Stock markets hold power

Senior Economic Analyst

Economists often say that the stock markets don’t reflect the real economy, at least in developing countries like India. On the face of it, this seems logical. A little over 6 per cent of Indians have demat accounts, two-thirds of them were added in the past three years and half of them opened accounts in the two Covid years. This sharp rise is almost inexplicable, considering it came at a time when businesses were shutting down, and the middle classes faced their worst financial crisis in decades.

Economic recipes of mainstream economists are mainly meant to deliver the best returns to equity investors.

One possible explanation is that households which had only one demat account holder, got new accounts for other members to make the most of the large number of IPOs which came in the past couple of years. That means, not more than 2-3 per cent of households in India would have investments in stocks. If we were to double the numbers for those who have invested in mutual funds, without opening demat accounts, it will still be around the 5-6 per cent of families who have a connection to the stock markets.

That is good enough reason to believe that the stock markets do not affect the lives of 95 per cent of Indians. Nothing could be further from the truth. Those who invest in the markets decide economic policies for all of us. And whether mainstream economists know it or not, their economic recipes are all meant to deliver the best returns to equity investors.

There is no better example of this than the way authorities, the world over, deal with inflation. Orthodox economists have two broad arguments about what causes prices to rise. The first is that the general level of prices is determined by the total amount of money that is in circulation and how fast currency notes change hands. If governments borrow and spend too much, they end up increasing the supply of money. The same happens when central banks print notes and allow businesses and people to take easy loans. That is when too much money chases the same amount of goods and services, and this causes high inflation.

The way to deal with inflation, therefore, is for governments to spend less and for central banks to reduce money supply. The quickest way to do that is to raise interest rates. When rates go up, consumers and businesses borrow less and spend less. That automatically reduces the demand for goods and services and tames inflation.

The second argument has to do with employment and wages, and it is a corollary of sorts of the monetarist thesis. If there’s too much easy money available, businesses borrow and increase output at a fast pace. As they invest more, they hire more people. Soon, the economy reaches a stage of full-employment. Now, if any business wants to set up a new factory or expand output, they have to poach workers from other factories. Workers only come if they are paid higher wages. They also demand easier work hours. Soon, all businesses have to pay their workers more and work them for fewer hours in a week. This increases their costs, and this increased costs is passed on to consumers as higher retail prices.

Workers soon discover that inflation is eating into their higher wages, and they demand even more. They also expect inflation to keep rising, and this ‘inflation expectation’ drives them to ask for even bigger wage-hikes. It becomes a self-fulfilling prophecy – high employment pushing up wages, increasing production costs, which, in turn, leads to a rise in retail prices, causing heightened inflation expectations amongst workers, who then demand more wages, and cause even more inflation.

What is the remedy? Economists will tell governments to cut back on spending, and implore central banks to tighten the money supply. They will say that the economy is overheated and the only way to cool it down is to squeeze new investments. This will reduce employment levels and force workers to accept lower wages. The drop in the wage bill will lower costs and retail prices will also come down, bringing down the overall level of prices in the economy.

It is taken for granted that profits should not be touched to reduce inflation. The only reason to target wages to tame inflation is to ensure that profit margins remain intact. If governments reacted to inflation by controlling prices and forcing businesses to maintain wages, it is the entrepreneur who would have to sacrifice profits. And that would affect the value of the shares of companies, because their valuation is dependent on future profits. So, governments and central banks, across the world, follow whatever mainstream economists prescribe to ensure that inflation targeting is done at the cost of the worker and never that of the capitalist.

But this, too, is only half the story. While individual capitalists are driven by the will to maximise profits, the capitalist system, as a whole, is driven by accumulation. If governments and central banks tackle inflation by slowing down investments, they effectively hurt the prospects of this very accumulation process. If the pace of growth outstrips the rate of wage inflation, capitalist profits will not be affected by inflation at all. It is possible for inflation and wages to rise, but still grow at a slower pace than the rate of rise in profits.

The real reason why governments and central banks target inflation is because the world is ruled by finance capital. If inflation rises, the value of financial assets goes down. After all, a 10 per cent return against 4 per cent inflation is much better than a 15 per cent return against 11 per cent inflation. This is the reason why inflation targeting has become the universal dogma in countries across the world, so that financial assets do not lose their value.

That is why even if the stock markets do not directly involve 95 per cent of the population, what happens there determines everyone’s economic existence.

The author is a senior economic analyst