Why financial markets matter for the real economy

Alex Edmans
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A worker is caught reflected in multiple
Financial markets are not just a mirror of the workings of the real economy (Source: Getty)

Much like Jose Mourinho’s second spell at Chelsea, 2015 turned out to be a false dawn for the stock market. After breaking through 7,000 in April, the FTSE 100 ended the year barely over 6,000. The rollercoaster was even bumpier in China, where the market rose by 54 per cent by mid-June, only to lose it all a month later.

But the real economy has been devoid of such excitement. Quarterly GDP growth in the UK hovered around 0.5 per cent throughout the year, while unemployment fell slowly, but steadily, from 5.7 per cent to 5.2 per cent. And it’s the real economy which determines how many “actual” goods and services are bought, how many people are in work, and how much investment is undertaken. So do financial markets actually matter, or should we only pay attention to real measures?

The textbook answer is that financial markets are forward-looking, while real indicators are historic. Peaks and troughs in the stock market tell us about the real economy’s future prospects. But even under this argument, financial markets are merely a mirror – they passively reflect the economy, but do not actively affect it. As a rather blunt analogy, if a person dislikes the waistline reflected back at them, the solution is not to change the mirror but to change one’s habits. If true, then the UK financial industry is £120bn wasted on a mirror which should be reallocated to bricks and mortar.

Of course, real production requires funding. And so it’s clear that primary financial markets create value, by providing new capital to businesses. But the vast majority of activity occurs in secondary financial markets, where no new funds are being raised. Hedge funds, mutual funds, and other investors typically trade second-hand stocks and bonds, and do so among each other. Real companies are not involved, so surely they can’t benefit?

But they can. In a paper entitled The Real Effects of Financial Markets, professors Philip Bond, Itay Goldstein, and I highlight two channels through which secondary financial markets can improve real efficiency, even though no new capital is being provided.

The first is incentives. Managers’ shares, options, and reputation all depend on the stock price. Thus, their incentives to take real actions depend on the extent to which those actions will be reflected in the stock price. If the financial market is inefficient, because unsophisticated traders value a firm based on short-term profit rather than long-term value, then the stock price will reflect the former, and so managers will focus on the former. But an active financial sector, where investors are critically analysing a firm’s brand, strategic positioning, and innovative capability, will ensure that prices more closely reflect the firm’s long-term prospects – in turn encouraging the manager to think long-term.

The second is learning. Many of the key drivers of a firm’s long-run value, such as its strategic positioning, are difficult to measure objectively. Like an efficient polling system, the stock price aggregates the information of millions of investors, each with their different viewpoints, and summarises them into a single number which can be used by anyone for free. For example, a bank deciding whether to lend, a worker choosing which company to join, and a customer or supplier deciding whether to enter into a long-term relationship can use the stock price (in addition to other measures) to guide them.

Most importantly, it can be used by the company’s management. Many key decisions are enhanced by managers supplementing their own internal information with external perspectives. While consultants cost millions, the stock price is a freely available signal of the quality of a firm’s decisions. Indeed, studies have shown that a chief executive’s likelihood of completing an M&A deal depends on the initial stock price reaction to its announcement. For example, Carly Fiorina, the former chief executive of Hewlett-Packard, dropped her bid for the consulting arm of PwC because investors “simply voted with their positions in the stock... I realise [they] made some valid points.” More broadly, chief executives increase real investment when their stock price is high, as this signals favourable growth opportunities – and the effect is stronger where the stock price is more informative.

Of course, a larger financial sector is not necessarily a more efficient financial sector, and not all trading is good. Stock prices may be manipulated, reducing rather than enhancing the amount of information in prices.

But the benefits of an efficient financial sector for the real economy are clear. The challenge for policymakers is to harness the financial sector’s vast resources to increase the informativeness of market prices. One channel may be to encourage investors to take large stakes, to ensure that they have sufficient incentives to gather intangible information, rather than relying on freely-available earnings figures. When stock prices reflect long-term value, not short-term numbers, managers’ decisions will too.

Alex Edmans' TEDx talk on The Social Responsibility of Business is at http://bit.ly/csrtedx

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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