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Home > Blogs > Anthony Harrington > A lesson in economics: How stock markets really work…

A lesson in economics: How stock markets really work…

Finance Blogger: Anthony Harrington Anthony Harrington

One of the most astonishing articles I have come across in a long time is a piece entitled “How the Stock Market and the Economy Really Work” by former Wall Street trader and research analyst Kel Kelly. For Kelly, while they have a role, consumer confidence and consumer spending are not the drivers of economic growth. What does drive economic growth, then? Simple. Increases in the money supply drive up prices, that’s it. That’s the whole story.

Kelly puts a great deal of faith in George Reisman’s critical formula for the derivation of economy-wide pricing. P (pricing) equals D (demand) divided by S (supply). But to make this work Kelly fashion, you have to forget about demand equating to millions of consumers going about the business of shopping and just focus on the money in their sweaty hands. If, say, 100,000 consumers are clutching all the money that the society has, say £1,000,000 (it’s a small society), and there is a vast and growing amount of goods out there, the average price of each item has to shrink. It can’t expand because all those goods are competing for a finite supply of cash. Shrink the number of goods and expand the money and the reverse happens, the price of each item starts to soar.

For Kelly, you can’t shrink the number of goods available in a modern economy, therefore when you see price inflation of 3-4% per year, what you are actually seeing is more money entering the marketplace. When stock markets go off on a sustained tear, rising year after year as they do in a good bull run, what is really happening is not that the companies whose stocks make up that market are getting more productive. What is happening is that bank credit is flowing into the stock market, pumping up prices.

Kelly recognises that other factors can drive up the markets, but they do so only temporarily, he argues. So if people suddenly stop spending and start saving, and channel their savings towards stocks to get a better return, then the market will rise until it has absorbed its full share of that savings stream. Then it will stop rising and start moving sideways.

So if you want to know what drives a long-term bull market, it is new and additional bank credit, pure and simple. The public has to be able to get access to additional credit to drive stock markets higher. Markets can go higher when people convert their savings to holdings in stock, but only until this “dis-hoarding” is complete.

At the same time that new bank credit pushes up the stock market, it also pushes up GDP.  This is Kelly on GDP in a constant money world sans bank credit inflation:

“… a rise in GDP is mathematically possible only if the money price of individual goods produced is increasing to some degree. Otherwise, with a constant supply of money and spending, the total amount of money companies earn—the total selling prices of all goods produced—and thus GDP itself would all necessarily remain constant year after year."

How does all this work out in the real economy? Simple. When banks create new money (via the central bank printing the stuff) they loan it out largely to corporates who spend it buying goods and services from other businesses. This inflates the revenues of those businesses before their costs get a chance to get inflated as well, and the difference shows up as increased profit. This is largely (in fact in Kelly’s argument, wholly) illusory because when, a year or so later, those companies have to restock their inventories, prices will have moved up correspondingly.

So what they are recording as a profit this year, is just a time lag between their revenue moving up and their costs moving up. Revenues always move up faster than costs because of the time lag between selling and restocking. (Costs relative to revenues—i.e. being matched to those revenues in accounting terms—are incurred at an earlier period when the amount of money in circulation is significantly less, so the prices that comprise those costs are less.)

Naturally, Kelly is incensed that Governments of all complexions insist on grabbing a tax share of what is simply a time lagged mismatch. There is no actual profit and the tax simply forces companies to run faster just to stand still. Now that’s a familiar feeling…

My fellow QFINANCE blogger Ian Fraser notes that a similar point was made consistently by the Edinburgh fund manager Ian Rushbrook. In a speech at the AGM of the investment trust, Personal Assets Trust, he co-managed with Robin Angus, Rushbrook said:

In our view, there has been no real GDP growth at all (that is, growth based on savings and investment) from 2000 onwards. All GDP increases have been generated from debt: government debt, corporate debt and particularly consumer debt. But, unfortunately, a consumer boom and GDP growth based on debt can only continue for so long...

Since all debt must be repaid ultimately, whatever boom consumer debt has caused must be followed by a bust of exactly the same magnitude.

Effectively, real household earnings in the UK and US have not increased over the last six years. This is why company earnings are currently so high; businesses haven’t had to pay their employees more. When consumers spend not only their earnings but also their increased borrowings, businesses get to sell more without having to pay anyone more. The result is high but unsustainable corporate earnings.

Meanwhile, consumers have borrowed against the increased value of their houses and banks have been delighted to extend the credit. Unfortunately, even if their houses are worth three times what they were six years ago, it won’t help them pay off their debt—they still have to live somewhere and therefore they can’t very well sell their houses to repay the debt—so they have to cut their consumption. As housing weakens so will the UK and US economies.”

Rushmore was, of course, proved to be exactly right by the crash of 2008/2009.

Further reading on GDP and corporate profits

Tags: bank credit , bank credit inflation , bull market , constant money , GDP growth , George Reisman , Kel Kelly
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