14. The Influence Exerted on the Stock Market by Economic Fluctuations

The stock market is an important part of the marketplace in which securities representing loans to companies are traded (also called the “capital market”). Securities are the legal embodiment of investments which savers, or capitalists, make in the following type of transaction: Capitalists concede present goods to demanders of present goods, who are willing to hand over a larger quantity of future goods to savers, or lenders, in the future in exchange for the ability to use the present goods in production processes. These securities may take on a wide variety of legal forms; they may be stocks, bonds, etc. In any case the stock market has the great virtue of facilitating the exchange of ownership of such securities, and hence of the corresponding capital goods of which the securities represent a share. Another main advantage of the stock market is that it allows the holders of securities to obtain rapid liquidity should they wish to part with them.⁵⁹ In addition it permits economic agents to temporarily invest their excess cash on hand, which they can use to purchase securities, and though these securities may represent long-term investments, they can be held for shorter periods and sold at any time.⁶⁰

In an economy which shows healthy, sustained growth, voluntary savings flow into the productive structure by two routes: either through the self-financing of companies, or through the stock market. Nevertheless the arrival of savings via the stock market is slow and gradual and does not involve stock market booms or euphoria.⁶¹

Only when the banking sector initiates a policy of credit expansion unbacked by a prior increase in voluntary saving do stock market indexes show dramatic and sustained overall growth. In fact newly-created money in the form of bank loans reaches the stock market at once, starting a purely speculative upward trend in market prices which generally affects most securities to some extent. Prices may continue to mount as long as credit expansion is maintained at an accelerated rate. Credit expansion not only causes a sharp, artificial relative drop in interest rates, along with the upward movement in market prices which inevitably follows. It also allows securities with continuously rising prices to be used as collateral for new loan requests in a vicious circle which feeds on continual, speculative stock market booms, and which does not come to an end as long as credit expansion lasts. As Fritz Machlup explains:

If it were not for the elasticity of bank credit, which has often been regarded as such a good thing, the boom in security values could not last for any length of time. In the absence of inflationary credit the funds available for lending to the public for security purchases would soon be exhausted.⁶²

Therefore (and this is perhaps one of the most important conclusions we can reach at this point) uninterrupted stock market growth never indicates favorable economic conditions. Quite the contrary: all such growth provides the most unmistakable sign of credit expansion unbacked by real savings, expansion which feeds an artificial boom that will invariably culminate in a severe stock market crisis.

By the same token, as Hayek has shown, the significant capital gains acquired on the stock market during the expansion stage, to the extent economic agents consider them an addition to their wealth and spend them on the purchase of consumer goods and services, imply substantial consumption of capital, an event which will ultimately make society poorer.⁶³

Even when, analytically speaking, it is perfectly easy to identify the processes which tend to reverse the investment projects undertaken in error as a result of credit expansion, it is impossible to determine in advance exactly when and under what specific circumstances the artificial nature of the expansion will become evident in the stock market, ultimately setting off a crisis. However the stock market will definitely offer the first sign that the expansion is artificial and has “feet of clay,” and then quite possibly, the slightest trigger will set off a stock market crash.⁶⁴ The crash will take place as soon as economic agents begin to doubt the continuance of the expansionary process, observe a slowdown or halt in credit expansion and in short, become convinced that a crisis and recession will appear in the near future. At that point the fate of the stock market is sealed.

The first symptoms of a stock market crisis seriously frighten politicians, economic authorities and the public in general, and a widespread clamor in favor of enough further credit expansion to consolidate and maintain the high stock market indexes is usually heard. High security prices are mistakenly viewed as a sign of good economic “health,” and therefore it is wrongly believed that all possible measures should be taken to prevent the stock market from collapsing.⁶⁵Indeed neither the public nor the majority of specialists wish to accept that the stock market decline is the initial warning of the inevitable recession and that stock market indexes cannot remain unchanged in the absence of new doses of credit.⁶⁶ Such credit would only postpone the crisis and make the eventual recession much more severe.

When the crisis erupts, the stock market also acts as an indicator of its development. Other things being equal, indexes corresponding to the securities of companies that operate in the stages furthest from consumption reflect a more dramatic fall in market prices than those which represent companies that produce consumer goods and services. This is the stock market's confirmation of the fact that the greatest entrepreneurial errors have been committed in the most capital-intensive stages and of the necessity to liquidate these errors, save what can be saved and transfer the corresponding resources and original means of production toward other companies closer to consumption.

Once the recession period has begun, market sluggishness will continue for the duration of the readjustment process, indicating not only that this process is still painfully in motion, but also that market interest rates have risen to their pre-credit-expansion level (or even to a higher level, if, as usually occurs, they incorporate an additional premium for risk and inflation).⁶⁷ In any case, market sluggishness will last as long as the readjustment, and could last indefinitely if the readjustment never concludes because new loans prolong malinvestment, and labor and all other markets are highly controlled and rigid.⁶⁸

When the readjustment has ended the recovery can begin, assuming economic agents regain confidence and again increase their rate of voluntary saving. In this case the price of consumer goods and services will tend to decline, in relative terms, with respect to the wages and income of the original means of production. This will set off the “Ricardo Effect,” and entrepreneurs will again become interested in launching new investment projects to lengthen and widen the more capital-intensive stages in the productive structure. This rise in saving will stimulate growth in the price of securities, which will indicate the recovery has begun and entrepreneurs are again embarking on new processes of investment in capital goods. Nonetheless the upturn in stock market indexes will not be spectacular as long as new credit expansion is not initiated.⁶⁹

Although many additional considerations regarding the evolution of the stock market during the business cycle could be presented, the most important idea is this: in general, no significant, continuous rise in the price of securities can be accounted for by an improvement in production conditions nor by an increase in voluntary saving; such a rise can only be indefinitely maintained as a result of inflationary growth in credit expansion. A sustained improvement in the economy and an increase in voluntary saving generate a greater monetary influx into the stock market, but this inflow is slower and more gradual and is rapidly absorbed by the new securities issued by companies with an aim to finance their new investment projects. Only continuous, disproportionate growth in the money supply in the form of credit expansion can feed the speculative mania (or “irrational exuberance”) which characterizes all stock market booms.⁷⁰