It certainly does not challenge the "efficient markets" hypothesis. The hypothesis of EMH is that investors are attempting to maximize their profits, and all have the same information.
The housing bubble was driven by various players with incomplete information and irrational behavior:
1. Idiot homeowners: "Buying a home is the American Dream and house prices will never go down because everyone needs to live somewhere." These people are making an emotional purchase, not an investment. A conversation I had with such a person:
Me: You just left your wife. You plan to leave your job. In the next 3 years, you will probably leave the state, possibly the country. And the housing bubble just burst. WTF?
Him: Without owning a home, I feel rootless. I need to buy a 3 bedroom house in suburbia. It's a good investment!
2. Investment banks were mislead by mortgage issuers. If an investment bank is buying the loan, the mortgage issuer had less incentive to make sure it would be repaid. So the issuers slacked off. This means that there was a major asymmetry of information, violating the premises of EMH.
The influx of speculative capital into the commodities market is playing havoc with production networks in Africa and Asia. The subprime crisis was clearly happening as early as 2005: look at when Soros started betting against the USD.
When people say "efficient markets" they usually mean "efficient at not sucking" and/or "efficient at producing socially optimal outcomes". It is usually considered self-explanatory that people act in what they perceive to be their self-interest.
Do we need a sophisticated theory to describe "herd behavior"? And does it really challenge the "efficient markets" theory? I would say that an individual is making a _rational_ decision even if it is based on the behavior of others. I see that as valuable information before making a decision. If I understood it correctly, the author sees it as irrational.
The Glass-Steagall Act, which kept commercial banks and investment banks separate and set up the FDIC among other things, was revoked in 1999.
This removed important barriers between the various players in the mortgage market which had acted to keep them at least somewhat honest. IMHO, YMMV etc.
ONE great puzzle about the recent housing bubble is why even most experts didn’t recognize the bubble as it was forming.
Almost every mainstream publication and plenty of regular folks saw the housing bubble for what it was years before it popped, including our own Matt Maroon: http://news.ycombinator.com/item?id=100156
I can tell you right now that 100 percent of decisions in the marketplace are incorrect--at least, if I'm right in thinking the nytimes defines a "correct decision" as: Paying a price currently that will stay the same in the future.
Or, we can acknowledge that every transaction has one buyer, and one seller, and no matter how you define "correct", both of them can't be wrong.
Or, we could say that 100 percent of the decisions in the marketplace are correct, if we define the word itself correctly: The price that the market determines.
The housing bubble was driven by various players with incomplete information and irrational behavior:
1. Idiot homeowners: "Buying a home is the American Dream and house prices will never go down because everyone needs to live somewhere." These people are making an emotional purchase, not an investment. A conversation I had with such a person:
Me: You just left your wife. You plan to leave your job. In the next 3 years, you will probably leave the state, possibly the country. And the housing bubble just burst. WTF?
Him: Without owning a home, I feel rootless. I need to buy a 3 bedroom house in suburbia. It's a good investment!
2. Investment banks were mislead by mortgage issuers. If an investment bank is buying the loan, the mortgage issuer had less incentive to make sure it would be repaid. So the issuers slacked off. This means that there was a major asymmetry of information, violating the premises of EMH.