Under popular understanding, the share market allows people to invest in the economy’s production. Savings are channelled into productive investments. GDP increases as the invisible hand guides savings to the most productive investments. This picture is largely false.
Most share transactions are for existing shares. They merely shuffle money between people who buy and people who sell shares. Accompanying this shuffling of money is a shuffling of dividend rights. There is no increase in investment in the real economy. The only situation where investment increases is when a company issues new shares, but this is a minority of transactions.
What then does this shuffling of money achieve? Consider the motivations of those who buy shares and those who sell shares. The buyer is typically a saver, who seeks higher returns on their savings. The seller is typically a rentier, who lives off buying and selling shares. When a share transaction occurs, savers transfer their money to rentiers. Rentiers then use the money to support their lifestyles. In this sense, a share transaction transmutes savings into consumption.
In converting savings to consumption, the share market increases the velocity of money. Under capitalism, people save money for retirement. In the case of the rich, they save to acquire more money. Such saving impairs the velocity of money, as it idles in deposit accounts, rather than driving consumption. This threatens to undermine GDP. The share market recirculates savings as rentier consumption, which increases GDP.
A concrete example can illustrate this process. Suppose that Sundar Pichai has just received his $200 million paycheck. No matter how much he purchases to his heart’s content, he only manages to spend $50 million on his consumption. The remaining $150 million is saved. If it goes into the bank, there is a dead end to the money circulation. The bank could loan out $150 million, but banks do not loan merely because they have more reserves. QE proves as much. When banks were provided with trillions of reserves, this failed to translate into trillions in loans.
Instead, Sundar purchases $150 million of Microsoft shares. That $150 million is received by a hedge fund. That hedge fund then buys another share. The money continues moving between share sellers and buyers, but at some point, it must exit the market. Money going in must also result in money going out, no matter how much it ‘bounces’ between participants. There is no place in the stock market to ‘store’ the money. In this case, it exits the market when Vanguard liquidates shares to pay out 401(k)s. Newly minted retirees then spend the $150 million on healthcare, restaurants, and Broadway shows. In this way, Sundar’s savings are transmuted into the retirees’ consumption.
The share market ultimately rewards efficient companies, but only indirectly. By increasing GDP, efficient companies can recover money on investments. This allows them to continue growing and justifies increases in their share price.
Let us continue following the circuit of Sundar’s money. The businesses frequented by retirees spend money on various services, such as computer and cloud software from Microsoft. Microsoft’s profits increase, causing more savers to buy its shares. What began as a share purchase has ended up funding further increases in the share price, paying for itself. The circulation of money achieves marvellous things.
