Do Financial Markets Matter for the Real Economy?

01/18/2016 05:22 pm ET Updated Jan 17, 2017

After a frustrating 2015, the start of 2016 has been even more disappointing from the stock market, with the S&P 500 down by 8 percent after just two weeks. The new year has begun even worse in China, where markets are down 18 percent -- and this is after a rollercoaster 2015 where equities rose by 54 per cent in the first half, only to lose it all a month later.

But the real economy has been devoid of such excitement. U.S. unemployment fell steadily from 6.6 percent to 5.6 percent over 2015, with quarterly GDP growth consistently between 3 and 4 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 US financial industry is $1.26 trillion 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 (Washington), Itay Goldstein (Wharton), 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 favorable 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's TEDx talk on the importance of long-term value vs. short-term numbers is at http://bit.ly/csrtedx