I used to believe in efficient markets, but in these past months I’ve lost some faith. It has gotten to the point where I no longer ask if efficiency exists, but why it doesn’t. The answer to which I increasingly arrive has to do with size, and the growth of entities.

Inherent in the concept of an efficient market is a fragmented universe of investors – who are decision makers, who between them have access to all available information, who between them  represent a large variety of opinions – so that the marketplace is the point at which this perfect variety intersects. Now for argument’s sake, let’s assume a scenario in which all industry is consolidated into one entity: The management team of this hypothetical entity owns a small fraction of its stock – negligible really (due to the enormity of the entity’s capital base),  and for all intents and purposes zero – but is in charge of the one business entity in existence, and thus enormously influential.

Here we have a scenario in which unbridled power is combined with minimum economic incentive to decide, or, better stated, to decide thoughtfully. There is no competition, there is no equity. There is a paycheck and a product that goes on. Regardless of the decisions made, the risk and reward are both neutralized. What this does to efficient markets – actually, in this case there is no market at all – which are predicated on decision makers with opinions, information, and incentive to act, is destructive.

But this is an extreme scenario, which is hypothetical. It does, however, serve a purpose. From it, we can trace a path back, little by little, to two entities, three entities, four, five, in a number of different sectors, and determine an approximate point at which market efficiency is diminished, which point is not at the extreme depicted. Coming at it from the opposite direction, another exercise we can undertake is to assess the actual efficiency of our actual markets and actual economy, by determining our actual proximity to the point described.

With such backdrop, we read this editorial by economist Paul Krugman about the conflict of rating agencies who collect fees from the issuers they rate, rather than the investors whose interest these rating agencies theoretically protect. This only tells half of the story. The other half is that investors consider their interests protected by rating agencies whose fees are paid by the issuers of securities. A paycheck is a paycheck, right? There is a carelessness illustrated by this case of which a true owner, with true owner’s principles, would not be guilty. I recently posted about the end of the Wall Street partnership, and its replacement with an employee culture, as a root cause behind other fundamental flaws in the system. This had to do with individual firms, and I stopped short of considering the impact of this argument on the broader  markets. But now I wonder.

In a period of ten years, two financial bubbles have blown and popped.