LARS P SYLL

Phelps smacks down on Lucas’ rational expectations putsch

Question: In a new volume with Roman Frydman, “Rethinking Expectations: The Way Forward for Macroeconomics,” you say the vast majority of macroeconomic models over the last four decades derailed your “microfoundations” approach. Can you explain what that is and how it differs from the approach that became widely accepted by the profession?

Answer: In the expectations-based framework that I put forward around 1968, we didn’t pretend we had a correct and complete understanding of how firms or employees formed expectations about prices or wages elsewhere. We turned to what we thought was a plausible and convenient hypothesis. For example, if the prices of a company’s competitors were last reported to be higher than in the past, it might be supposed that the company will expect their prices to be higher this time, too, but not that much. This is called “adaptive expectations:” You adapt your expectations to new observations but don’t throw out the past. If inflation went up last month, it might be supposed that inflation will again be high but not that high.

Q: So how did adaptive expectations morph into rational expectations?

A: The “scientists” from Chicago and MIT came along to say, we have a well-established theory of how prices and wages work. Before, we used a rule of thumb to explain or predict expectations: Such a rule is picked out of the air. They said, let’s be scientific. In their mind, the scientific way is to suppose price and wage setters form their expectations with every bit as much understanding of markets as the expert economist seeking to model, or predict, their behavior. The rational expectations approach is to suppose that the people in the market form their expectations in the very same way that the economist studying their behavior forms her expectations: on the basis of her theoretical model.

Q: And what’s the consequence of this putsch?

A: Craziness for one thing. You’re not supposed to ask what to do if one economist has one model of the market and another economist a different model. The people in the market cannot follow both economists at the same time. One, if not both, of the economists must be wrong. Another thing: It’s an important feature of capitalist economies that they permit speculation by people who have idiosyncratic views and an important feature of a modern capitalist economy that innovators conceive their new products and methods with little knowledge of whether the new things will be adopted — thus innovations. Speculators and innovators have to roll their own expectations. They can’t ring up the local professor to learn how. The professors should be ringing up the speculators and aspiring innovators. In short, expectations are causal variables in the sense that they are the drivers. They are not effects to be explained in terms of some trumped-up causes.

Q: So rather than live with variability, write a formula in stone!

A: What led to rational expectations was a fear of the uncertainty and, worse, the lack of understanding of how modern economies work. The rational expectationists wanted to bottle all that up and replace it with deterministic models of prices, wages, even share prices, so that the math looked like the math in rocket science. The rocket’s course can be modeled while a living modern economy’s course cannot be modeled to such an extreme. It yields up a formula for expectations that looks scientific because it has all our incomplete and not altogether correct understanding of how economies work inside of it, but it cannot have the incorrect and incomplete understanding of economies that the speculators and would-be innovators have.

Q: One of the issues I have with rational expectations is the assumption that we have perfect information, that there is no cost in acquiring that information. Yet the economics profession, including Federal Reserve policy makers, appears to have been hijacked by Robert Lucas.

A: You’re right that people are grossly uninformed, which is a far cry from what the rational expectations models suppose. Why are they misinformed? I think they don’t pay much attention to the vast information out there because they wouldn’t know what to do what to do with it if they had it. The fundamental fallacy on which rational expectations models are based is that everyone knows how to process the information they receive according to the one and only right theory of the world. The problem is that we don’t have a “right” model that could be certified as such by the National Academy of Sciences. And as long as we operate in a modern economy, there can never be such a model.

Bloomberg

 

Phelps’ critique is much in line with the one yours truly put forward in his Real-World Economics Review article Rational expectations – a fallacious foundation for macroeconomics in a non-ergodic world (2012).

Too big to fail?

Bayesian decision theory – a critique

A farmer is offered a choice between, on the one hand, getting a horse if it is raining tomorrow and a cow if it is not raining and, on the other hand, a cow if it is raining and a horse if it is not. He prefers getting a horse to getting a cow; this is a ‘pure preference’. But which of the offered alternatives does he prefer? Assume that he professes to be indifferent as between them. How shall we then understand his attitude?

To this question there is an answer, first proposed by F. P. Ramsey, which has later come to play a great role in so-called Bayesian decision theory …
 
Ramsey thought that an attitude of indifference here means that the person rates the two events, ‘rain’ and ‘not rain’, as equally probable. Accepting this, one can then proceed as follows:

Assume that our farmer is next presented with this option: On the one hand a horse if it is raining and a sheep if it is not raining and, on the other hand, a cow if it is raining and a hog if it is not raining. Again he says he is indifferent. This, on Ramsey’s view, means that the value to him of a cow is as much less the value of the horse as the value of a sheep is less than that of a hog. With this the way is open to a metrization of value and the introduction of utility functions. This done, one can use attiyudes of indifference in other, more complex, conditional options for defining arbitrary degrees of (subjective) probability. The product of the value of a good an dthe probability of its materialization is called expected utility. Attitudes of preference in options aim at maximizing this quantity.

Ramsey’s method is elegant and ingenious. Nevertheless, it seems to rest on a mistake. It ignores the distinction between two senses of ‘indifference’.

The farmer who, when presented with the first of the above two options, professes an attitude of indifference can do so for one or two reasons. Either he ‘simply has no idea’ about the chances of rainfall for tomorrow and therefore cannot make up his mind about which alternative is more to his advantage.
This does not mean that he thinks rain and not-rain equally likely; he simply suspends judgement. Or, he considers them equally likely and therefore judges the two alternatives to be equally advantageous. He could, for example, support his attitude with the argument that if he repeatedly opted for one of the alternatives, no matter which one, on average half the number of times he would ‘probably’ get a horse, which is to his advantage, and half the number of times a cow, which is to his disadvantage. So, therefore, he is indifferent as between the alternatives. It is, in other words not his judgement of indifference which gives meaning to the probabilities for him; but it is his prior estimate of the probabilities which determines his attitude of indifference.

Georg Henrik von Wright

Keynes on mathematical economics

But I am unfamiliar with the methods involved and it may be that my impression that nothing emerges at the end which has not been introduced expressly or tacitly at the beginning is quite wrong … It seems to me essential in an article of this sort to put in the fullest and most explicit manner at the beginning the assumptions which are made and the methods by which the price indexes are derived; and then to state at the end what substantially novel conclusions has been arrived at … I cannot persuade myself that this sort of treatment of economic theory has anything significant to contribute. I suspect it of being nothing better than a contraption proceeding from premises which are not stated with precision to conclusions which have no clear application … [This creates] a mass of symbolism which covers up all kinds of unstated special assumptions.

Keynes to Frisch 28 November 1935

Så pinsamt, så pinsamt

Nils Gottfries är professor i nationalekonomi i Uppsala och en av vår regering anlitad expert på arbetsmarknadsfrågor.

I Erik Sandbergs synnerligen sevärda dokumentär Lönesänkarna som igår sändes på SVT (missade du den, så finns den på SVT Play) intervjuas Gottfries, som i den senaste långtidsutredningen gett regeringen Reinfeldt rådet att sänka lönekostnaderna för att öka sysselsättningen (ett råd som alla regeringar i vårt land redan följt under de senaste tre decennierna …)

Vad Gottfries visade sig inte ha en susning om var dock att denna politik inte alls haft någon effekt, utan att tvärtom arbetslösheten fortsatt ligga på en mycket hög nivå och att löntagarnas andel av BNP trendmässigt sjunkit under trettio års tid. Professor Gottfries, experten, hävdade bestämt att andelen varit konstant.

Först när journalisten konfronterat Gottfries med data som klart visar att så inte är fallet är han beredd att medge att han nog hade fel men sagt som han sagt av “pedagogiska” skäl.

Snacka om att bli ertappad med brallorna nere.

För Gottfries – och alla andra – rekommenderar jag att kika på följande diagram:

Källa

Källa

“Irrational exuberance” på svensk bostadsmarknad

De kvalitetsjusterade bostadspriserna steg enligt Valueguard/KTH mycket kraftigt i januari. De genomsnittliga bostadspriserna har aldrig legat högre i Sverige.

I hela landet steg bostadspriserna i genomsnitt 4.14 % (3.08 % för bostadsrätter och 4.66 % för villor).

Bör vi vara oroliga? Ja, tyvärr tror jag det. Eller som cornucopia? uttrycker det:

Det här kommer sluta mycket illa. Frågan är om vi nu ser det sista rycket i den maniska fasen innan bubblan kraschar brutalt?

Kanske kan det också vara intressant att fundera över vad Paul Krugman skrev igår apropå den amerikanska bobubblan …

at the time when evil liberals were supposedly forcing helpless bankers to lend into a housing bubble, leading to crisis, pretty much the very same people now claiming that it was all the government’s fault were vehemently denying that there was a bubble — and asserting that the only reason anyone even imagined that there might be a housing crisis looming was the malign impact of the biased liberal media.

It’s really pretty awesome.