Compared to the worldwide financial carnage that followed the Subprime Crisis of 2007–2008, it may seem of small consequence that it is also said to have demonstrated the bankruptcy of an academic financial institution: the Efficient Capital Market Hypothesis (“ECMH”). Two things make this encounter between theory and seemingly inconvenient facts of consequence. First, the ECMH had moved beyond academia, fueling decades of a deregulatory agenda. Second, when economic theory moves from academics to policy, it also enters the realm of politics, and is inevitably refashioned to serve the goals of political argument. This happened starkly with the ECMH. It was subject to its own bubble—as a result of politics, it expanded from a narrow but important academic theory about the informational underpinnings of market prices to a broad ideological preference for market outcomes over even measured regulation. In this Article we examine the Subprime Crisis as a vehicle to return the ECMH to its information cost roots that support a more modest but sensible regulatory policy. In particular, we argue that the ECMH addresses informational efficiency, which is a relative, not an absolute measure. This focus on informational efficiency leads to a more focused understanding of what went wrong in 2007–2008. Yet informational efficiency is related to fundamental efficiency—if all information relevant to determining a security’s fundamental value is publicly available and the mechanisms by which that information comes to be reflected in the security’s market price operate without friction, fundamental and informational efficiency coincide. But where all value-relevant information is not publicly available and/or the mechanisms of market efficiency operate with frictions, the coincidence is an empirical question both as to the information efficiency of prices and their relation to fundamental value.
Properly framing market efficiency focuses our attention on the frictions that drive a wedge between relative efficiency and efficiency under perfect market conditions. So framed, relative efficiency is a diagnostic tool that identifies the information costs and structural barriers that reduce price efficiency which, in turn, provides part of a realistic regulatory strategy. While it will not prevent future crises, improving the mechanisms of market efficiency will make prices more efficient, frictions more transparent, and the influence of politics on public agencies more observable, which may allow us to catch the next problem earlier. Recall that on September 8, 2008, the Congressional Budget Office publicly stated its uncertainty about whether there would be a recession and predicted 1.5 percent growth in 2009. Eight days later, Lehman Brothers had failed, and AIG was being nationalized.