God is a Capitalist

Saturday, December 7, 2013

What we have here is a failure to coordinate



                The great Austrian economist Ludwig Lachmann described the way the stock market works better than any economist I have read. He taught that expectations play a vital role in coordinating the decisions of entrepreneurs in the market process. Spot prices communicate important information, but only information about the past. For the economy to function well, that is, stay out of recessions, markets must coordinate the expectations of buyers and sellers, producers and consumers. Recessions are nothing but a failure to coordinate. Markets communicate expectations through the futures markets, including options and other derivatives, but primarily through the stock market.
                Following are excerpts from Lachmann’s books on the vital nature of the stock market to a well-functioning market economy. Lachmann shows that the market is neither mechanical, as the EMH suggests, nor irrational as behavioral finance insists. 



The Stock Exchange... offers an instance of trading in 'continuous futures'. If I buy a share I buy not merely this year's dividend and next year's dividend but, in principle, an infinite and continuous series of dividends, a 'yield stream'. In buying it I thus express explicitly a series of expectations about dividends, and implicitly an expectation about the future yield from other assets I might have bought instead... If the directors of a company announce a bold expansion programme, the effect of their announcement on the price of their shares tells them whether or not the market agrees with their expectations: If price falls it means that the market takes a less optimistic view of the company's prospects, and such a price fall will convey a warning signal to the directors that they must walk warily.
The Stock Exchange is a market in 'continuous futures'. It has therefore always been regarded by economists as the central market of the economic system and a most valuable economic barometer, a market, that is, which in its relative valuation of the various yield streams reflects, in a suitably 'objectified' form, the articulate expectations of all those who wish to express them.[1]

The above throws some light on the function of the stock market in the market economy. Here, shares of different capital combinations, consisting essentially of fixed capital goods, are continually being evaluated. The stock exchange not only registers success and failure, but also expresses expectations about the prospects of plans already set in motion. The stock exchange may be viewed as the central forward market for future capital yields of indefinite horizon. Buyers and sellers on the exchange express their expectations about the chances of various plans, and thereby also evaluate the underlying capital combinations.
The function of the stock exchange is the same as that of any forward market, namely, to distill from many individual expectations a ‘market expectation,’ finding its expression in the stock price, to which each interested person may orient himself. The equilibrium price of the stock market is determined, not by an ‘objective’ body of information [e.g., NPV], but by the respective expectations of buyers and sellers. That this price changes from day to day indicates the sensitivity of the price-forming mechanism with regard to expectations, and not the impaired capability of the stock market to function; for the function of the stock exchange, as of any market, is not to guess the future but to reconcile, as much as possible, present actions that extend into an uncertain future.[2]

In fact it is hardly an exaggeration to say that without a Stock Exchange there can be no market economy. What really distinguishes the latter from a socialist economy is not the size of the ‘private sector’ of the economy, but the ability of the individual freely to buy and sell shares in the material resources of production.  Their inability to exercise their ingenuity in this respect is perhaps the most important disability suffered by the citizens of socialist societies, however large their incomes might be, however wide the range of choice of consumption goods that may be available to them.
In the traditional view the chief function of the Stock Exchange is to serve as a channel through which savings flow before they become transformed into additions to the capital stock. Keynes taught us to regard the apportioning of the flow of savings to various investments as a function subsidiary to the constant turnover of an existing stock of securities prompted by divergent expectations. Thus, seeing the importance of expectations in asset markets, and disliking the implications of what he saw, he launched his famous diatribe on the Stock Exchange as a ‘casino.’
The Stock Exchange consists of a series of markets for assets, i.e., future yield streams. In each market supply and demand are brought into equality every market day. Demand and supply reflect the divergent expectations of buyers and sellers concerning future yields. Transactions take place between those whose expectations diverge from the current market price. Since as much must be bought as is sold, we may say that the equilibrium price in an asset market reflects the ‘balance of expectations.’ As without divergence of expectations there can be no market at all, we can say that this divergence provides the substrate upon which the market price rests.
Since all assets traded on a Stock Exchange are substitutes, albeit imperfect substitutes, for one another, these markets form a ‘system.’ And as equilibrium is attained simultaneously in each market which forms part of it, our system is free of those problems which in the Walrasian system are apt to arise when equilibrium is reached in some markets before it is attained in others.
In this way the market economy accomplishes daily a consistent, because simultaneous, valuation of all its major productive assets. The practical importance of this fact is that it makes possible, whether in the form of ‘take-over bids’ or otherwise, the transfer of the control of material resources from pessimists to optimists, i.e. to those who believe they can make better use of them than others can. Critics of the market economy who scoff at the continuous  and often violent day-to-day fluctuations of share prices, have failed to notice that an equilibrium price which rests on a balance of expectations is bound to be flexible since it must change every time the substrate of this balance changes. For precisely the same reason for which equilibrium in an asset market is reached so smoothly and speedily, it cannot last longer than one day. For expectations rest on imperfect knowledge, and not even a day can pass without a change in the mode of diffusion of knowledge.[3]




[1] Ludwig M. Lachmann, Capital & Its Structure, Kansas City: Sheed Andrews and McMeel, 1978, p. 68.
[2] Ludwig M. Lachmann, Capital, Expectations, and the Market Process, Kansas City: Sheed Andrews and McMeel, 1977, 124. 125.
[3] Capital, Expectations, 161, 162.
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