The Real Effects of Financial Markets

January 2nd, 2012

In a new NBER working paper, The Real Effects of Financial Markets, researchers Philip Bond, Alex Edmans, and Itay Goldstein investigate the interaction between the stock market and the real economy.

On this site we frequently discuss the intrinsic value of firms as the discounted value of future cash flows, and we note (as nonbelievers in the Efficient Market Hypothesis) that individual security prices often diverge quite dramatically from this true value. Determining why this occurs is an unresolved quest, but it appears to me that this paper contributes to the objective. Consider these questions raised in the study:

Why do managers constantly track the performance of their firms’ stocks? Why does the press so frequently report the developments in the stock market? Can this be rationalized in a world where secondary market prices are passive (i.e., epiphenomenal), in that they merely reflect expectations about future cash flows and do not affect them, as in many economic models, including most of those used in the asset-pricing literature? Related, is it plausible that secondary-market prices are purely passive, and have no effect on real decisions, given that a vast empirical literature documents how much information prices contain about future cash flows?

The authors point to a feedback loop between the secondary market and the real economy:

George Soros, a prominent trader, has termed this feature “reflexivity,” and summarized it as follows: “In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect.” In reviewing the theoretical literature, we show that accounting for the feedback effect from market prices to the real economy significantly changes our understanding of the price formation process, the informativeness of the price, and speculators’ trading behavior.

Though in the early stages, this area of research could give way to important practical implications, from regulation to corporate governance, as well as asset pricing.

Here’s the abstract:

A large amount of activity in the financial sector occurs in secondary financial markets, where securities are traded among investors without capital flowing to firms. The stock market is the archetypal example, which in most developed economies captures a lot of attention and resources. Is the stock market just a side show or does it affect real economic activity? In this article, we discuss the potential real effects of financial markets that stem from the informational role of market prices. We review the theoretical literature and show that accounting for the feedback effect from market prices to the real economy significantly changes our understanding of the price formation process, the informativeness of the price, and speculators’ trading behavior. We make two main points. First, we argue that a new definition of price efficiency is needed to account for the extent to which prices reflect information useful for the efficiency of real decisions (rather than the extent to which they forecast future cash flows). Second, incorporating the feedback effect into models of financial markets can explain various market phenomena that otherwise seem puzzling. Finally, we review empirical evidence on the real effects of secondary financial markets.

Read the full paper here [PDF].

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