Market Efficiency after the Financial Crisis: It\u27s Still a Matter of Information Costs

Contrary to the views of many commentators, the Efficient Capital Market Hypothesis ( ECMH ), as originally framed in financial economics, was not disproven by the Subprime Crisis of 2007-2008, nor has it been shown to be irrelevant to the project of regulatory reform of financial markets. To the contrary, the ECMH points to commonsense reforms in the wake of the Crisis, some of which have already been adopted. The Crisis created a lot of losers – from individual investors to pension funds and German Landesbanken – who purchased mortgage-backed securities that they did not, and perhaps could not, understand, and it cost them extraordinary amounts of money as a result. Perhaps more significantly, the knock-on effects of the Subprime Crisis rippled through the finance markets, pushed Lehman Brothers over the edge, decimated other financial institutions across the world, and resulted in massive provisions of government assistance and sometimes the full nationalization or failure of financial institutions and even giant industrial enterprises such as General Motors and Chrysler. Moreover, the damaging consequences of the Subprime Crisis continue. America\u27s recovery is fragile. The Great Recession of 2008-2010 is also the backdrop for Europe\u27s sovereign debt and banking crisis that still lingers today. Some smaller European nations – including Greece, Iceland, Ireland, and Portugal – required large international aid packages, and even larger countries such as Italy and Spain were at risk of default prior to decisive intervention by the European Central Bank. The resulting pressure to slash government spending threatens political stability across Europe. The recent political Sturm und Drang in the United States over budget deficits and debt limits reflects similar sharply divided views about the causes and policy implication of the Crisis. Against this backdrop, one might think it of small consequence that the Subprime Crisis is also said to have dealt major setbacks to academic theories, most particularly the ECMH. After all, the only loss that follows a crisis in theory – as opposed to a debilitating crisis in the economy – is damage to the egos of the academics who defend or reject a contested theory. Indeed, academic theories (unlike economies) thrive on contradiction to make advances, a point famously stressed by Thomas Kuhn almost fifty years ago. Nevertheless, the particular iteration of theory and response attending the ECMH after the Subprime Crisis differs importantly from other encounters between theory and seemingly inconvenient facts. The reason is that the ECMH had moved beyond the academic community beginning in the 1970s, and has played a prominent role in the larger world political debate and regulatory reform ever since. One or another interpretation of the ECMH has influenced regulatory policy for well over thirty years. As a result, the public understanding of the limits of the ECMH is not just a matter of academic debate; it carries real political consequences. Important regulatory implications follow if the ECMH itself is held partially responsible for the Subprime Crisis