Why do stock markets exist?

What your pension is doing in the meantime

Money leaves your pay before you ever hold it, and something is done with it for a very long time. If you retire at sixty-five, a contribution made at twenty-five has to be put to work for forty years before it is handed back to you, and it is not left in a drawer. It is used to buy small pieces of companies you will never visit, in industries you may never think about, chosen by managers you will never meet. The arrangement asks a good deal of trust, and it raises a plain question that the account statement never answers. What is the money actually doing in the meantime, and how can it be locked into ventures that take decades to pay off while also being there for you the day you stop working.

The answer runs through an institution most people picture as a trading floor or a scrolling ticker, and misunderstand accordingly: the stock market. Seen from the outside it looks like a place for gambling on prices, and part of it is. But the reason it exists, the job it does that nothing else does as well, is quieter and stranger than the ticker suggests. A stock market is a machine for turning a commitment that lasts decades into one you can undo in an afternoon, and that trick is what makes it safe for ordinary savings to fund things that take a very long time. Where your pension money goes to retire, and who pays for that retirement, is a question this volume shares with the chapters on pensions and the welfare state (Volume IV, on who pays for old age). This chapter takes the narrower half: why the market that holds your savings exists at all, and why speculation has ridden along with it from the first day.

The thing a market actually sells

Begin with the problem the market solves, because the institution makes no sense until the problem is clear. Many of the most valuable things an economy can do take years to pay back. A shipping voyage in the seventeenth century might sail for seven years before its cargo came home; a railway, a mine, or a semiconductor plant ties up money for a decade or more before it returns a penny. The venture needs that capital committed for its whole life, because a half-built railway is worth nothing. Yet the people whose savings could fund it are not willing to lock their money away for a decade, because a saver may need it next year, for a roof or an illness or an old age that arrives ahead of schedule. The venture wants permanence; the saver wants to be able to leave. Those two demands look impossible to satisfy at once.

The stock market satisfies them by separating the life of the venture from the tenure of any one owner. The company keeps the capital for as long as it needs it; the saver holds a share, a tradable claim on the company, that can be sold to someone else at a moment’s notice. When you sell, the venture loses nothing, because your money stays inside it; all that changes is whose name is on the claim. The economist’s term for this is liquidity, and the market’s real product is exactly that: it manufactures liquidity for assets that are themselves deeply illiquid. Ross Levine put the mechanism plainly in 1991: savers get liquid claims they can sell, while firms get permanent use of the capital those claims represent. The saver’s ability to leave and the venture’s need to stay are reconciled by making the two things different transactions.

Why the resale market had to be invented

This solution is not obvious, and for most of history it did not exist. It had to be built, and it was built for a specific reason at a specific moment, alongside the institution that made it necessary: the corporation with permanent capital and tradable shares, whose assembly is the subject of the previous chapter. When the Dutch East India Company was chartered in 1602, it did something no trading venture had done before. Instead of raising money for a single voyage and paying it all back when the ships returned, it locked its investors’ capital in for the long run. When the settling-up its charter had promised after ten years was set aside, a subscriber could no longer demand his money back from the company at all, and the only way out was to find another person willing to buy his share.

That single design decision created the need for a place to trade shares, and trading began almost at once. Shares in the Company changed hands in Amsterdam within months of the charter, and over the following decades that trade matured into the first organised market where ownership of a business changed hands continuously, developed enough that by 1688 a merchant named Joseph de la Vega could write the first book ever devoted to a stock exchange, Confusión de Confusiones, describing its bulls and bears and manias in terms a modern trader would recognise. The permanent-capital company and the resale market were two halves of one invention. The company could demand that savers commit for the long term only because the market let any individual saver change his mind. Liquidity, in other words, was not a feature added to make the market lively. It was the thing that made permanent corporate capital fundable in the first place.

The same logic reaches all the way to your pension. A retirement fund can hold shares in businesses whose payoffs lie decades away precisely because those shares are liquid: the fund can sell them to meet a retiree’s cheque, rebalance them, or value them each day, none of which forces any underlying company to break itself up. Strip out the resale market and a pension could hold far less of it, and only by locking its members in for the same decades the venture needs. The liquidity that looks like mere convenience is what lets patient money and impatient savers occupy the same asset. That is the answer to the question the account statement leaves open: in the meantime, your savings are the permanent capital of real ventures, and it is the market’s standing offer to buy your claim that makes the arrangement bearable.

Speculation came with the institution, not after it

There is a price for all this, and it was there from the beginning. The same feature that recruits patient savings, the ability to sell a claim to anyone at any price, also lets a claim be bought purely in the hope of selling it dearer, with no interest in the venture underneath. Once a share can be flipped, it can be gambled on, and the market that makes long-term investment possible also makes speculation possible with the very same machinery. This is not a modern corruption of a once-sober institution. The first great mania to seize a stock market broke out little more than a century after the first exchange opened, and it remains the cleanest illustration on record that the casino and the capital machine were installed together.

The South Sea Company was chartered in England in 1711, and despite its name its real business was not trade but government debt. It existed to hold and manage a large slice of the British national debt, taking bonds off the state’s hands in exchange for its own shares. In 1720 it proposed to swallow most of the remaining national debt in the same way, converting the government’s creditors into its own shareholders, and Parliament agreed by the South Sea Act, which received royal assent in April. The scheme handed the Company a powerful incentive to drive its own share price up: the higher the price, the fewer shares it needed to hand over for each pound of debt it absorbed, and the more stock was left to sell for cash. It talked its price up, lent people money to buy its own shares, and sold new stock in instalments to buyers who never put down the full sum. A speculative fever took hold, spread to a rash of other new companies, and then broke.

The human wreckage was real. Fortunes made on paper in the summer were gone by the autumn, and the losers included the careful as well as the greedy. Isaac Newton, by his family’s later account, was among them, having sold early at a profit, bought back in near the top, and lost heavily in the fall; the sum usually quoted, around £20,000, is family tradition rather than a figure from any ledger, though a careful modern reconstruction suggests his true losses may well have been at least that large. What matters for this chapter is not the scale of any one ruin but the timing of the whole episode. The first sophisticated stock market had existed for little more than a hundred years, and it had already produced a mania that converted the national debt into a casino chip and back into ashes. The recurring machinery of boom and bust, why crashes come round again and again and how credit feeds them, is not this chapter’s subject; it has its own home in the volume on economic pathologies (Volume V, on why booms and busts keep happening). South Sea belongs here for a narrower reason: as the founding proof that speculation is coeval with the institution, built into the same liquidity that makes the institution useful.

The casino and the ledger

This is the ground on which the market’s harshest critics stand. The best-known version of their case was made by John Maynard Keynes, who knew markets from the inside as an investor. In the twelfth chapter of his General Theory (1936) he argued that a liquid market tempts everyone to play the wrong game. Because you can sell at any moment, you need not care what a company is truly worth over its life; you need only guess what other traders will pay for it next week. Investment then becomes a contest in anticipating the average opinion about the average opinion, which Keynes likened to a newspaper competition to pick not the prettiest face but the face others will call prettiest. When enough of the market plays that game, he warned, “enterprise becomes the bubble on a whirlpool of speculation,” and the allocation of a country’s capital is decided as a by-product of what he flatly called a casino. He went further, and aimed straight at the argument this chapter has built: of the maxims of orthodox finance, he wrote, none is more anti-social than the fetish of liquidity, because there is no such thing as liquidity for the community as a whole, only the illusion of it for each individual who thinks he can get out first. His proposed remedy, a tax on every transaction to make speculation less rewarding, is the ancestor of what later economists called a Tobin tax.

The critique has a modern form as well, which points out that most trading on an exchange is in second-hand shares, swapping ownership of claims that already exist rather than funding anything new, so that a great deal of market activity is a zero-sum contest for advantage that produces no investment at all. A former chief of Britain’s financial regulator, Adair Turner, drew wide notice in 2009 by calling swathes of such activity “socially useless.” Anyone who watches a market lurch on a rumour, or who follows the 1720 arc in the figure above, has seen the pattern it points to.

The reply does not deny the casino; it denies that the casino is the whole building. Keynes was right that the secondary market, taken by itself, only reshuffles existing claims. But the secondary market is the precondition for the primary one. Few savers commit money to a thirty-year venture at a tolerable return unless they believe they can sell the claim tomorrow, and weaken that belief and the flow of new long-term capital thins and grows dearer. The reshuffling that looks socially useless is what makes the original funding possible, in the same way that a resale market for houses is what lets a bank offer a thirty-year mortgage. The speculation and the capital-raising are not two markets, one good and one bad, that could be separated with a clean cut. They are the same market seen in two lights, because the liquidity that recruits the patient saver is the identical property that entertains the gambler. The question is not whether to have the casino or the ledger, but how much speculative weather a society will tolerate for the sake of the funding the same mechanism provides, which is a question of degree and regulation rather than of abolition.

Where the argument goes next

The stock market, then, exists to perform one difficult trick: to let a venture keep its capital for decades while letting any single owner of that capital leave in an afternoon. That liquidity is what makes it safe for ordinary savings, including the pension quietly working on your behalf, to fund things that take a lifetime to build, and the permanent possibility of speculation, on vivid display in 1720 and every boom since, is the standing cost of the same arrangement. The institution is neither the pure engine of prosperity its boosters describe nor the pure casino its critics see. It is one mechanism that does both jobs with the same moving part.

How that speculative weather turns from a background hum into a recurring storm, why booms and crashes arrive in cycles and how credit and human memory conspire to bring them back, is not settled here; it is the subject of the volume on what goes wrong (Volume V, on why booms and busts keep happening). Nearer to hand, this volume turns next from the institutions that move capital to the ones that judge people. Before a bank will lend you the money to buy a share of anything, or a landlord will rent you a room, someone decides whether you can be trusted to pay, and in the modern world that judgment has been compressed into a single number. How trust became a score, and what that industrialised judgment gained and lost, is the next chapter’s question.