The failures in the financial market: Market Failures vs. Government Failures

Journal of the Academy of Business and Economics, Jan, 2003 by Ge Wu, Jun Liao

ABSTRACT

The paper compares the "failures" in the U.S stock market with Chinese stock market recently. The authors find that the phenomena of the failures in two markets are very similar: the boom-bust of the stock prices, the corporate accounting scandals, and the negative effects on the whole economy. However, 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. Therefore, we should take different actions to avoid the "failures".

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. However, 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 should take different actions to avoid the "failures" (In this paper, "Government" is a broad concept. It includes not only the traditional government, but also the Security Regulation Committee, the Monetary Authority and other management or regulation departments.).

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 what its advocates claim it does best. A number of market failures spoil the idyllic picture assumed in efficient market: imperfect competition, externalities, and imperfect information (Paul A. Samuelson, 1998). 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. However, in fact the managers and the other corporate insiders always have more information than the small investors do. 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. However, 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 cannot avoid the "failures" sometimes. Therefore, if the regulation could not keep pace with the development of the market, the market chaos and "failure" would happen.