Stock Market Efficiency and Economic Efficiency: Is There a Connection?

In a capitalist economy, prices serve to equilibrate supply and demand for goods and services, continually changing to reallocate resources to their most efficient uses. However, secondary stock market prices, often viewed as the most "informationally efficient" prices in the economy, have no direct role in the allocation of equity capital since managers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economicefficiency?We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment opportunities. In equilibrium, information in stock prices will guide investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers' past decisions. However, because this role is only indirect, the link between price efficiency and economic efficiency is tenuous. We show that stock price efficiency is not sufficient for economic efficiency by showing that the model may have another equilibrium in which prices are strong-form efficient, but investment decisions are suboptimal. We also suggest that stock market efficiency is not necessary for investment efficiency by considering a banking system that can serve as an alternative institution for the efficient allocation of investment resources. INA CAPITALIST SOCIETY, prices for goods and service play the central role in resource allocation. The strength of capitalism lies in its ability to make these prices reflect essential information so that resources are deployed efficiently. Consider a fishmonger whose prices for different kinds of fish change every day in response to availability. These prices have a direct effect on the behavior of customers entering the shop: if the price is high they may choose to eat beef for dinner instead. In other words, the allocation of fish to the most efficient uses (in this case, to the people with the highest marginal utility of fish consumption) is accomplished by price changes. These price changes directly regulate the use of the fish. Now consider the equity capital market and its relation to the allocation of funds for capital investment. If a company's share price goes * Dow is from the European University Institute and is also affiliated with the London Business School. Gorton is from the Wharton School of the University of Pennsylvania and is a research associate a t the NBER. We thank seminar participants a t Princeton, UCLA, Boston College, Duke, Stanford, Northwestern, Temple, the CEPR Conference on Financial Intermediation, and London Business School for comments. 1088 The Journal of Finance up, it is not obvious whether its access to equity capital will be altered. This is because stock prices differ from prices in the fish market and most other markets in two ways. First, in the case of the fishmonger, the consumer decides how much fish to buy. In contrast, decisions about the allocation of investment capital are generally delegated to managers with little or no ownership stake in the firm. Managers decide dividend policy, leverage, the timing of new issues of seasoned equity and other securities, and therefore they have discretion over the amount of funding available for investing in new assets. Although the equityholders supply the capital to the firm, they do not decide directly how much capital to supply: instead, the managers do. This is somewhat analogous to the fishmonger telling his customers how much fish to buy. The stock market price is a secondary market price: it values the entire firm rather than a marginal investment. The role played by the stock price is the same as in the fish market example only in the simple case where a newly organized firm issues equity for the first time to fund its investment. In this special case, there is no managerial discretion: if investors believe that the capital can be more efficiently deployed elsewhere, or if the expected returns on the project are insufficient to induce enough saving, then the price will be low and the project may not be undertaken. However only an insignificant fraction of investment capital is raised in this way: the vast majority of investment is funded by retained earnings, by seasoned equity issues, or by new non-equity external financing such as bank loans or bonds. The second difference between fish prices and secondary stock prices is that the flow of information in a stock market may be bidirectional: the market may want to learn about the quality of the managers's decisions, but the manager may also want to learn the market's valuation of prospective investments. The stock price, although intrinsically irrelevant to the investment decision, may be useful indirectly because it conveys information about prospective investment projects and cash flows. For example, a high stock price may signal to the manager that the market believes that the firm has profitable investment opportunities. The fact that the manager seeks to infer information from the price means that the stock price is different from the price of fish: the fishmonger's customers do not care that the market price reflects the marginal utilities of other consumers and the marginal costs of fishing. They need only compare the price to their own marginal valuation (see Hayek (1945)). In other words, the fish market is analogous to what is termed a "private values" model in the theory of auctions. By contrast, stock markets concern essentially "common value" models. In a setting where consumers learn about product quality from the price, both effects may be present: consumers will first infer the quality from the price, then compare the price to their marginal valuation. Models of Rational Expectations Equilibrium (REE) capture both of these effects in general. At one extreme, in the fishmonger example, prices have a direct allocative role and no indirect signaling role. When consumers buy fish it is important that the price reflects information, but the consumers care only about the price and 1089 Stock Market Efficiency and Economic Efficiency do not need to infer the information that determined the price. In general, commodity prices may have both a direct allocative role and an indirect signaling role. For example, if consumers receive different private signals about the quality of fish, the price will convey information about quality as well as information about scarcity. In REE, an agent's demand for the fish will depend on the price through this quality inference. We argue that secondary equity prices are a t the other extreme to fish prices: they have an indirect signaling role but no direct allocative role. These two distinctions between fish prices and stock prices mean that shareholders want managers to draw inferences from prices. There are two complications in designing contracts to induce managers to behave this way. First, managers may have private information that is relevant to the investment decision. The implication of this is that shareholders can not provide simple rules to guide investment based on the observed stock price. The second complication is that managers' decisions may have consequences for the longterm performance of the firm after they have retired. These special features of the stock market raise the question of whether "efficient" stock prices are related to the efficient allocation of resources. In this article we identify two roles for efficient stock prices in enhancing economic efficiency: a forward-looking or prospective role and a backward-looking or retrospective role. Managerial decisions and stock-price formation are linked. This link depends on stock market traders having incentives to produce information and trade profitably on it. We consider a model that integrates the managerial agency problem with a stock market in which information acquisition is costly and prices are partially revealing. In the stock market, traders are willing to produce information about the expected future profitability of current investment opportunities, and to trade on this information, if managers' investment decisions are guided by the price signals. Since, in this case, the information produced by the informed traders relates to an investment decision that has not yet been taken, we call this the "prospective" role of stock market prices. Because of the agency problem, managers will not necessarily extract information from stock prices; they must be given appropriate incentives to make good investment decisions. These incentives are linked to the stock market because stock prices can be used to evaluate previous management decisions. Stock prices can then improve investment decisions by allowing more accurate monitoring of the quality of past managerial investment policy. We call this a "retrospective" role for stock market prices. To summarize, the stock market has an information production role and a monitoring role. The prospective role of stock prices arises because we allow the market to have information that the manager does not already have. This potentially allows the current stock price to be of value in making current investment decisions. If the price goes down, the manager is less likely to invest; if the price goes up, he is more likely to invest. Of course, in equilibrium, the price movement incorporates the fact that the manager's investment will, itself, depend on the price. The retrospective role of providing suitable 1090 The Journal of Finance managerial incentives arises because we assume that managers' investment decisions can affect the value of the firm over a horizon that may be significantly longer than their tenure. As a result, compensation cannot be based on the realized returns resulting from their decisions, but if informed traders find it profitable to produce information about future profitability, then compensation may be based on the stock price. If the stock price is informative, such a compensation arrangement can ameliorate some of the affects of managerial discretion that can occur when the manager's objective function is different from those of the outside shareholders. Our model shows how stock prices can serve to allocate equity capital. This arises in an indirect way: agents infer information about investment decisions from stock prices, even though the stock price is not the "cost of capital" for the investment. However, our model may also have another equilibrium that is not economically efficient. If the stock price is uninformative, the manager may never invest (if the average project is a negative net present value (NPV) investment). Conversely, if the manager never invests, there is no reason for traders to produce information, and stock prices will remain uninformative. We show that this economically inefficient, but price efficient, equilibrium will exist if and only if the average project is negative NPV. This equilibrium exists in addition to the informative one in which stock prices lead to an economically efficient allocation of investment resources. Since the only function of the stock price is the indirect one of conveying information, the question arises of whether the same information transfer could occur in an alternative institution without the price. Indeed, the two tasks of investment appraisal and monitoring management that stock market information is used for are precisely the functions that banks are supposed to perform in making loans. A large literature identifies the role of banks as information producers and monitors of management, e.g., Diamond (1984) and Boyd and Prescott (1986). We also explore how a bank could replace the stock market in our model. Instead of informed traders making decisions about costly information production and possibly trading on their information, the bank hires loan officers who produce information that can be used for both prospective and retrospective evaluation. The same information is produced as in the stock market economy but it is not transmitted via prices. There is a large body of research on welfare economics, and an equally large one on efficient markets theory. However, there has been relatively little work linking these two literatures. By and large, welfare economists have not studied corporate control or asset pricing, while efficient-markets researchers have taken for granted that informational efficiency implies economic efficiency. For example, Fama (1976) writes: An efficient capital market is an important component of a capitalist system . . . if the capital market is to function smoothly in allocating resources, prices of securities must be good indicators of value. (p. 133) In welfare economics, there is a literature on the role of the stock market in the efficient allocation of risk (e.g., Arrow (1953), Diamond (1967), and Hirshleifer Stock Market Efficiency and Economic Efficiency 1091 (1972)), but relatively less work on its role in guiding investment in corporations. However, there are two strands of literature that do link stock prices and investment decisions: q-theory in Economics and capital budgeting in Finance. Tobin's (1969) theory is based on q, the ratio of current market value of assets to their cost: if q > 1, the firm should increase its capital stock. The q-theory is related to our model in that current stock prices play a role in determining whether new investment is desirable. As emphasized by Fischer and Merton (1984), "the stock market should be a predictor of the rate of corporate investment" (pp. 84-85). As in our model, rising stock prices cause higher investment. The empirical evidence is consistent with this view: investment in plant and equipment increases following a rise in stock prices in all countries that have been studied. In fact, lagged stock returns outperform q in predicting investment. This is true both a t the macroeconomic level and in cross-sections of firms. See Barro (1990), Bosworth (1975), and Welch (1994). We differ from q-theory in two main respects. First, we emphasize that firms are controlled not by owners but by managers. The q-theory incorporates the prospective role of stock prices but not the retrospective role. The second difference relates to the distinction between marginal q, which is relevant for investment decisions, and average q, which can be computed directly from the stock price (see Hayashi (1982)). Because, in our model, the informativeness of prices is endogenous, marginal q can only be computed as part of an equilibrium where agents form beliefs about the decision rules followed by other agents. In particular, stock market prices in our model only contain information about future projects that the market believes will be undertaken; this is because in equilibrium, managers will act on this information and so the informed traders will be able to make trading profits that offset their costs of producing the information. In contrast, q-theory takes stock prices, and hence q, as given: "In the q model, the origin of the information about new projects is unimportant. . . Indeed, Hayashi's formal model has no private information a t all. All investors are equally informed, and the stock price reflects fundamentals. This is all that is needed for a q theory model" (Bresnahan, Milgrom, and Paul (1992), p. 212). In contrast to q-theory, the finance literature typically views the chain of causality differently: the information partition of managers is assumed to be finer than that of agents outside the firm. This precludes the possibility of managers learning from stock prices. For example, Korajczyk, Lucas, and Macdonald (1990) and Lucas and Macdonald (1990) interpret the fact that positive abnormal stock returns (over a 200-day window) precede a seasoned equity issue as evidence of an adverse selection problem in issuing firms, rather than as evidence that rising stock prices send positive signals to managers. This unidirectional view of the information flow is clear in capital budgeting theory. Capital budgeting theory is a normative decision rule for evaluating investment projects: expected cash flows are discounted a t suitably risk-adjusted rates of return. In principle, expected cash flows should be conditional on all available information, which could include the current and past stock prices. 1092 The Journal of Finance While this point is generally understood in the literature, capital budgeting theory does not actually explain where expected future cash flows come from. In practice, it is generally assumed that expected future cash flows are exogenous, implying that capital budgeting has little financial or economic content: . . . we consider the investment decisions of firms whose shares are traded in perfect capital markets . . . Strictly speaking, such decisions are technological rather than 'financial' problems and so belong to the field of 'production.' For a variety of reasons, however, the general subject of 'capital budgeting' has come to be taught in finance courses . . . (Fama and Miller (1972, p. 108)). In our model, not all relevant information is always known by the manager and, consequently, he can improve his decisions by using the prospective stock price. In other words, the stock market may have information that the manager does not have. The expected cash flows for the project are calculated using the stock price and, hence, are not exogenous. To summarize, this article presents a view of the firm and the stock market with the following features: Information about an individual firm's prospects may flow from the stock market into the firm as well as in the other direction; Traders will make the effort to acquire this information only if managers will heed the resulting price signals; Firms are run by managers with discretion about the flow of investment capital into and out of the firm; Because managers' employment horizons are short compared to the horizons over which their decisions affect the firm, they may need to be motivated by compensation linked to share prices; Because the role of stock market prices is to signal information rather than to provide a direct allocative mechanism, other institutions, in particular banks, may be equally effective a t producing and transferring the information. The article proceeds as follows. In Section I we set out the model and discuss the assumptions. In Section I1 we characterize the economically efficient equilibrium. Section I11 discusses this equilibrium. In Section IV we discuss the uniqueness of the equilibrium, and Section V develops a bank economy. Section VI concludes.