The Economics of the Stock Market

216 Pages·2022·3.88 MB·English

by  Andrew Smithers

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The Economics of the Stock Market
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PRAISE FOR THE ECONOMICS OF
THE STOCK MARKET
‘Awe- inspring, encompassing, convention-f louting analysis, hard stick-y our- neck out
empirical discoveries, and counter-i ntuitive hypotheses. Endlessly stimulating and
intensely useful.’
Avner Offer, Chichele Professor Emeritus of Economic
History, University of Oxford
‘This is a bold book that questions virtually all the assumptions of prevailing neoclas-
sical theory. By rejecting the concept of the “representative agent”, proposing instead
that households and corporate management have totally different motivations,
Smithers shows how finance plays a crucial role in explaining developments in the
real economy. Leverage, ultimately driven by demographics, raises growth but
threatens it too. His attacks on theory, particularly the Modigliani-M iller theorem, are
supported by careful empirical work that also reveals important and unexpected
financial constants. Throughout, the book sparkles with insights based on decades of
close observation of how financial markets really work. Theorists must confront this
reality, not try to ignore it.’
William White, Senior Fellow at the CD Howe Institute and former
economic adviser to the Bank for International Settlements
‘Andrew Smithers addresses fundamental questions about the operation of financial
markets and their interaction with corporate decisions. He does so in a way that
leads him to question a great many of the predictions of corporate finance and of
resource allocation that are taught to students of economics. Some will part com-
pany with him along the journey but few will be bored and all will benefit from hav-
ing propositions central to their world view questioned.’
David Miles, Professor of Economics, University College London
‘Most economists tend to think of financial markets as being efficient, notwithstand-
ing an increasing body of evidence that there is a predictable component to move-
ments in share prices. In this book Andrew Smithers sets out a view very different
from the mainstream position of how share prices are determined. A key feature of
his analysis is that periods of high returns are likely to be followed by periods of low
returns—there is low frequency negative serial correlation. The book provides an
account of the factors that can give rise to this, based around the argument that dif-
ferent market participants have very different objectives and views of what risk is.
The book poses a substantial and important challenge to financial economics. It is
therefore important that the book should be published and the author’s views
debated.’
Martin Weale, Professor of Economics, Kings College London
‘This is a very formidable project and great accomplishment! The author has pro-
duced both a comprehensive critique of received doctrine and a constructive
approach to a macroeconomics that integrates finance with the real economy.’
Bill Janeway, economist and venture capitalist (Warburg Pincus)
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‘Advances a major new paradigm for the relationship between securities markets and
the economic system. Andrew Smithers’ insights have been stimulated not least by
the opening decades of the twenty- first century, with monetary authorities across
the globe mired in more or less blind recourse to so-c alled quantitative easing (QE)
on a vast scale—and with the economics profession conspicuously at a loss to judge
the impact of this policy on the course of events.’
Peter Oppenheimer, Student, Christ Church Oxford
‘Andrew Smithers is a free thinker, happy to confront conventional corporate finance
theory in the several respects in which this latter has gone astray. He does so on the
basis of careful study of the data combined with much practical experience and great
analytical ability. In particular, his assessment of the woeful implications of the
bonus culture on the incentives and decisions of corporate managers is of first-order
importance.’
Charles Goodhart, Professor Emeritus LSE and
a former chief adviser to the Bank of England
‘This is Andrew Smithers boldest sortie yet in his battle against the Efficient Market
Hypothesis, the doctrine that financial markets always price shares correctly on aver-
age, so that finance can be excluded from analysis of the economic equilibrium. As
Smithers convincingly shows the neoclassical macro model is poorly supported
empirically. Drawing inspiration from Keynes, he calls on economists to provide a
theory which accords better with reality—and human welfare.’
Professor Lord Robert Skidelsky
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The Economics of the
Stock Market
Andrew Smithers
1
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1
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© Andrew Smithers 2022
Foreword © Andy Haldane 2022
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First Edition published in 2022
Impression: 1
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British Library Cataloguing in Publication Data
Data available
Library of Congress Control Number: 2021947441
ISBN 978–0–19–284709–6
DOI: 10.1093/oso/9780192847096.001.0001
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To Kit and Pelham
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Foreword
Andy Haldane
Chief Executive, the RSA
Larry Summers once famously observed, tongue-i n- cheek, that much of
modern- day finance theory concerned itself with pricing a second bottle of
ketchup, once the price of the first bottle was already known. While an over-
statement, this quip contained an element of truth. Much of modern finance,
and in particular asset pricing, theory relies on arbitrage relationships
between different asset types (the second bottle of ketchup), largely taking as
given macroeconomic fundamentals (the first bottle). Finance and econom-
ics were, in this sense, fundamentally detached.
That theoretical detachment between asset pricing and fundamentals, or
between the financial and real sides of the economy in these models, pre-
vailed only under some strict behavioural assumptions. Prominent among
these were that the limits to arbitrage between asset types (bonds and equi-
ties, long- and short- duration assets) were small and short- lived and that the
behaviour shaping these markets could be well approximated by that of a
single representative investor and household. In other words, companies’
behaviours typically played a somewhat secondary role, if at all. And so too
did heterogeneity between investor and household types.
Although highly stylized, this approach to modelling found its way into
many mainstream macroeconomic models from the 1980s onwards. Many
of these models viewed both money and finance, and the corporate sector, as
a ‘veil’ which could effectively be looked through when understanding the
drivers of the economy. Financial factors—the financial sector and financial
markets—had at best a secondary role in explaining business-c ycle dynamics
and likewise the financing and investment choices of companies. These
omissions were a not insignificant contributor to the intellectual oversight
that culminated in the Global Financial Crisis of 2008/09.
This stylized approach to asset pricing and financial choice also dominated
academic discourse over much of the past half- century. Often, this focused
on the co- determination of asset prices across different risk classes and dur-
ations. In the 1970s and 1980s, this led to the identification, and indeed pro-
liferation, of various asset pricing puzzles—the ‘equity premium’ puzzle, the