Ketchup and the housing bubble: 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.