Columbia Law School
The New Mechanisms of Market Inefficiency
Mechanisms of market inefficiency are some of the most important and least understood institutions in financial markets today. A growing body of empirical work reveals a strong and persistent demand for “safe assets,” financial instruments that are sufficiently low risk and opaque that holders readily accept them at face value. The production of such assets, and the willingness of holders to treat them as information insensitive, depends on the existence of mechanisms that promote faith in the value of the underlying assets while simultaneously discouraging information production specific to the value of those assets. Such mechanisms include private arrangements, like securitization structures that repackage cash flows from debt instruments to produce new financial instruments that are less risky and more opaque than the underlying debt, and public ones, like the rules allowing many money market mutual funds to use a net asset value of $1.00. This essay argues that recognizing these mechanisms of market inefficiency as such is a critical first step in devising policy interventions that achieve desired aims. This runs counter to the instincts of many market regulators, like the Securities and Exchange Commission, and academics who have often assumed that markets should be structured to promote information generation and efficiency.
The essay further shows, however, that defenders of the informationinsensitive paradigm have failed to provide a robust institutional account of how those mechanisms can remain robust across different states of the world or the government support required if they cannot. When an adverse shock or other signal raises questions about the value of the assets underlying an information‐insensitive instrument, market participants can refuse, en masse, to treat those instruments as safe. Unless the government or some other actor can provide credible information about the value of the underlying assets or financial support that renders such information irrelevant, widespread market dysfunction can follow. When that happens, the very mechanisms of market inefficiency that had enabled a market to develop can exacerbate dysfunction. Following Ronald Gilson and Reineer Kraakman’s admonishment that institutions always matter, this essay calls for the development of rich institutional accounts of how the mechanisms of market inefficiency work, when and how they can fail, and what these dynamics reveal about the role regulators should play in these domains.
Very few scholars could write an article about the efficient market hypothesis (EMH) that could be widely cited while the notion was in vogue and remain influential as the notion has fallen out of vogue. In The Mechanisms of Market Efficiency (MOME), Ronald Gilson and Reinier Kraakman achieved just this feat. Moreover, they did so not by some clever sleight of hand that glosses over issues of whether or when the EMH holds, but precisely because of their willingness to dive into those tricky questions.
At the time they published MOME, in 1984, financial economists, lawyers, and others had widely, and often uncritically, embraced the notion of market efficiency. Against this background, Gilson and Kraakman brought a note of caution. Not so fast, they warned.
Markets are not magic places where everything just always works out in the end; policies and theories that assume as much are destined to fail. Institutions matter. Information is costly to access and costly to analyze. Market efficiency, therefore, is not a simple concept that can be assumed to hold across time and space. Rather, it is a theory that means little without an institutional account of how markets become more efficient and the conditions required to achieve that outcome.
Circumstances have changed significantly in the intervening 35 years. The rise of behavioral economics, stock market bubbles, the Enron and WorldCom scandals, and the 2007–2009 financial crisis (Crisis) are but a few of the developments that have chastened EMH enthusiasts. Paul Krugman expressed the sentiment of many in 2009, when he accused economists of “mistaking beauty for truth.” In his telling, economists had failed to foresee the crisis because “the field was dominated by the ‘efficient‐market hypothesis,’... which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information.” For many readers, the natural implication was that the EMH is wrong and should be left for dead.