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Just a few thoughts on the possibility of markets beating inflation in the long, long term (say, hundreds of years). I am a theoretical physicist, not an economist, so please forgive my ignorance.

I was wondering what can we say about a market in the $t \to \infty$ limit if that market beats inflation when averaged over long periods of time.

It seemed to me like market caps would have to just keep rising and rising. And in fact, it is true that for the available data to me (since 1996) the S&S500 market cap has risen at essentially the same YOY rate as the index itself. Meanwhile, P/E ratios have not changed very significantly. This means that to sustain the trend in both stock price and P/E, company earnings must increase YOY by more than inflation.

In a world where the money supply stays constant, this would mean that eventually the earnings of any individual company would have to exceed even the total money supply, as $t \to \infty$. This seems like a very unrealistic situation. And, in fact, M2 has increased just as quickly as the S&P in total! Since 1996, M2's YOY rate is 7.0%, while the S&P grew at 6.7%. Meanwhile M0 grew by a whopping 10.1% YOY.

This leads me to preliminarily conclude that in fact the ever-increasing money supply is providing a mechanism for companies to increase earnings faster than the CPI each year. This suggests the view that the increase in markets faster than inflation is caused by the following phenomenon:

More and more money is created. Yet that new money is unevenly distributed, with much more of it going towards businesses than to consumers. For this reason, the CPI, which only measures a particular cross section of the market, grows more slowly than M2, and also more slowly than business profits. Thus the creation of money is a necessary process to keep markets rising faster than inflation, and if this were to cease, eventually the trend would be over.

I would be interested to hear anyone's thoughts - in agreement or not - with what is outlined above, especially the last sentence.

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  • $\begingroup$ Knitpicking: "forever is a strong word, what about the heat death of the universe? $\endgroup$
    – Giskard
    Nov 14, 2022 at 14:16
  • $\begingroup$ Also, you seem focused on money creation as the sole cause of inflation. $\endgroup$
    – Giskard
    Nov 14, 2022 at 14:17
  • $\begingroup$ Fair enough, but yes of course I'm not considering the influence of that or the sun turning into a red giant or extinction by nuclear war. I'm most interested in how the growth of earnings in the long term depends on the creation of money, regardless of whether that creation of money causes inflation. I wonder how dependent our ever-increasing stock market is on that money creation. $\endgroup$ Nov 14, 2022 at 14:19

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Is it possible for the stock market to beat inflation forever?

Yes this is theoretically possible. Return on a stock depends on discounted value future value and dividends (and consequently profitability) of a company and there is no theoretical limit to that. So it is theoretically possible.

In a world where the money supply stays constant, this would mean that eventually the earnings of any individual company would have to exceed even the total money supply, as t→∞. This seems like a very unrealistic situation.

No even with constant money supply this is possible. Inflation is change in price level and in long run price level and price level is given by money market equilibrium that can described as:

$$M/P=L(Y,i) \implies P= \frac{M}{L(Y,i)}$$

where $M$ is money supply, $P$ price level (change in which gives you inflation), $L$ money demand that depends on $Y$ (real output), and $i$ interest rates.

Now money demand depends positively on real output $dL/dY>0$ and real output depends positively on profits. So as firms get more profitable (keeping $M$ and $i$ constant) price level $P$ drops leading to negative inflation (also known as deflation).

Recall that stock prices depend on profitability of a firm. Hence it is possible for stock return to beat inflation even with constant money supply because when inflation turns negative you need your returns to be less negative (e.g. when inflation is -10% you only need -9.99% nominal return to beat inflation). So theoretically the quantity of money does not constrain the real returns on market and to beat inflation you just need any positive real return.

Thus the creation of money is a necessary process to keep markets rising faster than inflation, and if this were to cease, eventually the trend would be over.

No this is not true as explained previously. There is however a kernel of truth in it. Small inflation has positive effects on economy because prices are sticky downwards and inflation thus helps economy to adjust whenever prices need to drop in real term. For example, it is much easier to lower real wages of workers via inflation than for each company individually negotiating new contracts with workers.

Inflation depends on money supply as equation above shows, so without ever expanding money supply we would end up with negative inflation (as Y increases over time thanks to technological progress and expansion of human activity). Hence without growing money supply we would be in a deflationary world, that requires perpetual downward adjustments in prices and wages, and since this is difficult to do it would hurt the economy leading to unnecessary high unemployment and underutilization of other factors of productions (such as capital) which will also hurt profitability. Nonetheless, even in such deflationary world economy should not completely collapse and so even though it would be perpetually working below full capacity there should be possibility for perpetual growth in factor returns (e.g. profits or wages) in real terms.

Of course, in nominal terms wages and profits and returns decline but nominal terms are irrelevant. Nobody would be upset to earn half of their salary if they can buy 4 times more goods and services than on the older salary.

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  • $\begingroup$ It makes sense that you can increase prices arbitrarily relative to inflation through deflation, even with constant money supply. But nonetheless, with long enough exponential growth eventually the price of a company would exceed the constant money supply $M$ 1 billion times over. Keeping price/earnings constant, company earnings would have to be so high that the entire money supply would be spent on a single company millions of times in just 1 year. This is just not plausible - and so it seems that without increasing $M$, eventually $P$ (=market cap) will not grow anymore. Am I wrong? $\endgroup$ Nov 14, 2022 at 14:31
  • $\begingroup$ Btw, that was an interesting point that constant $M$ leads to deflation. It makes sense if the population of the world is ever-increasing, and also if wealth accumulates at the top, both of which cause the median personal wealth to decrease in a constant-$M$ world $\endgroup$ Nov 14, 2022 at 14:34
  • $\begingroup$ @doublefelix based on what you came to this conclusion?: " But nonetheless, with long enough exponential growth eventually the price of a company would exceed the constant money supply M 1 billion times over" Thats not true, the inflation would also exponentially became more and more negative. $\endgroup$
    – 1muflon1
    Nov 14, 2022 at 15:13
  • $\begingroup$ @doublefelix "Btw, that was an interesting point that constant M leads to deflation. It makes sense if the population of the world is ever-increasing, and also if wealth accumulates at the top, both of which cause the median personal wealth to decrease in a constant-M world" - no this does not require population growth. Also it does not require growth of wealth. Growth of output is fully sufficient. Wealth is saved output, deflation does not require any savings at all, just growth of real value of output and real value of output has no limit to as high as it can be $\endgroup$
    – 1muflon1
    Nov 14, 2022 at 15:15
  • $\begingroup$ Comment 1 reply: Ahh I just got it. With earnings decreasing yet outpacing inflation they would never reach the value of $M$ which is truly constant. That took me a moment, thank you. Comment 2 reply: Aha that is interesting. So more output means increased supply, and if demand is the same then prices will go down. Basically, more efficient production can cause deflation, and this trends things down over time. This fully makes sense to me now. Though there surely is an impact of the money supply on profits, it's not a necessary condition as long as businesses continue to improve efficiency? $\endgroup$ Nov 14, 2022 at 15:22
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A simpler example is possible: suppose the real output of firms grows by 1% every year (due to population growth and/or wealth accumulation), while pretty much everything else (prices, capital share of income, P/E ratios, etc.) is unchanged. Then inflation is 0%, while stock prices grow by 1% per year.

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  • $\begingroup$ I'm wondering more about the relationship between money supply and the stock market (see end of question). Is this possible without increasing the money supply in the long, long term? In that case, eventually the output of any individual company would exceed the entire money supply many times over. Which seems impossible. $\endgroup$ Nov 14, 2022 at 14:21
  • $\begingroup$ My example does not really rely on money supply. The money supply or the velocity of money can both increase to accommodate this 1% growth in value. $\endgroup$
    – Giskard
    Nov 14, 2022 at 14:23
  • $\begingroup$ Supposing the money supply does not change, then for long times if we want to sustain that revenue growth then the velocity of money would have to be so great that even a single company earns many times the entire money supply in 1 year. Is there any reason to believe that this would happen? It seems unlikely and therefore seems to set a limit on how much earnings can grow in the absence of money supply increase. $\endgroup$ Nov 14, 2022 at 14:36
  • $\begingroup$ Okay, but why is this weird? The money creation here is pretty much a byproduct of the real output growth, not its cause. E.g., if a company made 10% more phones, it would need to hire a larger transport capacity to be able to deliver. But the increase of transport capacity is not a cause of the increased output. $\endgroup$
    – Giskard
    Nov 14, 2022 at 14:53
  • $\begingroup$ By what mechanism could the output growth be a cause for money supply? M0 is just decided by the government, so I don't see why it would need to increase if businesses become more profitable. As for M2 it also has a maximal value if M0 does not increase, and that maximal value depends on the reserve requirements for banks so it need not be affected by business prosperity. I may be naive here, apologies if so, I'm just sharing my thoughts. $\endgroup$ Nov 14, 2022 at 15:11

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