EFA (1): Stocks

Welcome to our new weekly series: Economics for Amateurs (EFA). Not "Economics for Dummies", you note. That's been done already. And anyway, Business Spotlight readers are not dummies, are they?

Each Monday, we'll look at the meaning of an important economic concept. To start with, let's ask a simple question. Is it good or bad when stocks go up? And the answer is — get used to this one — it depends.

There are two main meanings of stocks:

1. Stocks is another word for shares, a part ownership of a company. The term stocks is typically used in US English.
2. Stocks are unsold goods that firms have produced and have ready for sale. These are also called "inventories".

In general, it is better if stock (that is, share) prices rise. Firms are then worth more, which means they can borrow more easily. They are also less likely to be taken over. And the wealth of shareholders rises, which leads to increased spending.

Of course, if share prices rise too quickly, serious problems can occur when the bubble bursts. This is what we have seen over the past year. But rising share prices are still generally better than falling ones.

And what about inventories? Is it good if these go up? Again it depends. If firms plan the increase in their stock levels, this is usually a good sign — they expect demand to increase. (They might, of course, be wrong.)

On the other hand, if the rise in stock levels is unplanned — because consumers didn't buy as much as firms had expected, and the unsold goods have piled up — that's bad. It also usually means that firms will cut production in future and instead sell (or "run down") the stocks they have.

For example, the first estimate of total output in the US for the fourth quarter of 2008 showed a fall of 3.8 per cent at an annual rate. This was less than the 5 to 6 per cent fall that many experts had expected.

The explanation that was given was that stock levels had risen by an estimated $6.2 billion because firms had not anticipated the depth of the recession and had continued to produce at higher levels than the experts expected.

That seemed plausible until the second estimate came at the end of February. Output in the fourth quarter had in fact fallen by 6.2 per cent at an annual rate. Firms had indeed seen the recession coming and had cut production. Inventories had not risen, but fallen dramatically, by $19.9 billion.

Ironically, this fall in stocks was seen as a positive sign. Once stocks have been run down, firms have to start producing more again — they do,at least, if they think anyone wants to buy their products.