The Productivity of Stock Trading

Last week I was chatting with a co-worker about economics, and specifically about how the indirect nature of many economic processes makes them difficult to understand. This leaves laypeople vulnerable to simple but thoroughly wrong anticapitalist arguments.

One such area is the stock market. Its economic value is vastly underappreciated and popularly reviled. It is common to resent people who profit from stock trades because they didn't have to perform "real work" for it. Passive income from investments is also widely disliked, at least by people who don't have any.

What does the stock market have to do with economic progress? How does stock trading contribute to growth? Can it be rescued from the attacks of of the anticapitalists?

When I approach something like this I usually start by going to George Reisman's book Capitalism. Beginning on page 464 is an explanation that covers the following benefits of financial markets and institutions in general:

• They enable non-businessmen to earn a rate of return on their savings. This is a large population because most people do better as wage earners than businessmen, and includes people who are simply unable to run a business (the proverbial widows and orphans.)
• They encourage the investment of savings, promoting demand for capital goods and labor, as against stockpiling consumer goods or cash.
• They create concentrations of capital that make very large projects feasible.
• They promote capital accumulation when investment funds are channeled into productive rather than consumptive expenditures.
• They increase the savings rate by making it possible to consume without decumulating savings. (Not necessarily by increasing the incentive to save.)

On the stock market in particular, Reisman notes:

• People would be less likely to purchase newly-issued shares if it were subsequently difficult to trade them. Trading in already-issued shares makes it possible to quickly liquidate all or part of one's investment.
• Sale of already-issued shares may themselves finance spending on capital goods and labor, as when sold by a business owner to finance the purchase of a machine.
• Stock prices aid the decision of how a company should raise additional capital, and make it possible for successful companies to obtain capital more rapidly, increasing their competitiveness.
• The stock market protects stockholders from poor management through the threat of takeover.

To this, I would add a defense of the individuals involved in the capital markets. They do not deserve to be reviled as people who just trade but don't produce anything. Stock trading is productive work as much as is a manufacturing job. Indeed, the fact that traders tend to have a higher income than manufacturers suggests that their work is more economically valuable than the manufacturers. What is the nature of the productive work of stock trading?

Successful investment over the long run is the result of having a more correct prediction of future economic conditions than other market participants; that is, the ability to forsee the direction of (some part of) the economy.

The essence of this task is to allocate investments among the various possibilities — an enormous and difficult job. Which companies in which industries will be most successful? How does their current valuation compare to my own estimate of their worth? Should I trade in their stocks or bonds, or both, and how much?

The most successful investors also see when investment opportunities in the capital markets are not very appealing compared to investment in new businesses. A new business is a risky venture but may have an expected return greater than the opportunities in the capital markets. To say that "the whole market is overvalued" is to say that the most profitable investment opportunities lay outside the current market.

The successful investor need not be skilled in evaluating the potential of new business ventures himself; he may invest his money with a venture capital group which specializes in this activity. It is the investor's recognition that new businesses will yield better than existing ones that is important here, not the specific details of what new businesses would be created.

An issuance of new stock clearly raises capital for a business. Counterintuitively, so does trading in already-issued shares! This results from the fact that trading activity will tend to concentrate assets in the hands of the most skilled investors, who will be in a better position than the lay investor to know when new businesses should be created.

The overall economic effect of trading in the capital markets is to concentrate assets in the hands of those most capable of directing them toward the most profitable ventures, resulting in greater economic growth.

The bottom line is that stock trading is a wealth-creating activity. The mechanism of this creation is extremely indirect and not at all obvious — the trader does not create anything "with his own hands" — but his direction of capital does increase the rate of economic growth, and is praiseworthy.

UPDATE 2004-10-25 14:17:07 UTC: For those interested in a broader examination of this subject, Jeffrey T. recommends Fritz Machlup's The Stock Market, Credit and Capital Formation. The link is a free .pdf of the entire book, courtesy of the Ludwig von Mises Institute. I'll be reading it… shouldn't you? :)