Macroeconomics wars and rational expectations

20 Dec, 2012 at 14:36 | Posted in Economics | 3 Comments

In the latest issue of Real-World Economics Review (December 2012) yours truly has a paper on the Rational Expectations Hypothesis – Rational expectations – a fallacious foundation for macroeconomics in a non-ergodic world. Similar critique of REH is put forward in a recent book by Roman Frydman and Michael Goldberg:

Beyond_Mechanical_MarketsThe belief in the scientific stature of fully predetermined models, and in the adequacy of the Rational Expectations Hypothesis to portray how rational individuals think about the future, extends well beyond asset markets. Some economists go as far as to argue that the logical consistency that obtains when this hypothesis is imposed in fully predetermined models is a precondition of the ability of economic analysis to portray rationality and truth.

For example, in a well-known article published in The New York Times Magazine in September 2009, Paul Krugman (2009, p. 36) argued that Chicago-school free-market theorists “mistook beauty . . . for truth.” One of the leading Chicago economists, John Cochrane (2009, p. 4), responded that “logical consistency and plausible foundations are indeed ‘beautiful’ but to me they are also basic preconditions for ‘truth.’” Of course, what Cochrane meant by plausible foundations were fully predetermined Rational Expectations models. But, given the fundamental flaws of fully predetermined models, focusing on their logical consistency or inconsistency, let alone that of the Rational Expectations Hypothesis itself, can hardly be considered relevant to a discussion of the basic preconditions for truth in economic analysis, whatever “truth” might mean.

There is an irony in the debate between Krugman and Cochrane. Although the New Keynesian and behavioral models, which Krugman favors, differ in terms of their specific assumptions, they are every bit as mechanical as those of the Chicago orthodoxy. Moreover, these approaches presume that the Rational Expectations Hypothesis provides the standard by which to define rationality and irrationality.

In fact, the Rational Expectations Hypothesis requires no assumptions about the intelligence of market participants whatsoever … Rather than imputing superhuman cognitive and computational abilities to individuals, the hypothesis presumes just the opposite: market participants forgo using whatever cognitive abilities they do have. The Rational Expectations Hypothesis supposes that individuals do not engage actively and creatively in revising the way they think about the future. Instead, they are presumed to adhere steadfastly to a single mechanical forecasting strategy at all times and in all circumstances. Thus, contrary to widespread belief, in the context of real-world markets, the Rational Expectations Hypothesis has no connection to how even minimally reasonable profit-seeking individuals forecast the future in real-world markets. When new relationships begin driving asset prices, they supposedly look the other way, and thus either abjure profit-seeking behavior altogether or forgo profit opportunities that are in plain sight.

Roman Frydman & Michael Goldberg: Beyond Mechanical Markets


  1. Incorporating the Rentier Sectors into a Financial Model
    By Dirk Bezemer and Michael Hudson
    Current macroeconomics ignores the roles that rent, debt and the financial sector play in shaping our economy. We discuss the Classical view on rents and policy responses to the rentier sector in the 19th century. The finance, insurance & real estate sector is today’s incarnation of the rentier sector. This paper shows how financial flows can be conceptually and statistically studied separately from (but interacting with) the real sector. We discuss finance’s interaction with government and with the international economy.

  2. A friend of mine who worked as a mathematician was sometimes asked to make math of some hypothesis by some postgraduate student of economics. And, he told me, “when I did that, they took that as a proof that their hypitheses were correct”.

    But, he went on, “math is just a language, not a bit better or truer than other languages.”

    • Based on observation of peoples relation to maths I made a diagram depicting their relation to truth and how they experience truth. The mathematically minded tend to set more stock in maths than their understanding of maths would allow. Which means the distinction between the lie and the truth becomes more difficult, arguments alone has no effect since erroniuos maths are percieved as more true than any argument.

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