All Commentary
Sunday, September 1, 1996

It’s No Gamble: The Economic and Social Benefits of Stock Markets

The Stock Market Pools Funds and Spreads Risks

Theodore Roosevelt once quipped, “There is no moral difference between gambling at cards or in lotteries or on the race track and gambling in the stock market.” John Maynard Keynes echoed this view: “When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done.”

Every time a new market innovation arises, a similar chorus of catcalls waits in the wings to greet it. Fortunately for all of us who benefit from the capitalist system, financial markets are not without their defenders. Lewis Johnson and Bohumir Pazderka, professors at Canada’s Queens University School of Business, boldly take on the critics and deftly demolish most of their arguments. It’s No Gamble successfully balances recent scholarship (including the authors’ own) with a lively discussion that is accessible to those without formal training in finance and economics.

For starters, Johnson and Pazderka explain why a market economy without a stock market is like a ship without a rudder. They detail how the stock market pools funds, spreads risks, and gives owners some modicum of control over management. They also show how much maligned “derivative” securities such as options and futures strengthen the stock market by enhancing liquidity by permitting the management of risk.

Myths about the stock market sprout like weeds. Among the hardiest this work seeks to uproot is that the stock market is a zero-sum paper-shuffling game that breeds instability and infects managers with a dangerously short time horizon. Johnson and Pazderka draw from one of their own studies to make the point that the efforts of management to maximize the value of their company’s stock does not force them to eschew long-term considerations. Unfortunately, the authors’ data are not quite up to the task. They do, however, provide more persuasive evidence that potential future earnings do play their appropriate role in valuing share prices. They point out, for instance, that stock in companies with no current earnings will still sell for a positive price on the basis of their future prospects. The finding that high R&D spending does not render a firm more subject to hostile takeovers, as it would if market myopia systematically undervalued its shares, also helps to prove their point.

In their discussion of regulation, the authors rightly reject the notion that the government must step in to counteract stock markets’ supposed inability to direct enough capital to “socially desirable investments.” Their argument, couched largely in terms of cost-benefit analysis, would have benefited from some allusion to the violation of the property rights of shareholders involved in such schemes, not to mention questioning the presumption that the government should decide what is “socially desirable.”

It’s No Gamble provides an enlightening discussion of the role stock markets have been playing in the efforts of the various Eastern European countries to privatize. In the following chapter, the authors furnish a clear-headed discussion of the ethical issues involved in such practices as hostile takeovers and insider trading, which takes into account both efficiency and property-rights considerations.

In the final analysis, Johnson and Pazderka succeed in shedding light on an area in which misunderstanding can have serious consequences. Some have said that financial markets are feared because they are misunderstood. To the extent they are correct, It’s No Gamble, should pull the fear factor down a notch or two.