Just a few years ago, America’s stock market was the envy of the world. Thanks to new technology, friendly regulation, and the innovativeness of the financial services industries, it was open to anyone, anywhere, anytime. On-line brokerages like E*Trade let individual investors buy and sell just a few hundred dollars’ worth of stock from their homes or offices at the push of a button and for little or even no cost. A favorable tax regime on pension savings and sophisticated tools for retirement planning offered by the likes of Fidelity made it easy—even essential—for the average citizen to join the fun. Web sites like TheStreet.com and CBS MarketWatch kept stock market junkies up-to-date with breaking stories 24 hours a day, seven days a week. Americans poured into the market by the millions, and the more they invested, the more liquid, accessible, and attractive the markets became.
How the Quest for Efficiency Corroded the Market
Reprint: R0307F
Just a few years ago, the U.S. stock market was the envy of the world. Thanks to new technology, friendly regulation, and the innovativeness of the financial services industries, it was open to anyone, anywhere, anytime. Americans poured into the market by the millions, and the more they invested, the more liquid, accessible, and attractive the markets became. For a while, this seemingly virtuous circle worked economic wonders. In America’s equity-hungry culture, a record number of start-ups were able to go public and grow rapidly.
The world is much less jealous today. Belatedly, investors have come to recognize that the vaunted business models of the new economy were more effective at consuming capital than generating it. It has also become clear that irrational exuberance was not the only problem with America’s financial system.
The recent stock market and corporate governance failures, the authors argue, are rooted in regulatory and market changes introduced 20 years ago. These were intended to reduce the cost of financial information and increase liquidity—enhancements that the regulators believed would improve both investor access to the market and efficiency in pricing. The goal of liquidity was achieved, but the changes also triggered a race for the bottom in the auditing profession, destroyed the economics of investment analysis, and discouraged professional investors from relying on their own rational judgment.
In this article, the authors explore what went wrong and outline their ideas for radical reform. They propose putting the country’s stock exchanges in charge of the audit process; creating a new Investors Union modeled on the highly successful Consumers Union; and introducing a graduated tax on trading in pension savings.