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Jul 16, 2025  |  
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Frank Shostak


NextImg:Do Financial Markets Operate Upon Superior Knowledge?

Financial markets are various individuals engaged in the buying and selling of financial assets. Most of the time, the actions of market participants are driven by popular ideas. If the decisions taken by the market participants are based on a theory which is detached from reality, then the direction of the market is likely to follow the theory. Conversely, if the market participants were to follow a theory that corresponds to reality, then the market is most likely going to reflect this.

The employment of theories that are based on unrealistic assumptions was inspired by the writings of economist Milton Friedman. According to Friedman, since it is not possible to establish “how things really work,” then anything goes, as long as the theory can generate accurate forecasts. This means that what matters is not trying to understand how things work (i.e., to understand the economic fundamentals) but to have a theory that generates accurate predictions. But is forecasting capability a valid criterion for accepting a theory?

For instance, all other things being equal, an increase in the demand for bread will raise its price. This conclusion is true, and not tentative. Will the price of bread go up tomorrow or sometime in the future? This cannot be established by the theory of supply and demand. Should we then dismiss this theory as useless because it cannot forecast specific future prices of bread?

Another paradigm—the Efficient Market Hypothesis (EMH)—uses reasoning different from Friedman, but also dismisses fundamental analysis, arguing that the market adjusts so quickly to information that it is futile to pay attention to fundamental analysis. Whatever information this analysis reveals is already contained in asset prices, therefore, there is no point in paying attention to such things. A simple policy of random buying and holding will do.

It is hard to imagine that the effect of a particular cause—which begins with a few individuals and then spreads over time across many individuals—can be assessed and understood instantaneously. For this to be so, it would mean that market participants can immediately assess future consumers’ responses and counter-responses to a given cause. This, of course, must mean that market participants not only know consumers’ preferences but also know how these preferences will change. However, consumer preferences cannot be revealed before consumers have acted.

Contrary to much popular thinking, economics is not about gross domestic product (GDP), the consumer price index (CPI), or other economic indicators as such, but about human beings that interact with each other. For instance, one can observe that individuals are engaged in a variety of activities. They may be performing manual work, driving cars, walking on the street, or dining in restaurants. The essence of these activities is that they are purposeful.

Furthermore, we can establish the meaning of these activities. Thus, manual work may be a means for some people to earn money, which enables them to achieve various goals like buying food or clothing. What we observe are individuals employing means to achieve ends. By definition, human actions are purposeful, which also implies that these actions are conscious. This is an irrefutable proposition because to contradict purposeful and conscious human action is self-refuting. Ludwig von Mises—the originator of this approach—labeled this praxeology. Using the knowledge that human beings are acting consciously and purposefully, Mises was able to derive the entire body of economics.

This logically sound theory can assist in assessing the validity of the popular viewpoint that the key driver of the economy is demand. In the market economy, wealth-generators do not produce everything for their own consumption. Part of their production is used to exchange for the production of others. Hence, in the market economy, production precedes consumption. This means that something is exchanged for something else. This also means that it is an increase in the production of goods and services that allows for an increase in the demand for goods and services. Through production, the goal (i.e., demand) is reached.

Consumer demand is constrained by an individual’s ability to produce goods. The more goods that an individual can produce, the more goods he can demand. What enables the expansion of production is the expanding savings that develop a “subsistence fund.” It then follows that the key driver of the economy is not demand, but saving, capital investment, and production.

Often, to counter an emerging economic slump, various experts urge the central bank to increase the pace of monetary inflation and credit expansion. This artificial increase in the money supply, it is held, protects and enhances the economy. Money, however, is not a suitable means to promote wealth generation as it can only fulfill the role of the medium of the exchange. In fact, an increase in the supply of money will undermine the wealth-generation process.

Focusing on the Essence, Not So-Called “Indicators”

Most financial market participants respond to the multitude of economic data. Thus, if an economic indicator such as GDP is going up, then market participants tend to push the stock market higher. If price inflation moves up, this is perceived as bad news for the financial markets. Rather than reacting to the many dubious economic indicators, it is better to focus on the essential factors that drive the economy—saving, capital investment and production.

What about Positive Thinking?

Given the popular view that what drives the economy is demand (i.e., demand causes supply), many market participants are of the view that positive thinking is the key for economic growth. Positive thinking and a large dosage of “good news,” it is believed, can prevent the development of pessimistic expectations and, in turn, bad economic conditions. It is then crucial not to upset this psychology in order to keep the economy prosperous. Hence, whenever economists discuss the state of the economy, they try to portray the bright aspect of it. Even when the economy falls into a recession, various influential commentators are very guarded in their speech.

The main reason for this gentle talk is a view that a soft language will not upset individuals’ confidence. If individuals’ confidence is kept stable, then stable economic activity will follow, so it is held. However, irrespective of individuals’ psychological disposition, if the reality identified by a logically-based theory points to a likely economic slump ahead, then this is what is likely to emerge.

Conclusion

Contrary to the popular view, the market as such does not have superior knowledge. If the majority of the market participants follow misleading ideas, the market is going to display these ideas for a certain period of time until reality reasserts itself.