Are Markets Efficient? Competition, Incentives, and Financial Bubbles

Book: Financial Cold War
Author: James A. Fok
ISBN: 9781119862765

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Chapter 7 asks a basic question we skip too often. What are financial markets actually for? Fok opens with a Depression-era cartoon caption: “Phew! That’s a nasty leak. Thank goodness it’s not at our end of the boat.”

Trade civilized humanity. Money and finance followed. Markets should channel capital to productive uses and spread risk so bigger ventures become possible. But whether they do that depends on politics, incentives, and human psychology. Fok’s answer to “are global markets efficient today?” is yes and no.

Selective efficiency

Eugene Fama’s efficient-market hypothesis says prices reflect all available information. You cannot beat the market consistently. That idea powered index funds and free market policy since the 1970s.

Warren Buffett and others proved the theory wrong in practice. Investors swing between greed and fear. Behavioral finance documents loss aversion, confirmation bias, and availability heuristics. People hold losing positions too long. Losses hurt roughly 1.5 to 2.5 times more than equivalent gains feel good.

Paul Samuelson said markets are “micro efficient” but “macro inefficient.” Spotting mispriced stocks is easier than fixing the whole system.

Climate change is the clearest macro failure. Temperatures are up at least one degree Celsius since industrialization. Extreme weather and rising seas already kill and displace people. Markets focus on quarterly earnings. Cutting emissions means big costs now for benefits that are hard to price. Over 80% of world energy still comes from fossil fuels.

Markets price what can be monetized. Many social and environmental costs cannot be. Outsourcing public services to markets has reduced accountability. Covid exposed how thin public systems in developed countries had become.

Intergenerational conflict blocks action. Younger people inherit climate damage, aging-population welfare burdens, and public debt. Geographic distance matters too. Bangladesh, one of the poorest countries, sees 20-30% of its land underwater regularly from floods. Bangladeshis cannot fix that without China, the US, and other big emitters changing course.

Markets work when incentives align. Elites have repeatedly subverted them when competition threatened their position.

What happens when competition dies

Medieval Venice grew from 45,000 to 110,000 people through open institutions. The comenda partnership let young traders without capital share in voyage profits. That drove social mobility. Independent courts, contract law, and banking innovation followed.

Venice’s elite hated creative destruction. From 1286 they seized political control. The comenda was abolished. Trade was nationalized for nobles. Population shrank while Europe grew. Venice never recovered its dynamism.

The lesson: markets need institutional guardrails. State, market, and community fight for power constantly. Incumbent elites do not need evil intent. They just protect their children’s advantages. Over generations, hereditary meritocracy strangles mobility.

China’s reforms since the 1970s increased competition with good results. State control remains a question mark. In the US, free market rhetoric did not produce competitive markets. Most industries consolidated into monopolies or oligopolies.

Scale brings margins, financing, and pricing power. Smaller firms get acquired or crushed. Even innovators eventually exploit dominance. Kennedy’s antitrust chief Lee Loevinger told Congress that questions of power distribution are second only to nuclear survival.

The 1974-1980s breakup of AT&T unleashed modems, answering machines, and the internet revolution. Europe and Japan kept telecom monopolies and fell behind in computing. AT&T was the last major US breakup. Bush’s Justice Department brought zero anti-monopoly cases in eight years.

Facebook bought Instagram for $1 billion and WhatsApp for $19 billion. Google and Amazon made over 100 and 240 acquisitions respectively. Weak antitrust enforcement let giants buy competition instead of beating it. Share buybacks replaced R&D. That helped slow US productivity growth.

Wrong incentives

Principal-agent problems run deep. Paying executives in stock was supposed to align interests with shareholders. Instead it encouraged short-term stock pumps through buybacks.

Since the GFC, S&P 500 companies spent $2.8 trillion on buybacks. Buybacks were illegal after 1929 as market manipulation until 1982. Corporate reinvestment fell from 20% of revenue (1959-2001) to 10% (2002-2015). Cisco spent $129 billion on buybacks between 2002 and 2019, more than all its R&D. Huawei’s retain-and-reinvest model looks different.

CEO-to-worker pay went from 30:1 in the 1970s to 361:1 today. Boards, shareholders, and governments rarely stop it. Independent directors sit on multiple boards and avoid rocking boats. Compensation consultants benchmark upward. Institutional investors chase quarterly returns. Capital gains tax beats dividend tax, so buybacks win.

German two-tier boards with worker representation force longer-term thinking. In America, lobbying, campaign money, and the revolving door block reform.

Almost 50% of Harvard seniors went to Wall Street before the GFC versus 3.5% into government. Finance grew from 2.3% of US GDP in 1947 to 8.3% in 2020. One dollar in eleven of US income goes to financial services. Fok asks the obvious question: has the economy become excessively financialized?

Bubbles and cycles

The GFC and Covid recession were the worst downturns since the Great Depression. Crises have hit more often over the past 30 years. Bubbles inflate prices, then burst. Liquidity dries up. Banks stop lending. Governments choose between depositor losses and taxpayer bailouts.

The 1720 Mississippi Bubble helped cripple French finances and fed into revolution decades later. The 1929 crash fed Nazism and World War II. The GFC fed populism and Sino-US tension.

Bubbles are not all bad. They funded railroads, telecom fiber, and technologies that later paid off. Dot-com firms laid $500 billion in fiber. Shareholders lost $2 trillion. But cheap broadband enabled Netflix and the modern internet.

Quinn and Turner identify three bubble ingredients: marketability, credit availability, and speculation, plus a catalyst from technology or policy. Bigger bubbles with more linkages cause bigger busts. Mortgages hit almost everyone. Securitization made homes tradable. CDS created false safety. Government homeownership policy and cheap credit supercharged the 2008 disaster.

Fifty years of financial innovation increased marketability and credit. Stock turnover went from 39% of market cap in 1976 to 169% in 2020. Global liquidity pools hit around $130 trillion, two-thirds larger than world GDP.

More liquidity cuts trading costs but adds fragility. Leverage makes cycles more violent. Derivatives hide debt from GDP ratios. Shadow banks and cross-border lending escape oversight. Short-term repo financing increases rollover risk.

Retail investors opened brokerage accounts during Covid lockdowns. High-frequency traders run 50-60% of US stock volume. The 2010 flash crash showed algorithm speed can amplify volatility. HFT adds liquidity but does not fund the real economy.

Bill Hwang’s Archegos fund turned $200 million into a $30 billion paper fortune through leverage, then lost it in days in March 2021. Equity prices decoupled from earnings. The S&P rose 13x in the 1980s-90s while earnings tripled. Markets track liquidity more than fundamentals.

After the GFC and Covid, regulators forced banks to hold more capital. But global liquidity kept growing, driven heavily by central banks. Radical steps were needed in crisis. Fok’s question at the end of this section: has the path chosen stored up worse problems ahead?

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