Jenny Floki continues her beginner’s guides to economics. This week, she introduces the stock market and its role in modern economic crashes.
The stock market arrived at its modern form in around the 1800s. Throughout the years of its existence, through rumours as well as evidence of what it is capable of, it has been established as a vital element of the capitalistic economy as well as our nightmares. Only a few special people, â€œThe Investorsâ€, dare to dabble in it. They say that the stock market is considered the cornerstone of the capitalistic world in which we live because it facilitates capital formation and liquidity for entrepreneurs. What does this actually mean though, how does it work and why is it so important that it has its own featured segment in the news?
First, let’s imagine a situation in which four people are playing a game of Monopoly and see their progress at various stages of the game:
Stage 1: In the beginning of the game everyone wishes to buy as much property as possible and preferably of the same colour since this asset will enable them to create their real estate empire and therefore absorb the opponents’ money through rent. Everyone in the game is competing for the same thing. The funds are limited since bank loans are not allowed in the rules and players are only awarded 200 in Monopoly Money (M) each time they pass round the board. Let’s now assume that at some stage into the game, Player 1 (Alison) has two out of the three green properties and has just landed on the remaining green. Buying the property now is essential but she lacks the money to do so, so she decides to propose a new rule allowing her to ask Player 2 (Ben) to give her a loan that will facilitate the purchase of the desired property. In exchange, Ben will be entitled to a 10% share of Alison’s revenue whenever rent is due on one of her green properties. Hence, if the rent for any of the greens is, for example 100M, then every time Player 3 (Charlie) and Player 4 (Kirsty) land on the greens, Alison will get 90M net profit after Ben has received his 10% share of 10M. Consequently, every time Ben lands on Alison’s green properties he will only have to pay 90% of the property’s value as 10% comes back to him. In order for the deal to be confirmed, Alison writes on a piece of paper that she is committed to give 10% of her green property earnings. She does so and gives it to Ben as assurance.
Stage 2: Later in the game, Alison and Ben’s deal has proven rather successful since they both make money out of the other two players while at the same time Ben has secured cheaper rent for himself. Inspired by this initial deal, both of the other players start engaging in similar activities by exchanging their unwanted cards for percentage deals on each other’s properties. As a result, they have formed a new set of rules for this micro economy, in which, for the sake of their own profit, players now own a part of each other’s properties as well as their own. This is starting to somewhat resemble what is known is shareholding. As in stage one, to bind these agreements, contractual documents are written and signed by those players selling a portion of their property.
Stage 3: With all the properties on the board having been sold and houses and hotels, built, the players are competing against each other to avoid bankruptcy and accumulate as much capital as possible. Keep in mind that because players all own stakes in each other’s properties, in each transaction, a certain percentage of the revenue will have to be given away. Capital accumulation in this version of the Monopoly game is represented by property ownership, investment in houses and hotels, and share ownership. A few rounds ahead, Charlie faces financial difficulties and struggles to pay the money she owes to Ben for landing on one of his properties. In fear of potential bankruptcy, she proposes to pay half the debt in cash and substitute the other half by giving away her 20% shares in Kirsty’s pink properties. Ben accepts this offer and receives both the cash and the contract letter entitling him to shares in Kirsty’s property. A few more unlucky rolls of the die land Charlie on more rival properties so she adopts the same solution again. As a result, all her shares are given away to repay rent obligations. It’s worth noting, that the shares being traded are valued according to an agreement reached by her and whoever she is selling them on to as opposed to the value they initially held. Charlie manages to clear the last payment but unfortunately becomes bankrupt on her next go. Fast forwarding the game a little, we see that more and more capital is being concentrated to fewer and fewer players. Ben and Kirsty follow the same downward spiral to their finances as Charlie did until they too became bankrupt. Ultimately, Alison is claimed the winner of the game, having a monopoly on all properties and shares.
A key component of the capitalist world is constant economic growth as this is how success is measured in the real world version of this monopoly game. The stock market, where shares are bought and sold of companies rather than properties is the cornerstone of this growth. That is why following its daily trajectory is a mandatory feature in our news. Growth in this market oriented world comes from investments (the buying of shares) and in order for investments to be realised there needs be a large pool of available capital that ambitious businessmen can be given access to. Shares in a company are put up for sale on the public stock market by that company so that they can turn the potential value of the company into real funds with which to develop. In the monopoly game, Alison needed to acquire the last green property in order to expand her business and generate far more profit, and lacking the funds herself, had to find a funder to pay upfront who could trust in her chance at future success. It is this trust in un-guaranteed, potentially profitable returns that is at the heart of the stock market.
There are many such stock markets around the world that operate under the supervision of financial authorities recognised by the state. Through these, investors can access the available information on various companies and decide which business has the potential for higher profit, should they choose to purchase shares in them. These profits can take the form of dividends, which are when a company, following a successful period pays out a portion of its profits to its shareholders. They can also profit by reselling the stocks they own at a later date for a higher price than they bought them.
The stock market can be thought of as an enormous internationally played board game. Millions of players/investors are sitting around it and trying to make the right investment decisions as well as buying critical property blocks that will generate them vast amounts of money in both the short and long term. When they succeed, they use their extra capital to further accumulate other players’ assets and the cycle goes on. This game involves so many participants and extends to almost every corner of the globe which makes transparency and communication amongst players a difficult task.
In this frenetic capital accumulation game that goes on for centuries, every player wants to be the winner regardless of how many others they exploit and how much instability they bring to the economy. In many circumstances, reckless trading activities can massively affect the wider economy outside the stock market which, since the beginning of the 20th century has seen regular major crashes.
Letting the market go on without state supervision and intervention enables dangerous financial activities, creating an extremely fragile wider economic system based on trust in constant economic expansion. It takes only a single external shock such as the housing market crash of 2008 or a pandemic outbreak such as the Covid-19 crisis we are currently experiencing to completely undermine and destabilise the system. It is historically observable that these kinds of disturbances can very quickly transcend from a financial crisis into a real economy crisis. Though we are not obliged to play the game of the stock market ourselves, we as populations very often have to bear the burden of paying for its mistakes. Most of the time in such situations, governments choose to bail out the largest companies in their times of need, rather than confronting them for their damaging activities.
Apparently, free market financial activities often derail the real economy rather than helping it to improve. There is no such thing as indefinite economic growth. It is not sustainable and does not take into consideration the wellbeing of the majority of people. In the modern world, the stock market promises distribution of wealth through a trickle-down effect that will arise through higher employment and new technological developments however what we see is the contrary. Income inequality is higher now than ever, with the CEO-to-worker compensation ratio (the difference between company executives and average worker’s pay) up 940% since 1978.
It is time to turn the game in our favour by demanding more state intervention to reign in the rampant activities of private companies and the inevitably destructive nature of the stock market. It is among the most powerful forces in the world with wide reaching effects on the planet and its inhabitants, human or otherwise. Let’s make some new house rules that aim to build a better real economy for the real people in it.