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How the Stock Market and Economy Really Work

By Kel Kelly – Mises Daily

"A growing economy consists of prices falling, not rising."

The stock market does not work the way most people think. A commonly held
belief — on Main Street as well as on Wall Street — is that a stock-market boom
is the reflection of a progressing economy: as the economy improves, companies
make more money, and their stock value rises in accordance with the increase in
their intrinsic value. A major assumption underlying this belief is that consumer
confidence and consequent consumer spending are drivers of economic growth.

A stock-market bust, on the other hand, is held to result from a drop in consumer
and business confidence and spending — due to inflation, rising oil prices, high
interest rates, etc., or for no reason at all — that leads to declining business
profits and rising unemployment. Whatever the supposed cause, in the common
view a weakening economy results in falling company revenues and lower-than-
expected future earnings, resulting in falling intrinsic values and falling stock

This understanding of bull and bear markets, while held by academics,

investment professionals, and individual investors alike, is technically correct if
viewed superficially but is substantially misconceived because it is based on
faulty finance and economic theory.

In fact, the only real force that ultimately makes the stock market or any market
rise (and, to a large extent, fall) over the longer term is simply changes in the
quantity of money and the volume of spending in the economy. Stocks rise when
there is inflation of the money supply (i.e., more money in the economy and in
the markets). This truth has many consequences that should be considered.

Since stock markets can fall — and fall often — to various degrees for numerous
reasons (including a decline in the quantity of money and spending), our focus
here will be only on why they are able to rise in a sustained fashion over the
longer term.

The Fundamental Source of All Rising Prices

For perspective, let's put stock prices aside for a moment and make sure first to
understand how aggregate consumer prices rise. In short, overall prices can rise
only if the quantity of money in the economy increases faster than the quantity of
goods and services. (In economically retrogressing countries, prices can rise
when the supply of goods diminishes while the supply of money remains the
same, or even rises.)
When the supply of goods and services rises faster than the supply of money —
as happened during most of the 1800s — the unit price of each good or service
falls, since a given supply of money has to buy, or "cover," an increasing supply
of goods or services. George Reisman offers us the critical formula for the
derivation of economy-wide prices:[1]

In this formula, price (P) is determined by demand (D) divided by supply (S). The
formula shows us that it is mathematically impossible for aggregate prices to rise
by any means other than (1) increasing demand, or (2) decreasing supply; i.e.,
by either more money being spent to buy goods, or fewer goods being sold in the

In our developed economy, the supply of goods is not decreasing, or at least not
at enough of a pace to raise prices at the usual rate of 3–4 percent per year;
prices are rising due to more money entering the marketplace.

The same price formula noted above can equally be applied to asset prices —
stocks, bonds, commodities, houses, oil, fine art, etc. It also pertains to corporate
revenues and profits. As Fritz Machlup states:

It is impossible for the profits of all or of the majority of enterprises to rise without
an increase in the effective monetary circulation (through the creation of new
credit or dishoarding).[2]

To return to our focus on the stock market in particular, it should be seen now
that the market cannot continually rise on a sustained basis without more money
— specifically bank credit — flowing into it.

There are other ways the market could go higher, but their effects are temporary.
For example, an increase in net savings involving less money spent on consumer
goods and more invested in the stock market (resulting in lower prices of
consumer goods) could send stock prices higher, but only by the specific extent
of the new savings, assuming all of it is redirected to the stock market.

The same applies to reduced tax rates. These would be temporary effects
resulting in a finite and terminal increase in stock prices. Money coming off the
"sidelines" could also lift the market, but once all sideline money was inserted
into the market, there would be no more funds with which to bid prices higher.
The only source of ongoing fuel that could propel the market — any asset market
— higher is new and additional bank credit. As Machlup writes,

If it were not for the elasticity of bank credit … a 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, since even a large supply is ultimately limited. The supply of funds
derived solely from current new savings and current amortization allowances is
fairly inelastic.… Only if the credit organization of the banks (by means of
inflationary credit) or large-scale dishoarding by the public make the supply of
loanable funds highly elastic, can a lasting boom develop.… A rise on the
securities market cannot last any length of time unless the public is both willing
and able to make increased purchases.[3] (Emphasis added.)

The last line in the quote helps to reveal that neither population growth nor
consumer sentiment alone can drive stock prices higher. Whatever the
population, it is using a finite quantity of money; whatever the sentiment, it must
be accompanied by the public's ability to add additional funds to the market in
order to drive it higher.[4]

Understanding that the flow of recently created money is the driving force of
rising asset markets has numerous implications. The rest of this article
addresses some of these implications.

The Link between the Economy and the Stock Market

The primary link between the stock market and the economy — in the aggregate
— is that an increase in money and credit pushes up both GDP and the stock
market simultaneously.

A progressing economy is one in which more goods are being produced over
time. It is real "stuff," not money per se, which represents real wealth. The more
cars, refrigerators, food, clothes, medicines, and hammocks we have, the better
off our lives. We saw above that, if goods are produced at a faster rate than
money, prices will fall. With a constant supply of money, wages would remain the
same while prices fell, because the supply of goods would increase while the
supply of workers would not. But even when prices rise due to money being
created faster than goods, prices still fall in real terms, because wages rise faster
than prices. In either scenario, if productivity and output are increasing, goods
get cheaper in real terms.

Obviously, then, a growing economy consists of prices falling, not rising. No

matter how many goods are produced, if the quantity of money remains constant,
the only money that can be spent in an economy is the particular amount of
money existing in it (and velocity, or the number of times each dollar is spent,
could not change very much if the money supply remained unchanged).

This alone reveals that GDP does not necessarily tell us much about the number
of actual goods and services being produced; it only tells us that if (even real)
GDP is rising, the money supply must be increasing, since a rise in GDP is
mathematically possible only if the money price of individual goods produced is
increasing to some degree.[5] 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.

"Consider that if our rate of inflation were high enough, used cars would rise in
price just like new cars, only at a slower rate."

The same concept would apply to the stock market: if there were a constant
amount of money in the economy, the sum total of all shares of all stocks taken
together (or a stock index) could not increase. Plus, if company profits, in the
aggregate, were not increasing, there would be no aggregate increase in
earnings per share to be imputed into stock prices.

In an economy where the quantity of money was static, the levels of stock
indexes, year by year, would stay approximately even, or drift slightly lower[6] —
depending on the rate of increase in the number of new shares issued. And,
overall, businesses (in the aggregate) would be selling a greater volume of goods
at lower prices, and total revenues would remain the same. In the same way,
businesses, overall, would purchase more goods at lower prices each year,
keeping the spread between costs and revenues about the same, which would
keep aggregate profits about the same.

Under these circumstances, capital gains (the profiting from the buying low and
selling high of assets) could be made only by stock picking — by investing in
companies that are expanding market share, bringing to market new products,
etc., thus truly gaining proportionately more revenues and profits at the expense
of those companies that are less innovative and efficient.

The stock prices of the gaining companies would rise while others fell. Since the
average stock would not actually increase in value, most of the gains made by
investors from stocks would be in the form of dividend payments. By contrast, in
our world today, most stocks — good and bad ones — rise during inflationary bull
markets and decline during bear markets. The good companies simply rise faster
than the bad.

Similarly, housing prices under static money would actually fall slowly — unless
their value was significantly increased by renovations and remodeling. Older
houses would sell for much less than newer houses. To put this in perspective,
consider that if our rate of inflation were high enough, used cars would rise in
price just like new cars, only at a slower rate — but just about everything would
increase in price, as it does in countries with hyperinflation The amount by which
a home "increases in value" over 30 years really just represents the amount of
purchasing power that the dollars we hold have lost: while the dollars lost
purchasing power, the house — and other assets more limited in supply growth
— kept its purchasing power.
Since we have seen that neither the stock market nor GDP can rise on a
sustained basis without more money pushing them higher, we can now clearly
understand that an improving economy neither consists of an increasing GDP
nor does it cause the overall stock market to rise.

This is not to say that a link does not exist between the money that companies
earn and their value on the stock exchange in our inflationary world today, but
that the parameters of that link — valuation relationships such as earnings ratios
and stock-market capitalization as a percent of GDP — are rather flexible, and as
we will see below, change over time. Money sometimes flows more into stocks
and at other times more into the underlying companies, changing the balance of
the valuation relationships.

Forced Investing
As we have seen, the whole concept of rising asset prices and stock investments
constantly increasing in value is an economic illusion. What we are really seeing
is our currency being devalued by the addition of new currency issued by the
central bank. The prices of stocks, houses, gold, etc., do not really rise; they
merely do better at keeping their value than do paper bills and digital checking
accounts, since their supply is not increasing as fast as are paper bills and digital
checking accounts.

"An improving economy neither consists of an increasing GDP nor does it cause
the overall stock market to rise."
The fact that we have to save for the future is, in fact, an outrage. Were no
money printed by the government and the banks, things would get cheaper
through time, and we would not need much money for retirement, because it
would cost much less to live each day then than it does now. But we are forced
to invest in today's government-manipulated inflation-creation world in order to try
to keep our purchasing power constant.

To the extent that some of us even come close to succeeding, we are still
pushed further behind by having our "gains" taxed. The whole system of inflation
is solely for the purpose of theft and wealth redistribution. In a world absent of
government printing presses and wealth taxes, the armies of investment
advisors, pension-fund administrators, estate planners, lawyers, and accountants
associated with helping us plan for the future would mostly not exist. These
people would instead be employed in other industries producing goods and
services that would truly increase our standards of living.

The Fundamentals are Not the Fundamentals

If it is, then, primarily newly printed money flowing into and pushing up the prices
of stocks and other assets, what real importance do the so-called fundamentals
— revenues, earnings, cash flow, etc. — have? In the case of the fundamentals,
too, it is newly printed money from the central bank, for the most part, that
impacts these variables in the aggregate: the financial fundamentals are
determined to a large degree by economic changes.

For example, revenues and, particularly, profits, rise and fall with the ebb and
flow of money and spending that arises from central-bank credit creation. When
the government creates new money and inserts it into the economy, the new
money increases sales revenues of companies before it increases their costs;
when sales revenues rise faster than costs, profit margins increase.

Specifically, how this comes about is that new money, created electronically by
the government and loaned out through banks, is spent by borrowing
companies.[7] Their expenditures show up as new and additional sales revenues
for businesses. But much of the corresponding costs associated with the new
revenues lags behind in time because of technical accounting procedures, such
as the spreading of asset costs across the useful life of the asset (depreciation)
and the postponing of recognition of inventory costs until the product is sold (cost
of goods sold). These practices delay the recognition of costs on the profit-and-
nloss statements (i.e., income statements).

Since these costs are recognized on companies' income statements months or

years after they are actually incurred, their monetary value is diminished by
inflation by the time they are recognized. For example, if a company recognizes
$1 million in costs for equipment purchased in 1999, that $1 million is worth less
today than in 1999; but on the income statement the corresponding revenues
recognized today are in today's purchasing power. Therefore, there is an
equivalently greater amount of revenues spent today for the same items than
there was ten years ago (since it takes more money to buy the same good, due
to the devaluation of the currency).

"With more money being created through time, the amount of revenues is always
greater than the amount of costs, since most costs are incurred when there is
less money existing."
Another way of looking at it is that, with more money being created through time,
the amount of revenues is always greater than the amount of costs, since most
costs are incurred when there is less money existing. Thus, because of inflation,
the total monetary value of business costs in a given time frame is smaller than
the total monetary value of the corresponding business revenues. Were there no
inflation, costs would more closely equal revenues, even if their recognition were

In summary, credit expansion increases the spreads between revenue and costs,
increasing profit margins. The tremendous amount of money created in 2008 and
2009 is what is responsible for the fantastic profits companies are currently
reporting (even though the amount of money loaned out was small, relative to the
increase in the monetary base).
Since business sales revenues increase before business costs, with every round
of new money printed, business profit margins stay widened; they also increase
in line with an increased rate of inflation. This is one reason why countries with
high rates of inflation have such high rates of profit.[8] During bad economic
times, when the government has quit printing money at a high rate, profits shrink,
and during times of deflation, sales revenues fall faster than do costs.

It is also new money flowing into industry from the central bank that is the
primary cause behind positive changes in leading economic indicators such as
industrial production, consumer durables spending, and retail sales. As new
money is created, these variables rise based on the new monetary demand, not
because of resumed real economic growth.

A final example of money affecting the fundamentals is interest rates. It is said

that when interest rates fall, the common method of discounting future expected
cash flows with market interest rates means that the stock market should rise,
since future earnings should be valued more highly. This is true both logically
and mathematically. But, in the aggregate, if there is no more money with which
to bid up stock prices, it is difficult for prices to rise, unless the interest rate
declined due to an increase in savings rates.

In reality, the help needed to lift the market comes from the fact that when
interest rates are lowered, it is by way of the central bank creating new money
that hits the loanable-funds markets. This increases the supply of loanable funds
and thus lowers rates. It is this new money being inserted into the market that
then helps propel it higher.

(I would personally argue that most of the discounting of future values [PV
calculations] demonstrated in finance textbooks and undertaken on Wall Street
are misconceived as well. In a world of a constant money supply and falling
prices, the future monetary value of the income of the average company would
be about the same as the present value. Future values would hardly need to be
discounted for time preference [and mathematically, it would not make sense],
since lower consumer prices in the future would address this. Though investment
analysts believe they should discount future values, I believe that they should
not. What they should instead be discounting is earnings inflation and asset
inflation, each of which grows at different paces.)[9]

Asset Inflation versus Consumer Price Inflation

Newly printed money can affect asset prices more than consumer prices. Most
people think that the Federal Reserve has done a good job of preventing inflation
over the last twenty-plus years. The reality is that it has created a tremendous
amount of money, but that the money has disproportionately flowed into financial
markets instead of into the real economy, where it would have otherwise created
drastically more price inflation.
There are two main reasons for this channeling of money into financial assets.
The first is changes in the financial system in the mid and late 1980s, when an
explosive growth of domestic credit channels outside of traditional bank lending
opened up in the financial markets. The second is changes in the US trade deficit
in the late 1980s, wherein it became larger, and export receipts received by
foreigners were increasingly recycled by foreign central banks into US asset
markets.[10] As financial economist Peter Warburton states,

a diversification of the credit process has shifted the centre of gravity away from
conventional bank lending. The ascendancy of financial markets and the
proliferation of domestic credit channels outside the [traditional] monetary system
have greatly diminished the linkages between … credit expansion and price
inflation in the large western economies. The impressive reduction of inflation is a
dangerous illusion; it has been obtained largely by substituting one set of serious
problems for another.[11]

And, as bond-fund guru Bill Gross said,

What now appears to be confirmed as a housing bubble, was substantially

inflated by nearly $1 trillion of annual reserve flowing back into US Treasury and
mortgage markets at subsidized yields.… This foreign repatriation produced
artificially low yields.… There is likely near unanimity that it is now responsible for
pumping nearly $800 billion of cash flow into our bond and equity markets

This insight into the explanation for a lack of price inflation in recent decades
should also show that the massive amount of reserves the Fed created in 2008
and 2009 — in response to the recession — might not lead to quite the wild
consumer-price inflation everyone expects when it eventually leaves the banking
system but instead to wild asset price inflation.

One effect of the new money flowing disproportionately into asset prices is that
the Fed cannot "grow the economy" as much as it used to, since more of the new
money created in the banking system flows into asset prices rather than into
GDP. Since it is commonly thought that creating money is necessary for a
growing economy, and since it is believed that the Fed creates real demand
(instead of only monetary demand), the Fed pumps more and more money into
the economy in order to "grow it."

That also means that more money — relative to the size of the economy —
"leaks" out into asset prices than used to be the case. The result is not only
exploding asset prices in the United States, such as the NASDAQ and housing-
market bubbles but also in other countries throughout the world, as new money
makes its way into asset markets of foreign countries.[13]
A second effect of more new money being channeled into asset prices is, as
hinted above, that it results in the traditional range of stock valuations moving to
a higher level. For example, the ratio of stock prices to stock earnings (P/E ratio)
now averages about 20, whereas it used to average 10–15. It now bottoms out at
a level of 12–16 instead of the historical 5. A similar elevated state applies to
Tobin's Q, a measure of the market value of a company's stock relative to its
book value. But the change in relative flow of new money to asset prices in
recent years is perhaps best seen in the chart below, which shows the stunning
increase in total stock-market capitalization as a percentage of GDP (figure 1).

Figure 1: The Size of the Stock Market Relative to GDP

Source: Thechartstore.com
The changes in these valuation indicators I have shown above reveal that the
fundamental links between company earnings and their stock-market valuation
can be altered merely by money flows originating from the central bank.

Can Government Spending Revive the Stock Market and the Economy?
The answer is yes and no. Government spending does not restore any real
demand, only nominal monetary demand. Monetary demand is completely
unrelated to the real economy, i.e., real production, the creation of goods and
services, the rise in real wages, and the ability to consume real things — as
opposed to a calculated GDP number.

Government spending harms the economy and forestalls its healing. The thought
that stimulus spending, i.e., taking money from the productive sector (a de-
accumulation of capital) and using it to consume existing consumer goods or
using it to direct capital goods toward unprofitable uses, could in turn create new
net real wealth — real goods and services — is preposterous.

What is most needed during recessions is for the economy to be allowed to get
worse — for it to flush out the excesses and reset itself on firm footing. Broken
economies suffer from a misallocation of resources consequent upon prior
government interventions and can therefore be healed only by allowing the
economy's natural balance to be restored. Falling prices and lack of government
and consumer spending are part of this process.

Given that government spending cannot help the real economy, can it help the
specific indicator called GDP? Yes it can. Since GDP is mostly a measure of
inflation, if banks are willing to lend and lenders are willing to borrow, then the
newly created money that the government is spending will make its way through
the economy. As banks lend the new money once they receive it, the money
multiplier will kick in and the money supply will increase, which will raise GDP.
"What is most needed during recessions is for the economy to be allowed to get
worse — for it to flush out the excesses and reset itself on firm footing."

As for the idea that government spending helps the stock market, the analysis is
a bit more complicated. Government spending per se cannot help the stock
market, since little, if any, of the money spent will find its way into financial
markets. But the creation of money that occurs when the central bank (indirectly)
purchases new government debt can certainly raise the stock market. If new
money created by the central bank is loaned out through banks, much of it will
end up in the stock market and other financial markets, pushing prices higher.

The most important economic and financial indicator in today's inflationary world
is money supply. Trying to anticipate stock-market and GDP movements by
analyzing traditional economic and financial indicators can lead to incorrect
forecasts. To rely on these "fundamentals" is to largely ignore the specific
economic forces that most significantly affect those same fundamentals — most
notably the changes in the money supply. Therefore, following monetary
indicators would be the best insight into future stock prices and GDP growth.

Kel Kelly has spent over 13 years as a Wall Street trader, a corporate finance
analyst, and a research director for a Fortune 500 management consulting firm.
Results of his financial analyses have been presented on CNBC Europe, and the
online editions of CNN, Forbes, BusinessWeek, and the Wall Street Journal. Kel
holds a degree in economics from the University of Tennessee, an MBA from the
University of Hartford, and an MS in economics from Florida State University. He
lives in Atlanta.

[1] See G. Reisman, Capitalism: A Treatise on Economics (1996), p.897, for a
fuller demonstration. Most of the insights in this paper are derived from the high-
level principles laid out by Reisman. For additional related insights on this topic,
see Reisman, "The Stock Market, Profits, and Credit Expansion," "The Anatomy
of Deflation," and "Monetary Reform."

[2] F. Machlup, The Stock Market, Credit, and Capital Formation (1940), p. 90.

[3] Ibid., pp. 92, 78.

[4] For a holistic view in simple mathematical terms of how the price of all items
in an economy may or may not rise, depending on the quantity of money, see K.
Kelly, The Case for Legalizing Capitalism (2010), pp 132–133.
[5] Price increases are supposedly adjusted for, but "deflators" don't fully deflate.
Proof of this is the very fact that even though rising prices have allegedly been
accounted for by a price deflator, prices still rise (real GDP still increases).
Without an increase in the quantity of money, such a rise would be
mathematically impossible.

[6] To gain an understanding of earning interest (dividends in this case) while

prices fall, see Thorsten Polleit's "Free Money Against 'Inflation Bias'."

[7] Most funds are borrowed from banks for the purpose of business investment;
only a small amount is borrowed for the purpose of consumption. Even borrowing
for long-term consumer consumption, such as for housing or automobiles, is a
minority of total borrowing from banks.

[8] The other main reason for this, if the country is poor, is the fact that there is a
lack of capital: the more capital, the lower the rate of profit will be, and vice versa
(though it can never go to zero).

[9]Any reader who is interested in exploring and poking holes in this theory with
me should feel free to contact me to discuss.

[10]This recycling is what Mises's friend, the French economist Jacques Reuff,
called "a childish game in which, after each round, winners return their marbles to
the losers" (as cited by Richard Duncan, The Dollar Crisis (2003), p. 23).

[11] P. Warburton, Debt and Delusion: Central Bank Follies that Threaten
Economic Disaster (2005), p. 35.

[12] William H. Gross, "100 Bottles of Beer on the Wall."

[13] It's not actually American dollars (both paper bills and bank accounts) that
make their way around the world, as most dollars must remain in the United
States. But for most dollars received by foreign exporters, foreign central banks
create additional local currency in order to maintain exchange rates. This new
foreign currency — along with more whose creation stems from "coordinated"
monetary policies between countries — pushes up asset prices in foreign
countries in unison with domestic asset prices.