Introduction

From 1984 to 1988 Texaco and Pennzoil were engaged in a legal battle over Texaco's usurpation of Pennzoil in the takeover of the Getty Oil Company. The stakes were huge: the original jury award called for a payment of more than $10 billion; the companies ultimately settled for $3 billion. The Texaco-Pennzoil case presents a unique experiment for studying debt burdens and bargaining costs. Market assessments of the prospects of both parties in a prolonged dispute are rarely as observable as they are in the Texaco-Pennzoil case. Further, unlike in most other litigation settings and in almost all bankruptcy cases, the burden imposed on Texaco did not have a collateral effect on future cash flows.

This article examines the abnormal returns earned by the shareholders of Texaco and Pennzoil over the course of the dispute. A clear pattern emerges. Events affecting the size of the transfer resulted in opposite but asymmetric returns to the two companies. When its obligation to Pennzoil was increased, Texaco's value fell by far more than Pennzoil's rose; the opposite reaction occurred for events reducing the expected transfer. These “leakages” in value were enormous: each dollar of value lost by Texaco's shareholders was matched by only about forty cents' gain to the owners of Pennzoil. The ongoing dispute reduced the combined equity value of the two companies by $3.4 billion, over 30 percent of the joint value of the two companies before the dispute arose.

The reform of financial systems is an area of economics that has led broader swings in economic thought. At times economists – going back to John Stuart Mill – and policymakers have viewed the financial sector as irrelevant, except in times of crises, and hence have tried to repress finance and use it for the convenience of government. More recently, the pendulum has swung back toward Schumpeter, who viewed finance as the key sector for its role in allocating credit efficiently. In the past 20 years the move has been toward financial sector deregulation, in part out of ideology and in part in response to technological change, which has made regulatory arbitrage a popular sport. Among developing countries, initial reform efforts in finance – the Southern Cone experience – had such well-publicized problems that the reform effort lost some momentum.

However, other countries did persevere in attempting to reform their financial systems, not always as dramatically as in the earlier experiments, and in some cases in a less far-reaching manner. But reform they did, making it appropriate to look at these cases and review their successes and failures. While economists always want a bigger cross section and a longer time series, authorities in many countries, including those with very low incomes and the formerly socialist economies, need to know what has worked and what has failed. Thus the present study is without doubt a timely one.

The World Bank and the Centre for Economic Policy Research share the objective of promoting economic analysis with policy applications. A dominant concern in the current policy debate is whether the ‘new’ regionalism in trade policy can lead to a more integrated world economy. Will the regional approach promote world-wide economic integration? Or will it work at cross purposes with the more traditional multilateral approach? Are the resources needed successfully to complete the Uruguay Round being diverted into the negotiation of regional arrangements? Is the recent surge in regional arrangements leading to a world of a few trading blocs that will make the negotiation of future reductions in trade barriers easier? Is it likely that a world organised around trading blocs will entail a significant problem of market access for countries left out?

This volume is the outcome of the first collaboration between the World Bank and CEPR. It brings answers to these leading policy issues and advances the debate on the implications of the new regionalism for the world trading system. The contributions to the debate by eminent economists, many involved in policy making, address the choices facing a country that must choose between unilateral trade liberalisation that would be extended to all its trading partners but might be more difficult to implement domestically, and a trade liberalisation that is extended only to its regional partners, but that is more likely to have domestic support.

The volume also reviews the experience with all the major integration arrangements and discusses the prospects for new integration arrangements, including the Middle East and Eastern Europe.

Introduction

The proposition that securities markets are efficient forms the basis for most research in financial economics. A voluminous literature has developed supporting this hypothesis. Jensen (1978) calls it the best established empirical fact in economics. Indeed, apparent anomalies such as the discounts on closed end mutual funds and the success of trading rules based on earnings announcements are treated as indications of the failures of models specifying equilibrium returns, rather than as evidence against the hypothesis of market efficiency. Recently the Efficient Markets Hypothesis and the notions connected with it have provided the basis for a great deal of research in macro–economics. This research has typically assumed that asset prices are in some sense rationally related to economic realities.

Despite the widespread allegiance to the notion of market efficiency a number of authors have suggested that certain asset prices are not rationally related to economic realities. Modigliani and Cohn (1979) suggest that the stock market is very substantially undervalued because of inflation illusion. A similar claim regarding bond prices is put forward in Summers (1983). Brainard, Shoven and Weiss (1980) found that the then low level of the stock market could not be rationally related to economic realities. Shiller (1979 and 1981a) concludes that both bond and stock prices are far more volatile than can be justified on the basis of real economic events.