A fresh perspective on the link between the macroeconomy and equity markets

JUDGING by the behaviour of the stock market, we are living in challenging times for mainstream finance. Under the hypothesis that markets are efficient and investors are rational, neoclassical theory assumes away the problem of financial bubbles and the linkages between equity returns and the rest of the macro variables. After a decade of unconventional monetary policies, massive fiscal deficits, and the return of inflation, however, equity market behaviour in recent years has been nothing short of perplexing, leaving most practitioners struggling to understand the vagaries of stock markets. Today, the workhorse neoclassical model requires a thorough review of its assumptions (and conclusions). Now, more than ever, we urgently need a comprehensive alternative.

Andrew Smithers attempts to fill in this gap with his latest book, The Economics of the Stock Market, which offers an alternative theory of how stock markets work. The book builds on a small and obscure tradition of growth models, pioneered by Nicholas Kaldor more than 50 years ago, which dealt with distributional issues in a Harrod-Domar-type framework. One of these iterations showed that in a closed economy with two sectors (households and firms) and no government activity, equity valuation multiples are determined solely by macroeconomic variables – crucially, by the equilibrium between aggregate savings and aggregate investment. Kaldor’s framework was quite novel in that stock market valuations integrated seamlessly into the macroeconomy and were responsible for bal ancing saving and investment, in contrast to the Keynesian and neoclassical traditions in which the equilibrium process works through quantities (unemployment rate) and prices, respectively.

Although Kaldor never intended his model to be a framework for understanding stock markets, Smithers draws on this setup to articulate a theoretical alternative. Smithers is also very “Kaldorian” in the way he constructs his framework, for two reasons. First, he is primarily interested in the long-run behaviour of the system, or steady-state solutions. Second, he relies on several “stylised facts” about stock markets to inform his assumptions. In particular, four variables have historically been mean-reverting to a constant, and any model should take these into consideration: