The real effects of financial markets

An essential topic in financial economics is investigating whether financial markets exert an influence on the actual economy. This inquiry has gained significant relevance, particularly following the recent financial crisis. A notable area of study, as exemplified by Bernanke & Gertler (1989) and Kiyotaki & Moore (1997), delves into how issues of adverse selection or moral hazard impact primary financial markets by constraining entrepreneurs and firms from obtaining external capital. This restriction consequently curtails real investment, resulting in limitations in primary financial markets leading to a reduction in real economic activity.

However, an essential aspect of real-world financial markets is absent from this research stream: the considerable portion of activity occurring in secondary financial markets. In these markets, securities are exchanged between investors without capital flowing to firms. The quintessential example of a secondary market is the stock market, where capital flows to a firm exclusively during share issuance; otherwise, trading primarily involves investors and doesn't involve the firm directly. This applies to derivative markets as well, which are almost invariably secondary, along with substantial activity occurring in secondary bond markets. Developed economies allocate significant resources to secondary markets such as the stock market. However, in the research mentioned earlier, secondary financial markets either have no impact on the actual economy or only affect it insofar as post hoc liquidity influences firms' capital costs in primary markets.

Why, then, do secondary financial markets receive so much attention? Why do managers consistently monitor their firms' stock performance? Why does the media frequently report on stock market developments? Can this focus be justified in a scenario where secondary market prices are passive—meaning they solely mirror future cash flow expectations without influencing them—akin to many economic models, including those found in asset pricing literature? Similarly, is it reasonable to assume that secondary market prices remain purely passive and devoid of real impact, despite a vast empirical body of evidence demonstrating the extent to which prices encapsulate information about future cash flows?