Paul Woolley, a former academic, policymaker, International Monetary Fund economist and asset manager, argues that efficient market theory falls down because of the "asymmetric information" problem. This, simply put, is the difference in the quality of information enjoyed by agents - the banks, fund managers, brokers and so forth - and the principals, or end investors. The agents know more than the principals and exploit this to maximise their own wealth. While this worry isn't new, critics have in the past focused on banking and corporate finance and on abuses such as insider trading. Woolley, however, applies it to investment management, arguing that asymmetric information, especially in this area, has far graver consequences for the functioning of finance.
This "agency" problem leads to two bleak conclusions. First, that capital markets do not necessarily price assets efficiently and capital can be misallocated. When the misallocation grows big enough, as it has now, it can lead to substantial macro-economic dislocation. Second, it allows banks and financial intermediaries to capture too big a share of the economic gains from capital investment, and thus from growth itself. And this share - the "croupier's take" in the celebrated phrase of Warren Buffett's partner, Charlie Munger - has been going up as financiers have become ever more cunning. Woolley argues that big and unstable capital markets make it likely that we will suffer more and potentially bigger upsets in future.
Woolley's analysis differs from that of Soros or the behaviouralists in that it does not require one to depart from mainstream economics. In his vision, the participants in financial markets are all acting optimally and rationally in their own self-interest, while generating outcomes that are less than optimal in terms of growth and welfare. Modern financial markets thus tend, Woolley believes, towards dysfunction. This flies in the face of the inherited wisdom that has prevailed since Adam Smith, and his belief in the power of the "invisible hand".
Tuesday, 25 November 2008
Capital market dysfunction
Just a quick plug. There's another bit from a recent weekend FT worth a look here. It includes a look at some of the critiques of efficient markets, including that of Paul Woolley: