The line: since private investment equals private savings plus public savings, increasing gov't spending cannot employ people who are unemployed, it can only crowd out private investment.
I.e., he writes: PI = PS + GS (let's ignore his retained earnings for a minute).
Pretend for a second that you were just an ignorant University of Chicago economist, and hence, that you knew nothing about the Great Depression. In particular, you had no idea that the US economy grew at 8% from 1933 onward, once FDR started increasing spending, and that you didn't know that massive increases in wartime spending ended the Great Depression.
Other than to look at basic facts, how else might we refute free-market Fama?
Well, one way is that we could recall another identity, that private investment is the sum of investment in capital plus investment in inventory. In good times, of course, firms might borrow money to invest in building up inventories to sell during the Christmas shopping season, for example, but at the moment inventories are piling up b/c manufacturers can't sell what they've already produced. Hence, they are cutting way back on production, laying off workers, closing plants, etc. New investment in capital and machinery is pretty much nonexistent at the moment.Then there's the problem that banks are just sitting on hoardes of cash at the moment, afraid to loan it out, which also counts as "investment". So Fama's argument boils down to not wanting to see gov't spending crowd out "investment" in inventory and bank's cash reserves... The next problem is that who cares about gross private investment? Net private investment is more important. And if firms are boarding up perfectly good factories, that's a loss to Net Investment (analogous to an increase in depreciation). This is deadweight loss, and it need not effect any of the terms in the above identity directly, although it's important to remember that private saving is also a function of private income. Imagine that b/c of rising inventories it can't sell, GM were to just lay off all of it's workers. They'd spend less, yes, but since they'd be making nothing, the workers would be forced to spend out of savings, which would also reduce private investment. Now imagine the gov't comes along and buys the inventory and dumps it in the ocean. Now GM would be out of inventory, so it would take that as a signal to start producing again. The workers, who are now making incomes again, would spend some money & save part of it too. Hence, investment in capital structures could actually rise, depending on factors outside of this simple identity, which alone tells us nothing. (And private investment did rise once FDR increased gov't spending! Let's call it negative crowding out/crowding in.)
Of course, given that Fama is a contestant for both the Nobel Prize in Economics and for the Stupidest Man Alize contest, we can now apply the Squeeze Theorem to the rest of the academic Economics profession to conclude that there's just not much there. Tenured Harvard economist and former Bush CEA Chair Greg Mankiw displays http://www.dimensional.com/famafrench/2009/01/bailouts-and-stimulus-plans.html
the applicability of this theorem well -- though he disagrees with Fama, he can distill no fault in his logic.
Of course, Fama will probably still loses out in said contest to Gary Becker, who says that not only will gov't spending completely crowd out private investment, but that it will actually reduce total output. Can anyone top that for stupidity?
(Update1: Apparently I can come close to topping that for stupidity -- In the initial post I did not realize that Fama has not actually won a Nobel yet... though he has long been rumored to be on the short list. Let's hope not.)
(Update2: Great minds think alike! I see Brad DeLong (not that he reads this) made similar points five hours later!)