Share market growth isn’t the same as economic growth, in fact they go the opposite way

Edit: After I’d written this post I realised that John Ross had written a similar post here. I hemmed and hawed about whether I should post this but decided to in the end. Go visit John’s blog, it’s very good.

Edit 2: I am not Slajov Zizek. I don’t know why the Slajov Zizek image is showing up as the primary image in some places I share this, I wanted the graph to be the primary image. Sorry for any confusion.

I. The relationship between stockmarket growth and GDP growth is not what you think

Economic growth gets a bad rap sometimes, but ultimately any improvement in infrastructure, any improvement in how we do things etc. etc. is going to be reflected in economic growth. GDP per capita is far from a perfect measure of welfare, but it does have a reasonable correlation with many important metrics including lifespan, subjectively rated happiness and stability.

There’s a common misconception among non-economists that increases in share market prices reflect GDP growth. In fact they are distinct. More than distinct though, there is actually evidence they are opposed. That is to say Rising sharemarket prices are correlated with slower economic growth, and vice-versa. If this is true, if you want GDP growth, you should actually hope for lower share-market growth.

J.R. Ritter(1) finds:

Over the 1900–2002 period, for sixteen countries representing perhaps 90% of world
market capitalization in 1900, there is a negative correlation between per capita income
growth and real equity returns.

In fairness, the negative relationship between share market performance and per capita growth is not overwhelmingly strong, but it is visible in Ritter (2005), even if you eyeball it.

This is stuff is known among stock experts. For example Seigel in Stocks for the Long Run (2) writes:

In this chapter we have shown that faster economic growth in no way guarantees higher returns. In fact, based on the historical data, slow growing countries, because of their more reasonable valuations, have tended to have higher returns than fast-growing countries.

If you want to see the relationship with a regression line drawn on, Seigel helpfully includes the following graph:

You may be thinking “but when the economy tanks the share market usually crashes. Doesn’t this show a relationship?” It is true that the stock-market often crashes during recessions and depressions but the relationship we are talking about here is a long-term relationship. Sudden shifts in the stock market and GDP growth sometimes mirror each other, but the longer term relationship is not so joined.

II. Why do people mistake economic growth and share market growth? A theory of ideology.

Why then do people assume that there is a positive relationship between economic growth and share prices? Ideology.

Hang on though, what do I mean by that?

Ideology to my mind is a combination of two things:

Ideology= (An easy mistake) + (A reason for the powerful to encourage that mistake)

Because the equivocation of economic growth and asset growth is easy to make and benefits the owners of shares, typically among the most powerful people in society the equivocation gets made. Every easy mistake that benefits powerful people will be made again and again, crawling like cockroaches out of the walls no matter how many times you refute them. By ideology then, we mean something analogous to Gramsci’s concept of “Common sense”.

After all, from a certain point of view the equation of share market growth with real growth is quite natural. The people who think the most about economics in our society are rich, and for them share market growth kind of might as well be economic growth- it is growth in their wealth and income.

As to why it’s an easy mistake to make, share market figures:

1. Come out every weekday

2. Have a nice unambiguous quantitative form

3. Seem to touch on every part of the economy

4. And usually fall quite rapidly during periods of negative economic growth, especially at the start.

In general the substitution of something more easily and rapidly quantifiable in place of the true variable of interest is a pretty universal human error. In some cases it’s unavoidable. I’ve even heard it argued that part of what allowed the economic rot to set in during the gilded age before the Great Depression was the availability of share-market statistics. Everyone felt like the economy was booming because the share market was always rising. I can’t comment on the accuracy of this theory, not being an economic historian, but I can certainly see how it is plausible.

III. So why are share market growth and economic growth opposed?

Good question, and one that goes beyond me to answer. However Kieran Latty has some data on on this that I think may be pertinent. Basically Kieran finds that the more important the share market as a source of financing, the lower investment:

What if then the issue is a negative between the size of the share market and the rate of investment? There is growing evidence that large equity markets and high financialization generally may be associated with lower investment. Thus growth may be lower in countries with vigorous equity markets because of reduced investment.

Ritter(1) sums up Krugman and Young’s view on the matter as follows:

“Krugman (1994) and Young (1995) have argued that the high growth in East Asia that has occurred in the last 50 years has been due largely to increased factor inputs—a high personal savings rate and increased labor force participation,combined with rapid improvements in health and educational attainment. Neither of these necessarily benefit the owners of capital.”

Why is investment lower when returns to equity are higher? Because capital needs higher and faster returns before it will be invested. Short-termism results, and many opportunities for investment that would be perfectly good in other countries are turned down(4).

IV. Implications

It is usually thought that the rich have a financial interest in economic growth. Actually, if rich people are disproportionately more likely to hold shares (and they are), and a negative relationship between share prices and GDP growth holds, the rich may actually be less eager to see economic growth than the rest of the population. They may even all-things-considered benefit from lower economic growth.

Given a negative relationship between share market growth and GDP growth It may be in the best interest of the state to discourage the formation of a large and powerful equity market.  To allow powerful equity market is to create a powerful lobby of people who are uninterested in economic growth, and that’s surely a bad thing. At the moment governments around the world seem intent on encouraging workers to prepare for retirement by putting money into share portfolios. There are many concerns about this strategy(5), but to this list of concerns we might add the dangers of incentivizing wealthy retirees to oppose economic growth.

But above all, I would strongly advise against anyone who does not own substantial share assets from voting on the basis of sharemarket increases. Since economic growth is good for most people, sharemarket increases are not, contrary to popular opinion, a positive sign. If anything you should vote in the opposite direction.

References

(1) Ritter J. (2005) ‘Economic growth and equity returns’, Pacific-Basin Finance Journal

(2) Siegel, J. (2008) Stocks for the Long Run 4th edition McGraw Hill

(3) Kieran, L (2011) Income distribution, growth and social-welfare: towards an economic solution to the growth-equality trade-off problem Honours thesis, the University of Sydney political economy department.

(4) Gutierrez, G. & Philippon, T. (2016) INVESTMENT-LESS GROWTH: AN EMPIRICAL INVESTIGATION, NBER Working paper

(5) Bryan, R. (2004) ‘Superannuation: the ricardian crisis’. Journal of Australian Political Economy