Rational expectations – assuming we know what in fact we never know

30 Nov, 2012 at 10:23 | Posted in Economics | Comments Off on Rational expectations – assuming we know what in fact we never know

In a laboratory experiment run by James Andreoni and Tymofiy Mylovanov and presented here, the researchers induced common probability priors, and then told all participants of the actions taken by the others. Their findings are very interesting, and says something rather profound on the value of the rational expectations hypothesis in standard neoclassical economic models:

We look at choices in round 1, when individuals should still maintain common priors, being indifferent about the true state. Nonetheless, we see that about 20% of the sample erroneously disagrees and favors one point of view. Moreover, while other errors tend to diminish as the experiment progresses, the fraction making this type of error is nearly constant. One may interpret disagreement in this case as evidence of erroneous or nonrational choices.

Next, we look at the final round where information about disagreement is made public and, under common knowledge of rationality, should be sufficient to eliminate disagreement. Here we find that individuals weigh their own information more than twice that of the five others in their group. When we look separately at those who err by disagreeing in round 1, we find that these people weigh their own information more than 10 times that of others, putting virtually no stock in public information. This indicates a different type of error, that is, a failure of some individuals to learn from each other. This error is quite large and for a nontrivial minority of the population.

Setting aside the subjects who make systematic errors, we find that individuals still put 50% more weight on their own information than they do on the information revealed through the actions of others, although this difference is not statistically significant.

So in this experiment there seems to be some irrational idiots who don’t understand that that is exactly what they are. When told that the earth is flat they still adhere to their own beliefs of a circular earth. It is as if people thought that the probability that all others are idiots with irrational beliefs is higher than the probability that the earth is circular.

Now compare these experimental results with rational expectations models, where the world evolves in accordance with fully predetermined models where uncertainty has been reduced to stochastic risk describable by some probabilistic distribution.

The tiny little problem that there is no hard empirical evidence that verifies these models doesn’t seem to bother its protagonists too much. When asked in an interview by George Evans and Seppo Honkapohja (Macroeconomic Dynamics (2005, vol.9, 561-583) if he thought “that differences among people’s models are important aspects of macroeconomic policy debates”, Thomas Sargent replied:

The fact is you simply cannot talk about their differences within the typical rational expectations model. There is a communism of models. All agents within the model, the econometricians, and God share the same model.

One might perhaps find it odd to juxtapose God and people, but I think Leonard Rapping – himself a former rational expectationist – was on the right track (Arjo Klamer, The New Classical Macroeconomics 1984, p 234):

Frankly, I do not think that the rational expectations theorists are in the real world. Their approach is much to abstract.

Building models on rational expectations either means we are Gods or Idiots. Most of us know we are neither. So, God may share Sargent’s model, but it certainly isn’t my model.