How does the stock market affect business investment? There are three direct effects. One is that the market has traditionally served as a general barometer of the expectations of the business-minded community as a whole. We say “business-minded” rather than “business” because the demand for, and supply of, securities mainly comes from securities dealers, stockbrokers, and the investing public, rather than from nonfinancial business enterprises themselves. When the market is buoyant, it has been a signal to business that the “business climate” is favorable, and the effect on what Keynes called the “animal spirits” of executives has been to encourage them to go ahead with expansion plans. When the market is falling, on the other hand, spirits tend to be dampened, and executives may think twice before embarking on an expansion program in the face of general pessimism.
This traditional relationship is, however, greatly lessened by the growing power of government to influence the trend of economic events. Business once looked to the market as the key signal for the future. Today it looks to Washington. Hence, during the past decade when the stock market has shown wide swings, business investment in plant and equipment has remained basically steady. This reflects the feelings of corporate managers that government policy will keep the economy growing, whatever the market may think of events.
A second direct effect of the stock market on investment has to do with the ease of issuing new securities. One of the ways in which investment is financed is through the issuance of new stocks or bonds whose proceeds will purchase plant and equipment. When the market is rising, it is much easier to float a new issue than when prices are falling. This is particularly true for certain businesses — public utilities, for example — that depend heavily on stock issues for new capital rather than on retained earnings.
Finally, when the market is very low, companies with large retained earnings may be tempted to buy up other companies, rather than use their funds for capital expenditure. Financial investment, in other words, may take the place of real investment. This helps successful companies grow, but does not directly provide growth for the economy as a whole.