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Stock exchanges are organized markets where investors buy and sell shares of corporate stock and bonds. Some of the better-known stock exchanges are the New York Stock Exchange (established in 1792), the Tokyo Stock Exchange (1878), and the London Stock Exchange (1698). Stock exchanges are important insofar as they promote economic efficiency. They offer private investment opportunities to individuals and direct a large part of production in capitalist societies. If stock exchanges work well, this efficiency will promote efficiency in the general economy.

Corporations promote economic efficiency by producing goods that consumers want most urgently and keeping production costs to a minimum. Investors speculate over which corporations will be most efficient and profitable before they buy corporate stocks. After buying shares of stock, investors must monitor the activities of corporate officers to see that their company is operating efficiently to earn the highest potential profit. Corporate officers can mismanage their businesses in several ways. First, they can form faulty business plans. Management can invest in producing products that consumers do not want or invest in a production plan that is excessively costly. Second, corporate officials can mismanage the execution of essentially sound business plans. Third, corporate officials can commit deliberate fraud or deception for personal gain. In any case, stockholders in a mismanaged corporation will lose money.

Competition in stock exchanges determines who plans much of production. When corporate executives plan and carry out efficient production, profits rise and the price of the corporation’s stock increases. When corporate executives form defective business strategies or mismanage the execution of sound strategies, stockholders have an interest in replacing them. If stockholders do not replace incompetent corporate executives, then the price of the stock will likely fall. That is, if stockholders do not deal with inefficient corporate executives, the stock exchange can penalize stockholders by cutting the value of their stock. This is how stock exchanges pressure corporate shareholders to terminate incompetent corporate managers. Of course, stockholders may not respond to such pressure from the stock market. However, if stock holders fail to remove incompetent corporate managers, the low price of that corporation’s stock will make it an easy target for a takeover bid or leveraged buyout. In other words, a new group of investors could move to buy out some or all of the old stockholders and replace the existing management. Takeovers and leveraged buyouts often transfer ownership of a corporation from a large number of inattentive stockholders to a small number of large investors, who demand better performance from their executives. One of the more famous examples of such a move is when Henry Kravis bought out RJR Nabisco for $25 billion in 1989 and ejected CEO Ross Johnson.

Investors compete in stock exchanges to earn money for themselves. Yet competition between investors promotes the careers of efficient corporate executives and ruins the careers of incompetent ones. This is how stock exchanges determine who plans production. Of course, it always takes some time for pressure from the stock exchange to remove inept management from any particular corporation. However, stock exchanges do not tolerate incompetence indefinitely.

There are reasons to question the efficiency of stock exchanges. The key issue in stock exchange efficiency is information. A stock exchange is efficient if the price of each stock reflects all relevant and available information on that stock. Any stock that is undervalued, given available information, will be coveted—and its price will rise. Any stock that is overvalued will be sold off and its price will fall. In theory, such buying and selling of stocks will push stock prices to their true values.

Ideally, stock prices will reflect the actual performance of the corporate management. In actual stock exchanges, the price of corporate shares can overestimate or underestimate the performance of corporate management. Since investors have incomplete, and sometimes inaccurate, information regarding corporations, there will always be some inaccuracy in stock prices. Investors do, however, profit from being accurately informed, and this prompts them to eliminate serious deficiencies in their information. Stock prices move toward levels that reflect the true performance of corporate officers, but it always takes some time for pertinent information to be uncovered.

Efficient stock exchanges adjust to a continuous flow of new information, but the fact that this information is always incomplete means that stock prices are never perfectly accurate measures of executive performance. Trading with incomplete information is speculative, but unavoidable. The lack of perfect information means that stock exchanges can never achieve 100 percent efficiency, yet stock exchanges are relatively efficient if they adjust to new information as it becomes available. Some studies indicate that stock markets are efficient. Yet other studies of stock exchanges indicate inefficiency. Stocks of small firms tend to earn excess returns in January, and returns tend to be low on Mondays. Also, upswings and crashes in aggregated stock prices (bull and bear markets) indicate that stock prices deviate from their true values, based on market fundamentals. For example, on October 19, 1987, the Dow Jones Index declined 22 percent. Some argue that this and other crashes are evidence of irrationality in stock exchanges, while others claim that the October 19 crash was triggered by the proposal by the House Ways and Means Committee to limit the deductibility of interest on corporate debt.

While it is obvious that stock exchanges are not perfect, the case for regulating stock exchanges is less clear. Some insist that anomalies in stock exchanges indicate a need for government regulation. Given the importance of stock exchanges in modern economies, governmental regulation that improves stock exchange performance can improve overall economic conditions. On the other hand, government regulation is sometimes flawed and will sometimes impair market performance. Expert opinion is divided over the issue of stock exchange regulation, but there is a considerable amount of evidence indicating that current regulations are excessive.

We can illustrate the importance of stock exchanges by examining the economic performance of countries where they do not exist. Stock exchanges are particular to capitalism. Socialist economies prohibit private ownership of stocks, private dividends, and stock exchanges. In a socialist society, all citizens have an equal stake in all parts of industry and all are paid a social dividend as equal owners of industry. Since socialist societies lack stock and other financial markets, socialist production gets directed by central authorities. This is a critical difference between socialism and capitalism. Twentieth-century experience with Soviet-style central planning indicates that Wall Street does a better job of directing industry than do central authorities. While there is room for doubt concerning the need for regulation of stock exchanges, there is far less doubt about the need for some kind of market for trading equities. Stock exchanges are an indispensable part of modern economies because they provide an efficient means of planning production in an efficient manner. Without stock exchanges, capital investment would be far less efficient.

Some recent proposals for socialism would allow people to own shares of stock in particular businesses. However, every citizen would be limited to an equal amount of stocks that could be traded only for other stocks. Advocates of this proposal believe that this sort of limited stock exchange would improve managerial performance, while approximating equal ownership of the means of production. However, a “socialist stock exchange” would not be as effective at removing inept managers, simply because it would eliminate hostile takeovers and leveraged buyouts at the hands of large professional investors.

Stock exchanges promote overall economic efficiency, despite the occasional appearance of significant flaws. Improvement in information technology has improved the efficiency of stock markets, and this trend will most likely continue. The general public often misunderstands the role that stock exchanges play in modern economies. People often see stock trading as a purely financial matter, but stock exchange activity is important for planning real production. Stock exchanges have and will continue to play a central role in modern economies because of their indispensable role in promoting economic efficiency.

Bibliography:

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Fama, Eugene, and Kenneth French. 1988. Dividend Yields and Expected Stock Returns. Journal of Finance 22 (1): 3–25. Grossman, Sanford. 1989. The Informational Role of Prices. Cambridge, MA: MIT Press.
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Mitchell, Mark, and Jeffrey Netter. 1989. Triggering the 1987 Stock Market Crash: Anti-takeover Provisions in the Proposed House Ways and Means Tax Bill. Journal of Financial Economics 24: 37–68.
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