When the Internet bubble popped in 2001, some legal scholars heard an explosion while others heard an annoying hiss. Prior to the 1990s, financial economists spoke of market efficiency in the same way an electrician might describe a toggle switch: it’s either on or off. Markets are either “efficient” or “inefficient.” What that usually meant, when describing capital markets, was either that securities prices incorporated all publicly available information about the issuing company (“efficient”) or they did not (“inefficient”).

More recent economic scholarship has taken a more nuanced view of market efficiency. Instead of a toggle switch, most financial economists liken market efficiency to a dimmer switch, with varying degrees of brightness depending on one’s faith in market institutions. Under this view, the issue is not whether a market is efficient, but whether the market is efficient enough.

This difference in view between toggle switches and dimmer switches has important implications for debates about corporate governance. During the 1980s, corporate governance scholars were preoccupied with the implications of the efficient markets on governance law and practice. For most of that decade, efficient markets was treated as more than a hypothesis. In the oft-quoted words of Michael Jensen, “there is no other proposition in economics which has more empirical evidence supporting it.” Embracing this view, many legal scholars relied heavily on efficient markets to do the work of corporate governance, particularly through hostile takeovers.

Recent research is less sanguine on the ability of markets to perform the tasks necessary to a well-functioning corporate governance system. This research suggests two propositions on which financial economists could likely reach broad consensus: (1) irrational investors have the ability to push prices around; (2) these deviations from fundamental value are either trivial in size or impossible to detect, thus limiting arbitrage opportunities for rational investors. In other words, markets might be “efficient” in the sense that rational investors will not be able to consistently beat the market, even while prices generated by those efficient markets deviate from fundamental values.

The implications for corporate governance are clear: markets need help. Recent reforms by Congress and the SEC have been much criticized, but the general inclination is right. Corporate governance cannot run on the fuel of efficient markets alone.

Corporate Governance | Bookmark

TrackBack URL for this entry:
https://www.typepad.com/services/trackback/6a00d8345157d569e200d834226f8d53ef

Links to weblogs that reference Corporate Governance & Market Efficiency: