Stock Markets and Money Creation

On the recent QE debate, the main issue discussed by the participants is whether or not the asset swap of Treasury securities for "cash" is inflationary or deflationary. What we should also focus when defining what QE does, is finding out what it affects. According to traditional (neoclassical) economic theory, for inflation to rise (or to occur) the money money supply needs to be increased. This means that money needs to be created, via the usual monetary policy transmission mechanism, the banking sector, or by employing the printing machine. As I have argued in a previous post, although it is doubtful whether QE can actually do that, it is very successful when it comes to increasing stock prices. This, as I will later argue, if it is persistent, will increase inflation expectations and thus boost the economy.

Thus, the question is: can the stock market increase money supply? The short answer is yes, if it has a persistent increasing trend over some time, as I will shortly argue. 

Assume we have a closed economy (for simplicity) where we have a fixed amount of money supply (M), a stock market exists with just 1 company listed (again, for simplicity) and some amount of agents (i.e. consumers/investors). Then, we can safely assume that the profits of the listed company will represent the state of the economy (i.e. if the economy grows, profits grow. If it contracts, profits contract) and thus its stock market valuation will represent both the current state of the economy as well as the agents' expectations about its future state. 

If the agents decide to put some of their money in the stock market, they will do it with the purpose of having some gain in the future (otherwise it will be just foolish). If the economy is growing, it is likely that more and more people will want to invest some of their money in the company, hoping that its rising profits will result in rising prices (or higher dividends), thus rendering them some profits. If we assume that the company price was €1 at time 0 (when we start observing this economy), with a capitalization value of €1bn for €100m profits, an increase in the price to €2 would mean that the market capitalization of the company would be increased to €2bn. Yet, as the reader may observe, this extra €1bn came out of thin air! Thus, at the end of the day, money supply has been theoretically increased by €1bn without any money printing and without any lending by the banks.

Nevertheless, this amount cannot be used to purchase goods or services (unless it is employed as collateral for loans) since it represents what traders call "paper profits". This are profits which have not yet been realized (i.e. you have not sold the shares you own yet), yet the potential for realizing them exists. If everyone tries to sell their shares when the price reaches €2, it is more than likely that the price will fall, maybe to a level even lower than the starting one. If this happens, then although many will have profited from their speculation, many will suffer losses, making it unsure whether the actual money stock has been increased or decreased. Thus, what we need is a sustainable higher level of stock prices, one which would make the realization of paper profits and the increasing of the money stock possible (for those wondering what happens to the money stock with constant buying and selling until it reaches the €2 level, it increases. Yet for simplicity we do not use this here). 

Increasing the money stock would mean that prices (i.e. inflation) would also increase. With inflation rising, investment would soon follow and the economy would continue its course. Yet, for this we need the stock market price to follow an upwards trend not just for a few periods but for longer. The rationale behind this is both because of the need of investors to be reassured that the trend is here to stay as well as for them to have time enough to both invest (i.e. reduce consumption) and sell out (i.e. increase consumption and money). As a consequence, even if in the short run, we may experience deflation or disinflation, it is more than possible to experience inflationary pressures in the medium- and long-run. (for the chain of events after QE see chain of causality here)

Japan is a good example in this case. Rising Nikkei prices lead to increased inflation as the real estate bubble grew larger and larger and by the time inflation reached its peak in early 1991, the Nikkei had already began its downwards trend which basically lasted until early 2013, when Shinzo Abe's policies intended to boost the economy. Any notion of GDP reduction causing the stock market fall can easily be discarded as the graph indicates that the fall in GDP occurred six year later, in 1996, although a flattening of GDP can be seen in the 1990-1991 period.

Nikkei values up to 31/12/1990. Source Yahoo! Finance

Nikkei values from 1991 to 2013

What should be noted is the decrease in money supply, an outcome of the bubble, over the 1990-1991 correction period, which, combined with the stock market crash, resulted in a reduction of the GDP growth rate from 2.5% to approximately -0.3% in just one year. Nevertheless, as stated above, GDP continued to rise over time, with an upward trend visible (albeit much smaller than before).

Most importantly, what holds of inflation, can also hold for deflation in our case. Thus, if a protracted period of falling stock market prices occurred in the economy, it would, in its turn, decrease the money stock, which would cause either disinflation or deflation. What should be noted, of course, is that although the stock market has an effect on the money stock, this is an outcome of the policy implemented and not of the market itself. It may be true that we cannot have a protracted period of deflation unless we self-induce it, yet, it is more than possible for deflationary pressures to exert their powers in the market over the short-run. Thus, through the use of QE, increased stock market prices would result in higher inflation expectations in the future but only if they can last long enough to make this point credible.