The media seems to have reached a consensus that the efficient markets hypothesis (EMH) has been discredited by the financial crises. I have been somewhat bemused by this, as I could not see the connection.
I did rather wonder if I was being stupid, and missing something that all these journalists, and a scattering of academics out to get efficient markets, all knew. I was. I did not realise how stupid regulators were. It is less surprising that journalists have been conflating a number of related concepts: the efficient markets hypothesis, rationality, related bits of financial theory, and, most of all, market efficiency in the micro-economic sense (economic efficiency)
The main problem has been with the last of these: it is the justification for laissez-faire neo-liberal politics, which has become dominant. It is the basis on which
A related problem is that both the EHM and economic efficiency have been treated as absolutely true, not normative. They are a normal state of affairs to which correctly functioning markets tend, but the deviations from the normal state are what regulators and market participants should be focused on.
What the efficient markets hypothesis says is that securities prices reflect all available information. This also implies that you cannot predict futures movements in prices from past movements (i.e. technical analysis does not work). This is entirely different from economic efficiency that is the state in which markets in products and services function optimally.
Markets may function optimally without external intervention (as is the case for a market in perfect competition, with all consumers having full information and if no externalities or public goods (side effects on people other than a buyer and a seller) ) — then they do not need intervention. How well this reflects the market in financial services, especially given the existence of government guarantees against bank failure, you can decide for yourself.
The assumption that regulator made was the lassez-faire one, that the market in financial services (not the market in securities) would function correctly without much regulatory intervention. One reason this failed is that banks have both explicit and implicit state guarantees (they are “too big to fail” because of systemic risk)
The biggest single mistake made was to allow banks to use their own risk models for capital adequacy purposes. This was particularly stupid given that one reason for the reforms was that banks had been manipulating the previous system. Imagine you are running a bank and you are making a choice of different risk models. One says that you need to raise a lot more capital, and shut down some of your most profitable businesses (because they need so much capital raised that it would be uneconomic to do so). Another model says everything is fine. Which to you choose? If each model was devised by a different quant, who do you give a big bonus to?
Obviously, that is a gross oversimplification of how banks choose risk models: the process would involve many people, and there would be a lot of scrutiny: but everyone doing the scrutiny would have the same sort of bias.
This has absolutely nothing to do with the EMH. The only assumptions the risk models took from the EMH was that securities prices are unpredictable, and that is right. The financial theory, and the data, to do better risk models existed: fat tails, in particular, had been discussed extensively for decades before the financial crisis ()they were certainly a mainstream part of the syllabus when I did my MSc a decade ago).
Where regulators may have actually relied on EMH is in assuming that asset prices were always correct, so no unexpected nasty surprises would emerge. Even here they were really relying on rationality, not efficient markets: during a bubble prices reflect all available information, but the assessment of the information is systematically incorrect. Of course it means that the regulators did not believe bubbles happen: how did they come to that conclusion.
Now we have dealt with the stupidity of regulators, now back to the journalists. To be fair, the mis-reporting is not entirely their fault. A number of academics and other critics of the EMH have taken the chance of blame the EMH for everything that went wrong, and journalists have swallowed a line fed to them by experts.
Another reason for blaming the EMH, is to avoid admitting that the way markets have been allowed to function does not lead to economically efficient outcomes. It is a bizarre mixture of tight regulation and light touch, that largely favours big business. The problem here, is that this does not only apply to financial markets, but the whole economy, and there is little appetite among politicians, or journalists, or businesses, or anyone else that matters, for so fundamental a challenge.