I’m working on the relationship between economic theory and the current crisis, and one thread obviously involves the role of efficient market theory in breeding complacency. So I ran across this revealing late-2007 interview with Eugene Fama. In it, Fama dismisses the whole idea of bubbles:

Well, economists are arrogant people. And because they can’t explain something, it becomes irrational. The way I look at it, there were two crashes in the last century. One turned out to be too small. The ’29 crash was too small; the market went down subsequently. The ’87 crash turned out to be too big; the market went up afterwards. So you have two cases: One was an underreaction; the other was an overreaction. That’s exactly what you’d expect if the market’s efficient.

The word “bubble” drives me nuts. For example, people say “the Internet bubble.” Well, if you go back to that time, most people were saying the Internet was going to revolutionize business, so companies that had a leg up on the Internet were going to become very successful.

I did a calculation. Microsoft was an example of a corporation that came from the previous revolution, the computer revolution. It was hugely profitable and successful. How many Microsofts would it have taken to justify the whole set of Internet valuations? I think I estimated it to be something like 1.4.

And he expresses confidence over housing (rather late in the game, wouldn’t you say?):

Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.

What this made me think of was an old paper by Larry Summers mocking finance economists as the equivalent of “ketchup economists”, who believe that they’ve demonstrated market efficiency by showing that two-quart bottles of ketchup always sell for twice the price of one-quart bottles.

In the case of housing, buyers do carefully compare prices — with the prices of other houses. That is, they make sure that two-quart bottles of ketchup are the same price as one-quart bottles. As we’ve seen, however, they don’t do a very good job of checking whether the overall level of housing prices makes sense.

Yes, it was a bubble — and as Larry said way back when, the ketchup test just isn’t enough.

I think this Michael Hirsch piece on Joe Stiglitz somewhat misses the point.

Yes, Joe should be playing a bigger role — he’s an insanely great economist, in ways you can’t really appreciate unless you’re deep into the field. I’d say that he’s more his generation’s Paul Samuelson than its John Maynard Keynes: as with Great Paul, almost every time you dig into some sub-field of economics — finance, imperfect competition, health care — you find that much of the work rests on a seminal Stiglitz paper.

But the larger story is the absence of a progressive-economist wing. A lot of people supported Obama over Clinton in the primaries because they thought Clinton would bring back the Rubin team; and what Obama has done is … bring back the Rubin team. Even the advisory council, which is supposed to bring in skeptical views, does so by bringing in, um, Marty Feldstein.

The point is that even if you think the leftish wing of economics doesn’t have all the answers, you’d expect some people from that wing to be at the table. Yet I don’t see Larry Mishel, or Jamie Galbraith … Jared Bernstein is it.

Joe Stiglitz stands out because in addition to being on the progressive wing, he’s also, as I said, a giant among academic economists. But I think the real story is more about excluded points of view than excluded people.

The Times editorial page says they make sense, done right. I agree on both the economics and the legal aspects.

No column tomorrow, and limited posting until late in the week. I’ll be hiking the Applalachian Trail taking some personal time.

The speech Larry Summers gave at the IIE was sensible and clear-headed. But his discussion of the stimulus and its size was disappointing — and, I hope, somewhat disingenuous.

What Larry said:

The size of the stimulus reflected a balance of several considerations: the size of the likely output gap that the economy was facing, the difficulties of ramping up spending and then ramping it back down after recovery in a high budget-deficit environment, the question of how much could be spent both quickly and productively, and the recognition that the Recovery Act was just one of several initiatives by the Administration that would have a dynamic impact on the state of the economy.

Look: it was really clear, even in January, that the stimulus wasn’t remotely big enough to close the output gap. My analysis at the time here and here.

It was also clear, at least to me, that the stimulus should, in fact, be aggressive — enough to achieve something close to full employment.

Now, you can argue that given the political realities it just wasn’t possible to pass a bigger stimulus, which may or may not be true. But that’s not the argument Larry is making — he’s saying that the plan was just right in economic terms. And I can only hope they didn’t really think that.

What about the argument that the stimulus was just one of “several initiatives”? Well, I did hear that at the time. But as we now know, not much is happening on other fronts. Foreclosure relief has been mostly a nonstarter; the PPIP has turned more or less into a joke; policy toward the banks is basically a muddle-through strategy, which might work out in terms of avoiding the need for further direct intervention, but certainly isn’t jump-starting lending.

The point is that I can respect the argument that this was all the administration could do, politically. I can’t feel equal respect for the argument that this was all it should have done, economically.

The really terrible numbers earlier this year had a lot to do with inventories: businesses decided they had too much stuff in warehouses, so they slashed production well below final sales. Correspondingly, the green shoots we’re seeing are to an important extent the result of the end of this de-stocking process.

The question is, how much has the underlying situation changed? Are we seeing anything more than the inventory bounce most of us have been expecting for three or four months?

Jan Hatzius at Goldman (no link) is skeptical. His latest suggests that final demand is still going nowhere: