Larry Summers thinks its limited.

“In four years of reflection and rather intense involvement with this financial crisis, not a single aspect of dynamic stochastic general equilibrium has seemed worth even a passing thought,” Summers said, adding: “I think the profession is not entirely innocent.”

Still, Summers said, the complaint that economists should have seen the crisis coming represents “a confusion” on the part of critics. Identifying financial bubbles and knowing when they will burst, he claimed, “is to ask more of the profession than it can reasonably expect to discover.”

This is a common viewpoint but I am not sure that I share it.

The basic way reasoning here is that if it were possible to see bubbles then one of two things would happen.

1) Private participants will see them and act so as to deflate the bubble in real time.

2) Government agencies – the Fed ect – will see them and act to offset them, preventing a catastrophe.

The problem here is that we have had hundreds of years of market evolution under a capitalist system where bubbles can and did occur. No, solution has emerged. This is despite the fact that evolutionary systems can evolve solutions to problems that no one understands or indeed is even aware exist.

This tells me that there is at least a reasonable chance that bubbles are the result not of mistaken expectations but of some combination of market and government failure. Its not crazy to suggest that we will be able to see this.

Its an open question whether we could do anything about it.