Consumption vs. Investment (and IPO vs. Secondary Market)

Scott Sumner answers what I imagine is an extremely prevalent question about the difference between consuming and investing.

I have read your site for years, but this is the first time I felt compelled to ask a question: some friends and I were discussing the various benefits to society that would accrue from say, my purchasing a product, vs investing the same amount of money in the stock market. While I know, at a high level, that investment is necessary to grow the economy, I had a more difficult time explaining the specific mechanism by which the action of “I buy 100 bucks of index funds on Vanguard” translates to “investment” in the economy. We were easily able to understand that if I buy a 100 dollar widget from Widget Corp, that benefits that company (and the economy), which now has $100 more to spend on wages or machines, but I am having difficulty coming up with a similar concrete sequence of steps for the 100 dollar stock investment.

On a larger point, I think this reflects part of the skepticism and suspicion that people have towards the stock market, particularly from the crowd that throws around terms like “gambling” and “speculation.”

Scott responds by reframing the question and explaining what ‘saving’ really is.

This is a surprisingly confusing subject. Consider the sentence that begins “We were easily able to understand . . . “. In fact, I don’t think they do understand, as money spent on wages and machines is not a benefit to the economy, it’s a cost. The benefit comes from consuming the widget. In the examples that follow, I’ll assume the $100 widget is a meal at a restaurant for the Moore family.

Before considering Brian’s stock market question, suppose he were trying to decide between spending the $100 on a meal, or spending it on materials for a new front sidewalk. The meal is considered consumption, and the new sidewalk is investment, because it’s durable and yields a flow of services for many years, or even decades. The money spent on the sidewalk is called “saving”. In either case, output gets produced and the effect on GDP is roughly the same, in the short run. In the long run, GDP will be a bit higher with the sidewalk investment, as it will continue to produce a flow of services for many years.

One more thing┬áto address is a distinction that Scott doesn’t touch on in the post. Scott goes on to discuss giving $100 to a company that installs sidewalks, and presumably will install more sidewalks because they have that $100. That is confusing to people in the “thanks for the tip”-zone, because most people think of the secondary market when they are thinking of buying and selling stock. In the secondary market, buying a share of XYZ Corp doesn’t put any money in their pocket to aid the building of sidewalks.

Actually, most people confuse these over and over and don’t have a coherent schema for thinking about how the flow of money in markets actually works — evidenced by many people who don’t want to “give money” to companies whose business practices they don’t like. The better reason not to buy shares of a company is that one wouldn’t want to be an owner of a company they don’t like and can’t change, which is fine, but suboptimal in my opinion. I digress.

The point that I wanted to add to Scott’s is that investments in the secondary market, even though XYZ Corp isn’t actually getting your money to build more sidewalks, also (as Scott says) ‘works on average’, because the cash you use to buy the shares go to somebody else who uses that cash to either consume or invest, which also works on average. Those dollars will eventually go either to someone consuming or investing in ‘sidewalks’ directly until equilibrium is reached.

As a brief example, if Scott owns 1 share worth $100 of NGDP Corp, and I can either spend $100 on lunch or buy $100 of NGDP Corp on the open market. I go to buy the stock and Scott is the lucky fellow with his ask price at $100. Scott was selling his share because he was hungry, so he goes to buy lunch. Nothing changed except the ownership of NGDP Corp, and $100 was still spent on lunch.


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