Lemon problem in financial markets?
After the countries of Eastern Europe converted from communism to the market system, they tried to set up share and bond markets. Most of these markets have remained very small, with few firms being able to find buyers for their shares or bonds.
One economist remarked that the reason these financial markets have been unsuccessful is that ‘the lemons problem has been too great’. Explain what the economist meant.
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Read up Akerlof.
Basically it means that there's not as many investors with knowledge of these local markets. This expression was used a lot in the early 1990's when Eastern European countries were in the process of trying to convert to free market economy systems. A lot of businesses were up for sale and western investors sought after. But many investors in the market are investing on behalf of someone else (ie. institutional investors on behalf of pension funds etc) and they have strict limits as to what they can buy and where. For instance, many US investment funds will not allow the purchase of foreign bonds and often only allow short term purchases e.g. commercial paper out to one year.
In Eastern Europe, a lot of the businesses requiring investment needed long term venture capital and this requires a lot of input from investors with a simultaneously high return. As it is, even in countries where the share and bond markets are understood, sometimes it can be hard to raise capital if the information isn't considered sufficient. A high rating is desired in the debt markets, and we've all seen what a load of rubbish rating agencies have turned out.
To get into any form of longer term investment requires a lot of local input and a financial institution with a knowledge of business practices, local employment and so on. That's a big committment. To just dabble in the markets without truly understanding market conditions was regarded as too high risk.
However, I can remember S&P getting very sniffy about the conversion of Chinese Banks back in the early 2000's - the view being that they were full of charlatans who rolled over loans and didn't stick to western accounting standards. All sorts of cautionary notes -the view being -ugh! Don't invest over there. Wear flame retardant gloves!
Then we had Enron. Then we had US and UK AAA mortgage/asset back securities. We were supposed to be the pillars of Western financial civilisation. Then we had the financial crisis.
But still the Lemon problem exists.
A detailed reply is already there.
In nutshell, these countries had very poor economy without any private ownerships at that point so there was not much money inside and not much confidence from outside. It however made them immune to gamblers who are third party " investors" playing thro' western banks. maybe they knew the dangers and kept themselves restrained( Once a marxist, always a marxist !).
Calling them unsuccessful by looking at size is completely wrong statement. The size involves 70 %5 bubble from gamblers, in "successful" western markets !
As regards ratings, one of them Austria holds AAA rating even today.
Lemon problem was noted byAkerlof in 1970. A popular example of the phenomenon is in the secondhand car market, where sellers know whether or nor their car is a lemon (i.e perform badly), but where buyers cannot make that judgement without running the car. Given that buyers can't tell the quality of the car they are buying, all cars of the same model will end up selling at the same price, regardless of whether they are lemons or not. But the risk of purchasing a lemon will lower the price buyers are prepared to pay for any car and, because secondhand prices are low, people with non-lemon cars will be little inclined to put them on the market.
This problem is commonly referred to as an adverse selection
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