The Wisdom of the Market

By Peter Blair Henry, Dean, Leonard N. Stern School of Business, Dean Richard R. West Professor of Business, and William R. Berkley Professor of Economics & Finance

In other words, the stock market serves both as a useful predictor of whether policy changes will have positive effects on the lives of people at all levels of society and as a conduit through which those effects are actually transmitted.

In an era of bubbles, crashes, tarnished reputations, and outrage over the gulf between the wealthy and the struggling classes, it may seem like the height of insolence to suggest that stock markets hold the key to economic recovery in the United States and Europe. Wasn't it market misbehavior that got us into this mess in the first place? But, in fact, policymakers would still do well to look to the stock market as an essential indicator of the likely impact of their reforms.

Stock market reactions to economic reforms provide powerful forecasts of policy effectiveness because changes in stock prices reflect the average opinion of thousands of shareholders who care little for ideological debates and simply consider whether a given change will create or destroy value. This predictive ability makes market movements an important complement to the traditional backward-looking measures Washington is fond of, including growth, inflation, and unemployment.

In particular, policymakers in the United States and Europe need to study the movements of markets over the last few decades in what we used to call the "Third World." With Europe back in recession and the United States offering temporary solutions to its problems that inspire little confidence, advanced countries sorely need a new direction. By enacting large, unprecedented policy changes over the last three decades, developing countries turned around their economies and became the "emerging markets" that now drive global growth. Historical analysis of stock price reactions to policy-reform announcements made by governments in emerging economies across the globe demonstrates repeatedly that decisive, clearly communicated plans to implement market-friendly policies are what drive growth and create value -- not just for shareholders but for all.

Read full article as published in Foreign Policy