The Stock Market and the Economy

My oldest daughter and my youngest grandchild are both taking economics this semester, and neither of them are enthusiastic.  Often it is taught in ways that make it seem irrelevant for your life, your values, or your idea of how people should behave for the good of the nation or globe.  If you are one of those people, try this little lesson on why it pays to know something about economics.

Defenders of Donald Trump often admit to his shortcomings, but at the same time, they defend his presidency with praise for the economy.  Asked for specifics, they point to the booming stock market (which has continued to boom since Biden was certified, but that is another story). They also point to low unemployment and GDP growth, both of which had also occurred under the previous administration. But the stock market is the one that comes up most often.

As an economist, I want all you non-economists to know that the stock market is NOT the economy. The economy is Gross Domestic Product (GDP), jobs, and income distribution.  That is a utilitarian answer, an ethical movement that defines the goal of society and economy as providing the greatest good for the greatest number.  Greatest good is measured, however imperfectly, by GDP, but greatest number requires that those benefits be widely shared across the population.  GDP was doing well before the pandemic, as was the stock market, but both had done well under the previous administration, and some of the further gains were a sugar high from the 2017 tax cut. The distribution of income and wealth has been deteriorating for several decades as both became increasingly unequal.

If the stock market is not our primary measure of economic performance, what is it?  Historically, the stock market is a place where investors can buy and sell ownership shares of business firms.  It serves three primary purposes and two secondary purposes.  One purpose is to provide a vehicle for raising capital for business firms. A second purpose is to provide a financial instrument where people can put their savings to work earning interest, dividends, and capital gains. The third purpose, which is a side benefit, is to discipline or reward firms for their past, current, and expected future earnings through the purchase of  shares for firms expected to perform well and selling shares of those firms that have been or are expected to perform poorly.

The two secondary purposes, which are incidental, are to serve as a leading economic indicator and to enable a sophisticated form of gambling.  A leading economic indicator is something that has a good track record in forecasting future output (GDP) and employment (which is closely tied to GDP). The stock market is one of about a dozen such indicators, which include building permits, manufacturers’ inventories, consumer expectations, and other tried and true predictors. They are all tied together in the index of leading economic indicators, a popular tool for forecasting recessions and recoveries.

The other secondary purpose is related to the growth of sophisticated tools like puts and calls, options, or short sales by hedge funds allows investors to use the stock market for what amounts to a form of gambling.  These tools are also used in commodities markets, which sell metals, fuels, and farm products among other things for future deliveries.  Like the stock market, the commodities futures market developed for a useful purpose, providing short- to medium-term capital to firms and especially to farmers to plant and harvest a crop.  Commodity prices are very volatile, so this futures market provided a way for producers to protect themselves against a price decline (the curse of an abundant harvest in the case of farmers). Guaranteeing a future price involves risk (a relative of gambling) for investors and insurance for sellers.

This past week or so we have seen a dramatic use of that gambling function by non-hedge fund individuals with the aid of social media to deliver a serious blow to hedge funds that had used these tools to bet against the price of a favorite retail chain, Game Stop. Hedge funds, as in hedge your bets.  Does that suggest gambling? Sometimes a hedge is just that, a way to “insure” against the risk of sudden changes in a stock that is a large part of your portfolio.  But  these tools can also force or accelerate a decline in the price of a stock with a short sale. Hedge funds were not protecting themselves from a Game Stop price decline, they were betting (and abetting) that it would happen. Hedge funds had used a short sale to gamble on a decline in the price of  Game Stop stock.  They sold shares they did not own for future delivery, betting that the price would be lower when they had to buy shares for delivery.  Caught short when the price rose, they had to divest themselves of other assets to cover the short sale, taking losses in the process. I am proud of those small investors, most of them young, who used the tools of the hedge fund managers to turn it into a life lesson on behalf of a company they liked.

I like  to gamble too, but I would rather gamble on the lottery where at least some of the money goes to support education in my state. Between buying my Powerball ticket and waiting for the result, I get the recreational benefit of dreaming about what I would do if I won the lottery. (At my age, I would give it away to worthy causes.)  And I even occasionally visit a casino if I am in the neighborhood and give myself a loss limit of $50.  But at least my personal occasional petty gambling does no harm, although there are people who have a gambling addiction who do need protection.  Maybe hedge fund managers should reflect on their own gambling addiction and check out Powerball as a less dangerous and less destructive alternative.