Economists tell us there are four principal types of market failure: public goods, externalities, asymmetric information, and market power. They do not talk about the fifth type, the one where efficient markets actually cause market failure by destroying the infrastructure underlying and stabilizing markets and their allocative activities.
Consider here the 2010 flash crash of the U.S. stock market. Subsequent investigations found that market transactions happened so quickly and were so numerous under conditions of high-frequency trading and collocated servers that a point came when no liquidity was left to meet proffered transactions. Liquidity dried up and with it, price discovery. ‘‘Liquidity in a high-speed world is not a given: market design and market structure must ensure that liquidity provision arises continuously in a highly fragmented, highly interconnected trading environment,’’ as a report by the Commodity Futures Trading Commission (CFTC) put it for the crash. Here, efficiencies realized through high transaction speeds worked against a market infrastructure that would have operated reliably otherwise.
The economist counters by asserting, ‘‘Obviously the market was not efficient because the full costs of reliability were not internalized.’’ But my point remains: Market failure under standard normal conditions of efficiency say nothing about anything so fundamental as infrastructure reliability as foundational to economic efficiency.
The research challenge is to identify under what conditions does the fifth market failure arise empirically. Until that is done, the better part of wisdom—the better part of government regulation—would be to assume fully efficient markets are low-performance markets when the stabilizing market infrastructure underlying them is prone to this type of market failure. Put positively, highly reliable markets are productive and sufficiently efficient when the underlying market infrastructure is not prone to the destabilizing fifth type of market failure.
But what, then, is “prone”? Low-performing market infrastructure results from the vigorous pursuit of self-interest and efficiencies that hobble real-time market infrastructure operators in choosing strategies that ensure longer-term high reliability of the market infrastructure.
There is another way to put the point: High reliability management of critical infrastructures does not mean those infrastructures are to run at 100% full capacity. Quite the reverse. High reliability requires the respective infrastructures not work full throttle: Positive redundancy or fallback assets and options—what the economists’ mis-identified “excess capacity”—are needed in case of sudden loss of running assets and facilities, the loss of which would threaten infrastructure-wide reliability and, with it, price discovery. To accept that “every system is stretched to operate at its capacity” may well be the worst threat to an infrastructure and its economic contributions.
In this view, critical infrastructures are economically most reliably productive when full capacity is not the long-term operating goal. Where so, efficiency no longer serves as a benchmark for economic performance. Rather, we must expect the gap between actual capacity and full capacity in the economy to be greater under a high reliability standard, where the follow-on impacts for the allocation and distribution of services are investments in having a long term.
Commodity Futures Trading Commission [CFTC] and the Securities and Exchange Commission [SEC] (2010a). Findings Regarding the Market Events of May 6, 2010: Report of the Staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues. Washington, DC
——— (2010b). Recommendations Regarding Regulatory Responses to the Market Events of May 6, 2010: Summary Report of the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues. Washington, DC
Vaughn, L. (2020). Chapters 10 and 11 in Flash Crash. Doubleday, New York