Take S&P for example. In the long run it just keeps climbing. Same for the market as a whole. Why would this happen? Why the market keeps going up (in the long term) all the time?
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1$\begingroup$ Because companies aim to grow their profits year after year, so they will be worth more if they make more money, and thus the index the stocks belong to will increase in price too. $\endgroup$– Mark DoonyMar 27 '15 at 4:16
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1$\begingroup$ Because people make more stuff. $\endgroup$– littleadvMar 27 '15 at 4:58
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$\begingroup$ @MarkDoony, so it's like that only because of population growth? $\endgroup$– SparklerMar 27 '15 at 7:09
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3$\begingroup$ Wouldn't economics.se be better place for such questions? While it impacts personal finances indirectly it seems to be more of a question of Macroeconomics. $\endgroup$– UserMar 27 '15 at 7:49
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$\begingroup$ @Sparkler not necessarily. Imagine caveman fisherman. She can catch fish by hand. However she can make a capital investment (net) and increase a number of fish she catches at the cost of temporary consumption reduction (if she makes her net she can't catch fishes). The economy is much more complicated that that but the principle is similar (spending some resources on capital investment -> more capital -> more production -> more resources -> more things to invest and consume). $\endgroup$– UserMar 27 '15 at 7:56
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Roughly, people produce "stuff" by spending their time working (labour) and by employing machinery/tools/land/etc. (capital).
If you have more workers or more machinery then it should not come as a surprise that more goods and services get produced.
But this is only part of the story. Even if we divide by the number of people to get the size of the economy per-capita, we still find growth:
So we clearly can't fully attribute growth to an increase in the population of workers.
For some time in the early 19th century, economists thought that growth was due to an increase in the use of machinery during the industrial revolution. If each worker has more tools—went the reasoning—then each worker can produce more and per-capita output will increase. But in 1957, Robert Solow found that only 12.5% of US growth in the first half of the 20th century was due to an increase in the capital / labour ratio. That still leaves 87.5% of growth unexplained.
If growth is not due to an increase in the availability of labour and capital, then it must be driven by the existing capital and labour becoming more productive. Why might that happen?
Education levels increase over time so that an average worker in 2000 produces more value than did an averager worker in 1900. Indeed, in 1900 the average worker was a farm hand or low-level industrial worker who produced a few thousand dollars worth of goods each year. Now, the average worker is a skilled industrial worker or office worker who produces good or services worth tens of thousands of dollars per-year.
Similarly, technological advancement makes tools and machinery more productive over time. For example, a \$200 modern computer is several orders of magnitude more powerful than a \$1million computer was in 1970. That means that we can now produce anything created by (or with the aid of) a computer in quantities many orders of magnitude larger than was possible 40 years ago.
So, in sum, more skilled workers who have access to better tools produce more stuff. Since a country's GDP is just the value of the stuff it produces in a year, education and technology cause GDP to increase over time.
answered Mar 27 '15 at 14:20
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$\begingroup$ from your last 2 points it seems that economy grows, only because every household (on average) is making more money and spending more money than before. but what makes this larger-than-inflation growth possible? why isn't it a "zero sum game"? $\endgroup$– SparklerMar 27 '15 at 15:35
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1$\begingroup$ @Sparkler Thinking in terms of money just confuses this (like many things). If we have workers and tools that are more productive then we must produce more stuff. Somebody must be consuming the extra stuff we produced. So, after we account for changes in prices and nominal incomes, the total amount of stuff per person has to increase. Indeed, the graph above corrects for inflation by evaluating per-capita GDP at 2005 prices. $\endgroup$ Mar 27 '15 at 15:50
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3$\begingroup$ @Sparkler. There are two people on an island. Each is a semi-skilled fisherman who can catch 5 fish per day. Thus, the island's GDP per day is 10 fish, and the GDP per capita per day is 5 fish. They both read a book that explains how to be a better fisherman, which helps them learn how to catch 10 fish per-day. Now, the new GDP per day is 20 fish and the GDP per-capita per-day is 10 fish. People are consuming and producing more because they became more skilled, not because there are more of them. I reworded my last comment to clear up a confusion that I may have inadvertently caused. $\endgroup$ Mar 27 '15 at 16:40
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2$\begingroup$ @Sparkler Suppose that they want to eat 5 fish per day. In the original situation they both spend all of their time catching fish (5 each per day), which they eat. After reading the book, they can now catch 10 fish per day. This means that one of the islanders can catch all of the fish they both need. This frees the other islander to spend his time gathering coconuts. The GDP per day would then by 10 fish plus $x$ coconuts, and the GDP per-capita would be 5 fish plus $x/2$ coconuts. So there is still per-capita growth. $\endgroup$ Mar 27 '15 at 17:38
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1$\begingroup$ wouldn't that mean the relative value of each commodity is diminishing? the limited resource here is their time, and the alternative uses are the coconut//fish. this would make fish and coconuts cheaper, but the sum of everything is still the same, no? $\endgroup$– SparklerMar 27 '15 at 18:50
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The Unit of Measurement keeps growing.
Prices are measured using money, and the total quantity of money in the economy is continuously growing due to the operation of the banking system, as you can see here for the USA:
US Money Supply (Bank Deposits)
As a consequence, so are any and all statistics that rely on any form of monetary derived data, such as share prices.
Stock indexes not only make no correction for this, but also suffer from "survivor bias" as less successful companies are removed from the index. Other economic statistics make a partial but inadequate correction by factoring in the inflation rate - however, this doesn't account for changes in production which also influence price.
The correct way to handle price data mathematically would be to normalise it for the growth in the money supply, which would at least remove the 'known' unknowns. If you do that however, a lot of economic statistics start looking very different.
On a personal finance note, it can be useful to know the monetary expansion rate for whatever country you're living in (it varies), since it makes it much easier to make sense of comparisons of price related data between different periods.
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$\begingroup$ what you're saying is that banks increase the cash pool by X% annualy, while somehow magically maintaining an inflation Y%, such that Y<X (indeed, inflation is much lower than an average diversified portfolio). How is that possible? $\endgroup$– SparklerApr 1 '15 at 3:24
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1$\begingroup$ Prices ~ M/P where M is the money supply, and P the number of things/services being produced and sold for money. (The approximate sign is there, because there are other factors involved like credit, and monetary distribution.) So essentially as companies produce more, prices drop, and as banks lend more prices increase, and the actual price level is the balance between those things. Shares track the money supply expansion quite closely, partly because of uneven monetary distribution, but also because of credit impacts on price levels. $\endgroup$– LumiApr 1 '15 at 13:37
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$\begingroup$ I do not think this is correct. Inflation is not equal to the growth of the economy and survivor bias is not a factor here. The reason economies keep growing is because our factors of production are improving. Labour and Technological capabilities are growing meaning we are able to do more with our current resources. $\endgroup$– JamzyApr 2 '15 at 2:50
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1$\begingroup$ Another reason I think this answer is incorrect, or at least incomplete, is that it only explains nominal GDP. Real GDP is controlled for inflation and still keep growing. $\endgroup$– JamzyApr 2 '15 at 4:08
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1$\begingroup$ I agree that the economy is growing. That's not the issue here. The problem is what monetary measurements are actually measuring. If the money supply was held constant, prices would have to adjust continuously downwards as production increased. As it isn't, and "real" adjustments only partially correct for the expansion, we see statistics growing, and paste on explanations for that. As for survivor bias, the indexes are continuously having companies added and removed. $\endgroup$– LumiApr 6 '15 at 23:14