Journal of Academy of Business and Economics

Volume: 1， 2003

The Failures in the Financial Market: Market Failures vs Government Failures

Wu, Ge 1 Liao, Jun 2

1. Introduction After the World War II, the International capital flows quickly across the world and the financial liberalization develops rapidly. The quantity of the financial assets exceeds the other assets. The financial assets grow faster than GDP no matter in the developed countries or in the developing countries. Furthermore there is a trend that the fictitious economy grows independently with the real economy (Drucker,1986). All these allocate the resources effectively, but there is a possibility that the financial markets would have negative impacts on the real economy. The credits are based on the investors’ expectations of the future earnings. In fact they are very “fragile”. If the credits boom irrationally and the asset prices are so high, one day the expectations would change rapidly and they would do great harms to the whole economy. The boom-bust of financial asset is the “failures” in the market. The nature of phenomena is the separation between the value and price of the assets. Under the conditions, the mechanism of the market and price is undermined. In fact, the “failures” do exist in any financial market. Now this paper will compare the “failures” in the U.S stock market with Chinese stock market recently. The author finds out that the phenomena of the failures in two markets are very similar: the boom-bust of the stock prices, the accounting scandals (Enron Scandals in U.S, Yin Guangxia Scandals in China) and the negative effects on the whole economy. But the causes of failures are much different. The failures in the U.S stock market are “Market Failures”, caused by the lack of regulations relative to the rapid changes of the financial market. While the failures in the Chinese stock market are “Government Failures” caused by too many interventions in the financial market. So the government 3 should take different actions to avoid the “failures”.

2. The “Failures” in the U.S Stock Market: Market Failures In 1956, Professor Bator in MIT created the concept of the “market failures”. Market outcomes are supposed to be efficient, both allocatively and productively. When they (market outcomes) are not efficient, we consider them failures. In the case of market failures we are productively inefficient and/or allocatively inefficient. The market system has failed to deliver on 1

Ge Wu earned his Master's degree at Tongji University, 2001. Currently he is a Ph.D. candidate at the Fudan University, Shanghai. 2 Jun Liao earned her Bachelor's degree at Tongji University, 2002. Currently she is a Master's degree candidate at the Fudan University, Shanghai. 3 In this paper, “government” is a broad concept. It includes not only the traditional government, but also the 1

Journal of Academy of Business and Economics

Volume: 1， 2003

what its advocates claim it does best. A number of market failures spoil the idyllic picture assumed in efficient market 4 : imperfect competition, externalities, and imperfect information. The characters of financial assets determine the fact that there are more “market failures” in the financial markets than in the products markets(Wang Sheng,2002). There are several reasons behind the “market failures” in the U.S financial market: 2.1 Information asymmetry and the incentive mechanism In stock market, it is the information symmetry that determines the efficiency and fairness of the market. But in fact the managers and the other corporate insiders always have more information than the small investors. The information is asymmetric between them. Information asymmetry causes markets to become inefficient, since not all the market participants have access to the information they need for their decisions making processes. Although the ownership and control in the large corporation are divorced, there is no clash of goals between the management and the stockholders in most situations. Higher profits benefit everyone. But there are potential conflicts of interest between managers and stockholders. The moral hazards in the corporate governance are always unperceivable and serious. In the chain of delegation, any concealment of information might have important impact on the gains of the investors. Furthermore the tiny flaw of the regulations in financial markets would be “exaggerated” and the consequences are much more serious than in the common product markets. Recently the cheat actions and the insider trading are becoming “common” in the U.S. stock market. The incentive mechanism such as stock option might be the key problem causing the scandals. The managers colluded with the accountants to deceive the investors and finally the insiders who have inside information would profit from it and the other investors would be suffered. With the rapid development of the financial assets and new derivatives, the markets are becoming more and more complicated. Although the U.S stock market is one of the “mature markets” in the world, it can’t avoid the “failures” sometimes. So if the regulation could not keep pace with the development of the market, the market chaos and “failure” would happen. 2.2 Free rider and “Irrational Exuberance” As we know, the more information we have, the less uncertainties we have to face. But there is no free lunch in the world. The information is not free for us assumed in the traditional economics. It will take us some costs to get the information we need. Especially in the situation of information asymmetry, the costs for the information are always very high. The small investors have to pay much for the supervision on the managers and getting some important information, but the benefits are shared by all the shareholders. Under the principle of “one share, one right”, the supervision and information become a kind of “public goods”. Then the “free riders” 5 appear in the stock markets. At the same time, listed companies always tend to offer information as little as possible. So the monopoly of information increases the investors’ costs for the search. The actions of the Security Regulation Committee, the Monetary Authority and other management or regulation departments. 4 Paul A. Samuelson, William D. Nordhaus: Economics- 16th ed. 1998. The McGraw-Hill Companies, Inc. 5 A free rider means the person who chooses to receive the benefits of a "public good" or a "positive externality" without contributing to paying the costs of producing those benefits. 2

Journal of Academy of Business and Economics

Volume: 1， 2003

investors who had made some researches would be easily “copied” by the other investors who hadn’t done. All these weaken the incentive for the information search. Robert J.Shiller 6 analyzed the reasons why U.S investors are irrational in his famous book “Irrational Exuberance”. The logic behind the irrational actions is “free rider theory”: since there are so many researchers had spent so much time and energy on the studies of the securities, why shall I waste time doing the same things? What I should do is following them: JUST BUY IT! Then the “Herd Behavior” comes into being. And together with the fabrications on the financial statements, the “fallacy of composition” leads to the boom of prices of securities and the probabilities of market “failures” in future. 2.3 The speculation purposes and negative externalities The negative externalities of stock markets are some kinds of “market failures” too. The incentives of investors especially in the secondary markets are the maximization of their profits. When a psychological frenzy seizes the market, it can result in speculative crashes and most of the investors would throw off their stocks regardless the negative impacts on the other markets or the whole economy. In fact, the boom-bust of the assets prices would lead to the bankruptcy of financial institutions and do great harm to the foundation of the growth of economy 7. According to the theory of Welfare Economics, the negative externalities could be compensated by Pigovian Tax. Unfortunately it is very difficult to carry out the plan in practice. The negative externalities can not be eliminated by the transaction of markets. So it is necessary for us to use another power (such as the government) to limit the negative externalities from financial markets. We could conclude from above that the “failures” in the U.S stock market are the kind of “market failures” that the causes are intrinsic market flaws with rapid growth of the financial market. All these provide the reasons why U.S government should regulate the financial markets more actively.

3. The “Failures” in Chinese Stock Market: Government Failures Although the “failures” in Chinese stock market are very similar to the U.S market, the Chinese “failures” have their own characters. In the transition economy, the government dominates the stock market. It is this kind of excess intervention that leads to the “failures”, the “government failures” 8. 3.1 Asian Values and government intervention

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Robert J.Shiller. “Irrational Exuberance”. Princeton University Press in association with Arts & Licensing International, Inc. 2000. 7 Michael D.Bordo and Olivier Jeanne, Boom-Busts in Asset Price, Economics Instability, and Monetary Policy, NBER Working Paper NO.8966.2002 8 The concept of “government failure” was advocated by James M. Buchanan. Government failure occurs

when the government intervention in the market to improve the market failure actually makes the situation worse. 3

Volume: 1， 2003

Journal of Academy of Business and Economics

In general, the spirits of freedom are advocated in Western country. While in Asian Values, the people pay more attention to the interest and privilege of the authorities, states or countries even in spite of the individual’s. The individual should yield himself to the power based on the Confucianisn. 9 In eastern cultures, governments are regarded as the power of the whole society. Frequent interventions in economic activity are believed to be necessary, so most of the eastern countries have their own powerful governments. The states are much more powerful than the markets. At the beginning, all these play positive roles in the economy and the government can gather its resources on some “great project” such as stabilizing the internal situations, defending the country against the enemy and so on. But in fact these do great harm to the whole economy in the long run. It is undoubted that Asian Values are the potential factors that the governments tend to intervene in the stock market. Just under such “cultures”, together with the lack of supervisions and laws, the statesmen always want to profit from “the right rents”. And the enterprises always ask for helps and supports from the governments. The market mechanism is feeble in Chinese stock market. Stock market is something like a “political tool”. From the point of view, the “failures” in Chinese markets are caused by Asian Values. 3.2 Accounting scandals and the collusions between governments and state-owned enterprises As we know, China is a socialism country with public ownership taking the leading role. The government and enterprises are one “family”. There is no efficient client-agency relationship between them. No one supervises the state-owned enterprises indeed. And government officials act in their own self-interest, often corrections for market problems create problems of their own. So lack of supervisions government and enterprises sometimes would collude together and stand against the small investors for the common interests. Accounting scandals occur when the state-owned enterprises collude with some immoral accountants and officials. Even if the government has realized the facts, they do not have an incentive to correct the problems and they would protect the enterprises because of so-called “paternalism”. All these provide a “hot bed” for the scandals. During the process the government shifts the money from small investors to state-owned enterprises by its power. In the end the interest of the small investors lose. 3.3 Control over the stock index and the special function of Chinese stock market From the historical figures of the stock index in Chinese market, it is easy for us to notice that each boom-bust of stock price has something to do with the government intervention. In contrast to most other countries, Chinese stock market has its special function in transition period: it serves as a “financing tool” for the state-owned enterprises. When the stock index is very low, the government would “save” the market by issuing many “good” policies.(Zhang Yichun,1997). Because it is not good for the enterprises to finance when the secondary market is inactive. On the other hand, when the stock prices have been booming for a long time the state-owned enterprises intend to invest much into the stock market. Because of inefficient client-agency relationship and the soft budgetary restraints, the actions of the enterprises are irrational and sometimes they even 9

Tu Weiming. “The western and eastern values”. Lianhe Zaobao.

Sep.4. 1995 4

Journal of Academy of Business and Economics

Volume: 1， 2003

use the money from banks or the primary market for their speculations. It is so dangerous when the bubbles burst finally. The enterprises’ financial assets would shrink rapidly and the banks have to face so many bad debts. Who will be responsible for the “investment”? No one! Then the government has to accept all the results and lose in the end. So in order to avoid this kind of embarrassments, the government would be sensitive to the higher stock index. When the index is booming, there is an intrinsic incentive for the government to “put it down”. It is the special function of the stock market and the existence of “paternalism” that lead to the irrational intervention in the market frequently by the government regardless the continuance of policies. Thus the government creates more systematic risk and distorts the expectations of investors. Perhaps the government sometimes issues some “good news” to stabilize the market, but the intervention in the markets is almost always more complicated than it initially looks and the result might be on the contrary because of no trust in the government (Peng Wenpin,2002).

4. Conclusions The scope of government control over the economy has been a political battleground for centuries. 10 Markets have over the last two centuries proved to be a mighty engine for powering the economies of industrial countries. Nonetheless, about a century ago, government in virtually all countries of Europe and North America began to intervene in economic activity to correct the perceived market failures and imbalances of economic power. In a word, there is no perfect financial market in the world. This paper compares the “failures” in the U.S stock market with Chinese stock market recently. The author find out although the phenomena of the failures in two markets are very similar, the causes of failures are much different. The failures in the U.S stock market are “Market Failures”, caused by the lack of regulations relative to the rapid development of the financial market. While the failures in the Chinese stock market are “Government Failures” caused by too many interventions in the financial market. So we should take different actions to avoid the “failures”. In conclusion, the “visible hands” and “invisible hands” are all necessary in our economy. Whether the government intervenes in the market or not depends on the culture background of the country, the mature degree of the market and so on. All countries across the world should grasp to find the appropriate balance between state and market. Although the U.S. market is relative mature, it can’t avoid the “failures”. With the rapid development of financial market and tools, the U.S government should strengthen regulations more actively. While in the newly emerging market like Chinese, the excess intervention is reasonable in some respects. But in the other hand, we should realize that the transition problems in China such as state-owned enterprises relate to the historical and intrinsic institutional causes. The lack of capital supply is not the key one to solve the enterprises’ problem. So finally we suggest that Chinese government should deepen the enterprise reform and withdraw from much of the financial market based on the regulations and laws. Thus the whole economy would benefit from the development of the stock market.

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Paul A. Samuelson, William D. Nordhaus: Economics- 16th ed. 1998. The McGraw-Hill Companies, Inc. 5

Journal of Academy of Business and Economics

Volume: 1， 2003

References Michael D.Bordo and Olivier Jeanne, Boom-Busts in Asset Price, Economics Instability, and Monetary Policy, NBER Working Paper NO.8966.2002 Robert J.Shiller. Irrational Exuberance. Princeton University Press in association with Arts & Licensing International, Inc. 2000. Paul A. Samuelson, William D. Nordhaus. Economics- 16th ed. The McGraw-Hill Companies, Inc. 1998. Peng Wenping, “Stock Market Policy and the Price Volatility.”, Economics & Management. 2002. No.6 Wang Sheng, “The Government Actions in Stock Market.”, International Finance Newspaper , Aug.10. 2002

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