THE ROLE OF STOCK MARKETS

The Role of Stock Markets

Table of Contents

1. Introduction3

2. Theoretical and empirical background7

2.1. Theory7

2.2. Empirical literature10

3. Economic decisions and the structure of the economy15

3.1. Technology and entrepreneur's objective15

3.2. Entrepreneurs' decision problem18

3.3. Ordinary investors' decision problem26

3.4. Capital markets30

3.5 Comparing UK's Financial32

3.6. Behavioral equations50

3.7. Equilibrium growth54

4. Growth implications of entrepreneurs' decisions59

5. Some stylised facts67

6. Conclusions80

References83

Appendix96

Appendix A. Supplementary data96

The Role of Stock Markets

1. Introduction

In the theoretical literature on the development of stock markets and economic growth, a positive link is traditionally presented between these two variables. In particular, three causal factors are commonly stressed as having a positive impact on efficiency or savings: increased liquidity, diversification, and improvements in corporate control. Yet the theoretical debate is far from settled since some authors also point out the negative sides of these three elements. The formation of an equity market is endogenized in the model presented in this paper to explain a non-linear relationship between market size and growth, and thus, it is able to explain why growth in the stock market might retard economic growth under certain institutional environment. It is argued that manager/owners might not be risk-taking enough so that despite the diversification allowed by acquiring shares in other companies, they may use low-return technologies that reduce the risk associated with large-scale production. Moreover, a larger capital formation may not offset the drop in economic growth due to the reduction in productivity since managers may become preoccupied with the acquisition of financial claims on existing projects to the detriment of the firms' aggregate savings.

In order to derive the previous results, the model incorporates concerns on the control of ownership and the existence of credit constraints as limits to the financial diversification of entrepreneurs. These constraints may induce the selection of a low-return technology as an alternative device for risk reduction. In addition, the model considers how capital allocation through the stock market,1 particularly in secondary markets, may have the negative consequence of diverting firms' earnings away from internal capital formation.2 Accordingly, the model implicitly considers institutional elements that characterize many emerging economies, namely, an inadequate legal and judiciary environment as well as social norms that inhibit the transparency of economic behavior.3 These features tend to produce family firms with concentrated ownership, severe failures in financial markets that exacerbate the problem of credit rationing, and stock markets with liquidity problems that preclude hostile takeovers and hamper the informational content of prices.4 In the model, no attempt is made to formalize the causal link between the institutional features and the stylized facts (control concerns, credit constraints, and price inefficiency); the latter are only taken exogenously to analyze the impact of firms going public on economic growth under the setting described above.5

Pagano (1993) has shown that an entrepreneur with borrowing constraints can improve his risk-sharing opportunities by going public and using the additional liquidity to buy shares of other companies. In the model presented in this paper, Pagano's ways of reasoning is extended in three different ...