus conditions occur, and so you still haven’t dealt at all with his argument on why stock markets rise as a percentage of real gdp because all you did by presenting this crappy ceterus paribus argument was present a huge strawman (and even in this huge strawman you still said prices doubled due to preferences being the same).

“I have no problems, you do. ”
roboticly… Yes you are perfect Smack, please instruct your hordes of minions /robotic

“The economy does not get into a state where it “runs out of money”. As long as the transaction rate accelerates, prices can increase without a corresponding increase in the quantity of money.”
Who said “the economy runs out of money”? I was talking about individual actors in the aggregate having less currency to use towards their purchases, and those who receive likewise having less currency to use on their purchases, and so on.

“If more persons gain intelligence about skills offered for hire, products offered for sale, more persons can transact under compressed time using the exact same quantity of money. Prices can rise as more persons become aware of products that many of them prefer simultaneously.”
Who denied prices rise on goods that consumers prefer to other goods? No one did is the answer to that question. Everyone admits the prices can rise for some goods in comparison to others if consumer preferences change. However, the rise in stock market prices as a percentage of GDP was not, during the 2000s, due to an increase in real savings so it was not tied to an aggregate change in consumer preference.

“Your beliefs are false, because you can see only from a static nature, In your distorted view, money exchanges hands once, from one buyer to one seller. Yet, in a real economy, money changes hands often.”
Your beliefs are false because you can see only from the narrow nature of price fluctuations due to consumer preference changes. You appear unable to see that price changes can occur absent preference changes regardless of money creation. No one denies that money exchanges hands many times, from consumer goods to capital goods to labor for physical resources necessary to produce both goods, etc. You simply fail to acknowledge that there is a misallocation of resources due to a change in the money supply, because you only deal with the idea under ceterus parabis conditions that don’t actually exist.

“Under a real economy, money is mere medium of exchange. In the end, wealth must swap for wealth.”
No one denies this.

“A commercial banker is a trader whose business consists in buying money and debts by creating other debts”

So bankers will always be in debt in every scenario? You are wrong about that. I noticed you completely ignored my argument about how banks haven’t always had a Federal Reserve to fund themselves by debt creation. I don’t deny that our current system is based on debt in many fashions, but you insulted the article that discussed that in detail because it’s inconvenient for you to accept that this is a bad thing. For your argument, you have to assume that’s the only way for the world to function. And you have to believe, despite clear evidence to the contrary, that money increases arise in ceterus paribus conditions.

Or perhaps you don’t believe that.. but you’ve done an extremely poor job in this response of explaining how changes without ceterus paribus conditions don’t result in changes in allocations of real resources that have nothing to do with consumer preference changes.

Inquisitor September 2, 2010 at 11:16 am

Small correction: it’s “ceteris”.

Matthew Swaringen September 2, 2010 at 1:35 pm

Thanks for the correction. I borrowed his spelling in order to avoid messing it up myself but apparently that didn’t work well for me here :/

Smack MacDougal September 2, 2010 at 4:18 pm

You wrote, “But if there is a fixed supply of money, the amount of dollars available is fixed. You run out of money”. Right there, you expressed that “the economy runs out of money”.

FOR EVERY GOOD EVER SOLD, the winning bids of demand in the face of supply sets the price. This great, invariant law — the Law of Prices — undergirds the WHOLE of economics. To deny this truth, means you don’t get economics, at all.

No such thing as aggregate prices exist. The concept of aggregate prices is expressed academia foolery.

NEVER is there misallocation of resources owing to the money supply. For wherever you have money supply, you have money demand. The rate of interest is the clearing price of the two.

Saying money supply for the correct concept — bankers’ credit — renders useless anyone’s claims about economics and economy.

Misallocation of resources arises owing to false beliefs about a future that does not materialize, which leads to overconfidence and the issuance of bankers’ credit as well as commercial credit, which cannot get repaid by future wealth, which does not materialize. It has nothing to do with money — mere notes and coins.

How do you come to your dumb conclusion that “So bankers will always be in debt in every scenario?”?

You’ve confused debt for profitability. Do retailers who have have debt outstanding not earn profits?

Also, nothing has been ignored. Kel’s article and my replies relate THIS economy and THIS money system. We’re not discussing the history of banking here, although from your words, it’s doubtful if you’ve studied, ever.

I explained it all, right up front, in my first post. [1] The great, invariant Law of Prices drives the whole of economics — Winning bids of demand in the face of supply set the price. [2] Stocks are goods, the same as any other goods and thus stock prices fall under the governance of the great, invariant Law of Prices. [3] No great mystery exists as to why stock prices rise. In short, prices rise when more money gets bet through time than money gets cleared away. Simply, persons buying stocks, which are mere goods, prefer these goods to other goods being offered for sale in marketplaces everywhere. [4] It is the frequency of higher bids in the face of supply that drives prices and nothing more.

No one should deny that when economic quantities of purchasing increase, invariably owing to credit, that money finds its way into stock markets.

What needs to be discussed is the prosperity cycle and how prices get affected because of increases in deposits, reserves, loans and money rates — the causal factor working out its influence on stock and bond prices, transaction volume on the stock exchanges, bank clearings, business failures, building, employment, production, imports, exports, prices and profits.

Matthew Swaringen September 2, 2010 at 5:48 pm

“No such thing as aggregate prices exist. The concept of aggregate prices is expressed academia foolery.”
If less money is available, then the total of everyone’s available money to be spent is less. Your $1 million -> $2 million example was an example of this. I’m not entirely sure what you mean by aggregate price, unless you are saying general price inflation and deflation don’t exist.

“NEVER is there misallocation of resources owing to the money supply…

Misallocation of resources arises owing to false beliefs about a future that does not materialize, which leads to overconfidence and the issuance of bankers’ credit as well as commercial credit, which cannot get repaid by future wealth, which does not materialize. It has nothing to do with money — mere notes and coins.”

Hmm…I wonder if that the creation, and therefore reallocation, of money (and credit) in an economy just might end up resulting in expenditures that would not otherwise occur, leading to demand for products, services, and thus resources that might have gone towards other purposes had that money not been created. Might this lead to … “false beliefs” and “overconfidence” about “future wealth” that doesn’t materialize because that money was not based on actual consumer preferences and was therefore unsustainable?

[quote]
How do you come to your dumb conclusion that “So bankers will always be in debt in every scenario?”?
[/quote]
How do you come to your dumb conclusion that misallocation can NEVER happen due to people basing the estimation of consumer preference on money created by the Federal Reserve?

My conclusion in that case was your statement that bankers “buy debt” and “create debt” to do so. So on both sides of the equation is debt.. so bankers apparently.. have debt… saying they are “in debt” doesn’t seem like a stretch. In reality, I think your buying money/debt & selling credit statements are either completely wrong or just using the terms buy and sell in ways that don’t reflect anything close to the meaning used by most people.

“You’ve confused debt for profitability. Do retailers who have have debt outstanding not earn profits?”
I’m only confused by your use of buy and sell, which I find to be terrible terms as it relates to bankers extending credit or taking deposits.

I wouldn’t claim that it’s impossible to both profit and be in debt. It certainly is possible. I would, however, say that it’s not the best plan. It is far better to have savings that can pay for expenses and to have no debt.

“We’re not discussing the history of banking here, although from your words, it’s doubtful if you’ve studied, ever.”
Give me a few links/books/etc. I’m curious what your “history” is.

“No one should deny that when economic quantities of purchasing increase, invariably owing to credit, that money finds its way into stock markets.”
What is “economic quantities of purchasing” ? Are you saying “total products sold?” Are you talking about quantities of stock purchased, or quantities of anything purchased? Your statement, lacking context, is incredibly unclear.

“What needs to be discussed is the prosperity cycle and how prices get affected because of increases in deposits, reserves, loans and money rates”
If the money supply can’t change prices, why would deposits, reserves, loans, or money rates change prices? Aren’t all of these things, like money, simply representations of actual wealth and physical goods? Since you said money supply can’t really affect anything how are these things resulting in change?

Why would you say that prices increase because deposits increase? Why would prices increase if reserves in banks increase? If reserves increase, wouldn’t the quantity of money available for use go down and thus result in lower prices (deflation?)

“the causal factor” – is?

Beefcake the Mighty September 2, 2010 at 4:23 pm

“The great, invariant Law of Prices undergirds the whole of economics — winning bids of demand in the face of supply sets the price.”

You’ve said this at least three times already. Could you possibly be troubled to explain it a bit more? I really have no idea what you’re talking about here, or least why this observation is supposed to be the cornerstone of economics.

The Kid Salami September 4, 2010 at 4:06 pm

I’m glad I’m not the only one thinking that.

Gerry Flaychy September 4, 2010 at 4:54 pm

It looks like a description of an auction.

For the price, if it’s only the price in terms of money, then it doesn’t include a barter economy.

Sean September 1, 2010 at 3:28 pm

“I have read a great many theories about what the stock market represents and THIS is yet another funamental justification for what I have personally come to believe is far beyond fundamentalism.”

What is “THIS”, and to what are you referring by “fundamentalism”?

Ted Stein September 1, 2010 at 3:48 pm

I would suggest that the author study the principle of equilibrium. As I told my daughter after she sold her house for less than she had hoped. When you start shopping to replace your home, you will find a great number of houses owned by folks who will be willing to sell their houses for a great deal less than they had hoped. Isn’t physics, as a basis for explaining the real world, grand!

Sean September 1, 2010 at 4:25 pm

I would suggest that Mr. Stein study the difference between short-run and long-run economic phenomena. And also the difference between physics and economics. Sorry to be so short, but c’mon man, stop with the uber arrogance. You really don’t know what you’re talking about.

Inquisitor September 1, 2010 at 11:30 pm

Is this purposeful denseness or are you just this ignorant?

filc September 1, 2010 at 4:24 pm

Wow, what a pleasant read.

Del Lindley September 1, 2010 at 4:24 pm

I have to break ranks a bit and say that this article is long on practical knowledge but short on theory. I believe that this deficiency can be traced to a poor starting point.

Consider the statement:

“The same concept would apply to the stock market: if there were a constant amount of money in the economy, the sum total of all shares of all stocks taken together (or a stock index) could not increase.”

This statement is incorrect because it is based on a mistaken understanding of how corporate earnings are derived. Ultimately this error can be traced to the assumption that corporate earnings are proportional to the level of consumer spending (C) which is itself taken (via constant velocity) to be proportional to the money supply (M). In Chapter Six of Rothbard’s Man, Economy, and State it is shown that the income rate (E) derived by the capitalist is proportional to the level of gross savings (S), more specifically E = iS, where (i) is the pure rate of interest. The valuation of the stock market (V) is given by the time discounted value of these earnings, where the discount rate is given by the pure rate of interest. For continuous discounting over an infinite time period (a reasonable approximation when considering the market as a whole), and assuming that all other variables are constant going forward, it is easy to derive:

V = aM / θ

Here θ = C/S is the current social time preference and “a” is a dimensionless constant. Clearly the valuation of the stock market depends on both the money supply level and the social time preference. Stock valuations can therefore increase over time with a fixed money supply so long as a secular decline in social time preferences is in force. The article essentially confirms this expression by noting that the trade off between “asset inflation” and “consumer price inflation” has led to increased stock valuations and subdued consumer price inflation. What is money flowing from the consumer market to the financial market besides a decrease in social time preference?

Finally, the financial problems derived from holding M constant can arise only in an unfree market. While it is true that constant M can help to increase the money purchasing power over time, the fixing of M is an artifact of a hampered market. A freely chosen commodity money supply should, after a period of adjustment, grow at least at the rate of all other goods in the economy. This outcome follows directly from Reisman’s analysis.

Kel Kelly September 1, 2010 at 5:14 pm

Del, thanks for your comments. I’ll make some clarifications. As to your last point, Reisman states clearly that he would expect commodity money to increase at less of a rate than other goods. The fact that prices fell while gold increased during the 1800s seems to confirm this—gold increased at less of a rate than other goods. Another small point: I do not consider that earnings are in proportion to consumer spending. They are in proportion to both consumer AND business spending, plus, spending from dividends, draw, or previously invested funds (Reisman’s Net Consumption components–since you are familiar with Reisman’s work). Also, the example of a constant quantity of money is only for perspective; for a point of reference; as a starting point. Of course: in a free market, there would be commodity money. But having said that, I’m sure you would prefer a central bank that didn’t print money to the current system where it does.

Now to address the larger points. While I might not agree with all the details of your assumptions and theory—just as Reisman does not agree with all the assumptions and theory of time preference, interest, and discounting that Rothbard and all other pure Austrians adhere too—I do agree with your overall point. But I think the main problem lies in your not realizing that I addressed that point in the article: yes, social time preferences can change, resulting in more saving, which would result in more spending on capital goods and stocks, and less on consumer goods. But as I stated, and showed that Machlup stated, this effect would be only to the extent of the increased savings, and would not be a long lasting effect. There is no way social time preferences could continue to increase indefinitely and drive the Dow from 10,000 to 100,000 and 1,000,000. Only new money could do this—that’s my overall point.

I didn’t exactly “essentially confirm” what you state that I do with regards to the flow of money in consumer prices relative to asset prices (as noted above, I addressed it earlier in the article). You ask: “What is money flowing from the consumer market to the financial market besides a decrease in social time preference?” Answer: it is NOT what you imply: it is not money flowing from consumer prices to asset prices while BOTH STILL RISE. Absent an increased quantity of money, if social time preferences increased and money flowed from consumer prices to asset prices, consumer prices would FALL, not still rise.

Bottom line, stock prices could not rise indefinitely, on an ongoing basis (as I stated in the beginning of the article), by any means other than credit expansion.

Del Lindley September 1, 2010 at 6:47 pm

Kel, thank you for your prompt reply. Perhaps I gave the impression that I objected to your overall thesis, but this is not the case. That it is much easier to influence stock prices via the money supply as compared to social time preference there is no doubt. This is especially true over short timeframes. The objective of my comment was to point out the error in the one quote that I highlighted, and to demonstrate how it might be possible to reach that erroneous conclusion. Another way to reach this conclusion is just to say that social time preference is practically constant when compared to the money supply, but this assumption was not stated explicitly.

Although I am not prepared to present a meaningful defense at this time, I have good theoretical reasons to believe that social time preference is in fact much more malleable than most people think, and that over a long timeframe its role (among other things) in determining stock valuations is not negligible. Maybe once I get the details sorted out you can comment on my article!

Regarding Reisman and commodity money I recently read the Natural Resources chapter in his Capitalism and came away with the impression that productivity growth in resource recovery should keep pace with economic productivity as a whole. There should be no theoretical reason why, ultimately, increases in gold extraction rates should lag the rate of increase in the supply of consumer goods. I noted the need for a transition period in order to arrive at this result because essentially all of the gold that has ever been extracted remains in the world gold supply. The mathematics of this are quite clear.

Kel Kelly September 1, 2010 at 8:15 pm

Del, I would love to see your article when it’s finished. I’m sure I will learn something.

newson September 2, 2010 at 10:09 pm

but surely social time preference has an upper limit (something must be dedicated to the now), whereas money supply doesn’t, hence the upward bias of the equities market.

Del Lindley September 3, 2010 at 4:15 pm

Yes, I do believe that social time preference in a free economy must have a lower (not upper) limit, but it is not a limit that can be determined by economic theory. If the social time preference were to approach zero this would imply that both the physical productivity of the economy and the population would be approaching infinity. In short, social time preference would not continue to fall unless society benefited from it, and so the current goods per person would have to be increasing.

The limiting social time preference will be enforced ultimately by a physical limitation or a circumstance of nature. This may come in the form of either a population constraint or a hard limit to physical productivity. Unfortunately these conclusions are remote from our everyday experience where the lower limit to social time preference is set high due to a lack of market and money freedom worldwide.

Jeremiah Dyke September 1, 2010 at 5:56 pm

One of the best articles i have read in months! Thank you. I thumbed through your book while in Auburn by the way, lookes like a great read.

question September 1, 2010 at 11:24 pm

Thanks for the article. Sounds nice in theory but lets see the problems in practice. Here are my main disagreements. These 2 objections present themselfs in your scenario of no gov intervention in money and a constant money supply.

1. Companies THAT CHOSE to be listed on a stock exchange tend be more succesfull then average so it’s possible that they could outperform the general economy.

2. Similar to n1 companies THAT ARE CHOSEN to be included on certain stock exchanges or in indexes like DOW or SP tend to be the top performing 20 or 500 companies. Stocks in DOW today aren’t they same as they were 100 years ago. So it’s quite possible that they could still outperform the general economy.

These 2 objections present themselfs in your scenario of no gov intervention in money and a constant money supply. However is this ever a realistic scenario?

3. Take gold for example because thats the commodity most austrians would clasify as “honest or real money”. Supply of gold increases by 1-2% per year. Now if gold were to be accepted as real money it’s almost certain this number will increase by a lot. So even in this scenario inflation will be with us, maybe higher then today.

There are benefits like decreasing risk for hyperinflation and gov manipulation by a lot but it would not lead to a scenario of falling stock prices.

In conclusion while thought provoking as a nice theory I see no basis for any real usefullness. What it does though, it panders to the masses who always hate the stock market (and speculators) as a scam. Every article on mises that panders to this opinion gets overwhelming support while articles on the other side get flamed.

While there are great comment wars on other articles, 90% of positive comments here indicate that there is a general dislike for the stock market across left/right libertarians alike which is a sad situation. Looks like the old “burn the speculators” mentality is alive and well.

Kel Kelly September 2, 2010 at 9:03 am

Hi question, I have answers. You’re absolutely right—there are numerous reasons why any single, or even hundreds of companies can outperform the general economy, and, other stocks as well, and thus rise in price. But what I’m arguing is that not ALL or even a MAJORITY of stocks can rise in price without more money existing.

The parameters of my scenario are indeed unrealistic since we do have government intervention. I present this scenario only to show how things would work without the intervention, so that you can see the difference, which is the effect of the intervention. It is true that with a gold standard, there would be inflation–I did state that prices fell in the 1800s under the gold standard. If the increase in the quantity of gold outpaced other goods and services, then yes, asset prices would rise. All I’m showing is that there has to be more money for a majority or most consumer prices and asset prices to rise indefinitely, and that under our current system, it is bank credit that is the cause. This is a 100% realistic analysis that applies to the real world every day.

Your last two paragraphs are just simply dead wrong. Are you sure you’re not confusing Austrians with Socialists? Free marketers are NOT against the stock market. It should be clear from the daily news that it is all leftists, Keynesians included, who are against the stock market. The stock market is an outcome of free markets, and has incredible benefits. I absolutely support the existence of the stock market 100%–it is a capitalist tool! Additionally, we free marketers love speculators, who also serve a useful purpose. If you will investigate more articles on this site, you will see that we always defend speculators against politicians and the public, who always believe they are to blame, when it fact the politicians are to blame (I discuss this in my book to a large degree). What we are against is the MANIPULATION of the market and MANIPULATION of the economy–manipulation that gives us our current financial and economic problems. Please read more articles on this site and it should become clear what we are really saying.

Matthew Swaringen September 2, 2010 at 1:47 pm

If anyone seems annoyed here (except michael, he’s not an Austrian by any stretch) it’s generally not with the speculators themselves, but rather the government incentives that cause that market to be larger than it otherwise might be.

Without continuous inflation destroying the value of the dollar (and tax incentives) people wouldn’t be forced into putting their money towards speculative investments (401ks, etc.)

The other problem with these types of plans is 3rd party management. 3rd parties may take more risks with their money than the person would. I’m not saying people wouldn’t use 3rd parties to take care of their investments in a freer market, but again, more people are doing this because they know that they can’t depend on the value of the dollar.

Jim Wadas September 2, 2010 at 1:22 am

The only part of this article which I was unable to understand dealt with the statement …’if banks are willing to lend and lenders are willing to borrow, then the newly created money that the government is spending will make its way through the economy.’
Lenders are willing to borrow? I do not understand this. Please clarify.
Thank-you.

Kel Kelly September 2, 2010 at 9:08 am

Jim–great catch, you found a mistake. That is supposed to say “if borrowers are willing to borrow”

trader September 2, 2010 at 5:01 am

Yep… Agree with most of this article, problem is, you can’t just use
http://trueslant.com/michaelpollaro/austrian-money-supply/

as a predictor… since MS numbers always come out with a major lag… as a leading indicator for financial mkts it’s useless, OTOH as a diagnostic on the economy it’s quite good.

Kel Kelly September 2, 2010 at 9:13 am

You can’t use it to time, but you can use it to expect. For example, after the raised rates in 2005 and 2006, we expected that the housing bubble and the stock market would slow and reverse at some point. But even after MS slows, old money is still filtering through the economy, and new money is still being created. Frank Shostak had a great article around 2005 showing how though the rate of increase had slowed, it was previously-created money still pushing prices higher, and that new money was still being created. You can certainly use MS to predict, you just can’t peg the time frame within a year’s period.

James W. McGillivray September 2, 2010 at 10:46 am

You are correct. The MONEY SUPPLY is of prime importance.
In Canada under 5% is produced by the Bank of Canada, the Central Bank.
In Canada over 95% is produced by the lending actions of the Chartered Banks.
The Bank of Canada is owned by the Government.
In the United States the Federal Reserve is the Central Bank and is privately owned.
It produces all the money ,does it not?
As long as the Fed produces all the money supply, why does anyone say that the government is ‘printing too much money’ and causing inflation.
When Lincoln had ‘greenbacks’ printed it was government money. it is not so today.
Expect the rich to get richer and the poor to revolt some time.

Mashuri September 2, 2010 at 12:44 pm

James,

Just because people call the Fed “private” does not make it so. Ownership is demonstrated by control. Read this article to see why the Fed is indeed a government institution: http://mises.org/daily/4171

David September 2, 2010 at 12:17 pm

Kel, you mentioned in the article how one reason so many people invest in the stock market is due to the government constantly devaluing money. Are you aware of any other laws, taxes incentives, or anything that encourage people to invest in the stock market beyond what would occur in a free market?

Mashuri September 2, 2010 at 12:46 pm

Off the top of my head I can think of one tax incentive directing wealth into the stock market: 401k’s.

David September 2, 2010 at 1:20 pm

What is the tax incentive for 401k’s? I’m new to all this stuff so I really don’t know.

Mashuri September 2, 2010 at 4:32 pm

Namely that any income you contribute and its subsequent gains will not be taxed. They will be when you finally withdraw in retirement but the numbers work out in your favor (assuming your investments go up in value, of course…)

Andeveron September 4, 2010 at 1:09 pm

Why do people invest in the stock market?

One word: Greed.

Another word: Lemmings.

Like it or not, people are greedy. People are also lemming-like in their behavior where success or the potential for success is emulated by the impetus of greed.

Andeveron September 4, 2010 at 1:06 pm

“Stuff” does not equate wealth. “Stuff” is dead and immaterial in the long run so how can stuff be called wealth? Can a guy with a massive comic book collection be called wealthy?

You know how I’d define wealth? I’d define it as productive capacity. I’d define it as human capital and the potential for creation. I’d define wealth as the ability to marshall resources (inputs) and build products or services (output). That’s wealth. You know the guy who signs Shaq’s paycheck? That guy’s wealthy.

It is real “stuff,” not money per se, which represents real wealth. The more cars, refrigerators, food, clothes, medicines, and hammocks we have, the better off our lives.

Matthew Swaringen September 4, 2010 at 1:14 pm

Potentiality cannot itself be wealth because potential can be lost before wealth is created.

Like it or not, that guys massive comic book collection is representative of his wealth. You may not appreciate his massive comic book collection, but I’m sure he does appreciate it. He finds that it adds to his life. It is what he worked for, and it matters as much to him as any nice car or a portion of the money that the guy who signs Shaq’s paycheck has.

Gerry Flaychy September 4, 2010 at 5:01 pm

Indeed, the notion of wealth can be very subjective.

Kel Kelly September 4, 2010 at 5:28 pm

Productive capacity is only a means to an end: We produce only so we can consume. Market prices lead us to produce what people individuals want (when production is not distorted by govt. intervention). You might not want comic books produced, but others do. I might like snow globes produced, others might not. That’s why there are multiple things in each category of consumer goods produced. But the fact is, these various things we consume and use to better our lives or to make our lives more enjoyable are in fact the only real form of wealth.

Chris September 25, 2010 at 8:23 pm

Hi, could i get clarification on this passage from the article (great article btw):

“With a constant supply of money, wages would remain the same while prices fell, because the supply of goods would increase while the supply of workers would not. But even when prices rise due to money being created faster than goods, prices still fall in real terms, because wages rise faster than prices.”

I’m still relatively new to Austrian economics and it appears you’re making the assumption that labor doesn’t increase. But what if it does, ie immigration, population growth? Also, i didn’t think wages rise faster than prices…isn’t the fact that wages lag price rises that we are losing out? For example, i have a 3% annual pay rise, inline with CPI, but we know that real inflation is actually much greater. I’m just confused and i’m sure you can offer an explanation or point me in the direction of an article.

Kind regards
Chris, Australia

Chris September 25, 2010 at 8:30 pm

P.S.
Are there any good finance or investment related books, articles.. written by Austrian economists/investors? Perhaps someone similiar to a Marc Faber? I want to learn more about investing and share markets but don’t want to read alot of the mainstream stuff. Thx.

Naevius February 19, 2011 at 1:42 am

This was just a wonderful read, Kel. I learned so much from this! Easily the best Mises daily I have ever read. Good job and thank you!

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