I’m generally a fan of efficient market theorists Eugena Fame, but I have to confess his argument in a recent Minneapolis Fed interview that bubbles aren’t bubbles leaves me cold.
Region: Some economists—you know them well—say that the stock market crash of 1929 and the more recent climb and decline of the market in the early 2000s suggest that “irrational exuberance” affects the stock market. How do you reconcile this alleged evidence of herding behavior and animal spirits with the notion of market efficiency?
Fama: 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.
Region: About one and a half Bill Gateses.
Fama: That’s right. And Microsoft was a good example because the worse their products were, the more money they made [laughter]. Who didn’t struggle with DOS and then the first versions of Windows?
Let me get this straight. The market is efficient because the stock market crashes you cite weren’t perfectly efficient? Maybe I’m just slow today, but I feel like Fama has out-cuted himself here.