Economic Forum:The efficiency of markets and resource allocation demystified

As pointed out in earlier articles, economists around the world are debating the new economic paradigm that will serve world economies for centuries to come, after the existing model fell flat (is expired!) as a result of the current financial crisis. This crisis has informed even the diehard capitalist adherents that, this model of development has serious flaws, and can no longer be trusted to ensure efficient resource allocation. Economic development literature is loaded with numerous endorsements of the capitalist model of development so much so that, any economist who dared question its application let alone legitimacy was relegated to the peripherals of the profession, and had to reinvent himself/herself or at worst change the career. Un like the planned/command economies (in their extreme case; the communist economic setting) where resource allocation decisions were made by a central planning authority, in capitalists economic setting, such decisions were left to individuals, and there is no place for the state to direct the allocation of such resources. The architects of this model (western model of development) held as a cardinal rule the theory that, markets would at the end ensure efficient allocation of resources to where their yielded the highest returns (even at the expense of social benefits). Financial economists in particular formalized the theory of efficiency of markets, asserting that, markets would regulate themselves and as a consequence, financial innovation resultant, would benefit these economies. Wall Street, London’s financial markets as well as those in Japan and other European esoteric financial instruments that were built on these ideals, for sometime seemed ideal until the recent financial crisis. How efficient was the Efficient Market Hypothesis (EMH)? The recent breed of economists (that have informed and shaped most western financial decisions) drew heavily from the Efficient Market Hypothesis (EMH) which was widely adored by most western economists, but controversial among conservative economists and admonished by socialists economists. EMH basically refers to a situation where the market prices instantaneously and fully reflect all available information (especially in financial markets). The pioneer of this hypothesis (Fama, 1970) had asserted that, “the primary role of the capital market is allocation of ownership of the company’s capital stock. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation… under the assumption that security prices at any time ‘fully reflect’ all available information”. Many famous names in this profession, including Joseph Stiglitz, Ross and Westerfield endorsed this hypothesis, and by extension became the hall mark of decision making in western financial markets where market regulation took a back seat. Nonetheless, the Enron scandals and others after it, signaled to western policy markers, that EMH can not after all hold when you have all sorts of characters who were bent to make most (read supernormal profits) by manipulating financial information and thus distort financial market mechanisms. As the saying goes; in every market place, there is ‘a mad man/woman’) and in financial markets the desire for quick returns drives irrationality to the highest levels it can be. Thus, one assumption that this hypothesis under-rated and which was to be catastrophic was that, efficiency or other wise of the financial market, was a product/function of the individuals in these markets, most of which became billions (either on their own or for corporations which were politically connected) by manipulating market information or using it to their advantage. Inefficient Markets That developing counties have not been hit hard by current crisis can be explained in part by inefficiencies of their financial markets. Existing consensus among financial economists is that, developing countries in general, have inefficient financial markets, owing mainly to a number of factors. The first and perhaps major obstacle to EMH in developing countries (including ours) is poor and imbalanced communication infrastructure, which has meant that, some investors have access to more information than others. Secondly, inadequate regulatory framework and low standards of reporting by companies distorts the entire financial environment. The size of financial instruments is another constraint, as these are inadequate to ensure diversified portfolios. This, coupled with inadequate number of traders (few buyers and sellers) makes such markets rather ‘thin’. These markets are in most cases dominated by monopolistic trading systems where buyers are at the same times sellers, bleeding the highest levels of market corruption in any market. The above constraints, mean that, the level of integration with developed financial markets has been negative. This has nonetheless reduced the extent to which the current financial crisis has hit developing economies. New Economic Paradigm? Given the market failures that have caused the current crisis, the emerging thinking is about the best economic model that fits the new economic panorama emerging after the current crisis. Capitalists model has been taken a big hit at its core, for the fundamental principles of EMF have been laid to rest. The massive intervention by western governments (through stimulus packages) has brought the state into this other wise free market, for good reasons. This is due to fact that, the same free markets, could not save themselves from their imperfections and thus the need for state rescue. And if markets can not rescue themselves from their own failures, then there is need to have a second force (state) to moderate excesses of the markets. The new regulatory regime being designed by many western economies attest to the extent to which the state will now be a major player in these markets. This development has therefore meant that, the idea of mixed economy where the state and market forces are at work is gaining momentum as a perusable option that will replace the extreme capitalism we have lived with for some time now. Good news is: the would be opponents of such new paradigm have had their credibility put to question, that their moral latitude will take time to define, if it does. The only lacuna with this new economic paradigm will be the limits to which the sate can intervene in the dynamisms of financial markets. It very likely that we will witness private financial corruption replaced by public financial corruption at scales much higher than what the inefficient markets has produced. This will result in less than optimal results to the underlying economies. But this will also mean redefinition of liberalism which has also been taken to the extreme. For instance the idea of free movement of capital across continents unchecked may be history. The same will be true to trade liberalization for financial liberalization is usually a means to facilitate trade liberalization. All these new development simply means that, as western economies redefine the new development paradigm, emerging economies of China, India, and Brazil, will be a head of the pack as they are more flexible to embrace the new order better than western economies. As for us in Africa, we shall follow which ever order emerges, once the Bretton Wood institutions have certified the same. Visionary policy makers in developing countries may design their own in advance. They only have to be sure that, it suits their economies. Convincing Bretton Wood institutions that it is what serves our interest best, would be a tall order though. Still, it is the best option we have regardless of who agrees with us. The current financial crisis has after all, eroded the prescriptive might of most. Ends