Simon Wren-Lewis’s attempt at rescuing rational expectations — an unmitigated failure

8 November, 2013 at 22:30 | Posted in Economics | 6 Comments

shackleIf at some time my skeleton should come to be used by a teacher of osteology to illustrate his lectures, will his students seek to infer my capacities for thinking, feeling, and deciding from a study of my bones? If they do, and any report of their proceedings should reach the Elysian Fields, I shall be much distressed, for they will be using a model which entirely ignores the greater number of relevant variables, and all of the important ones. Yet this is what ‘rational expectations’ does to economics.

G. L. S. Shackle

Oxford professor Simon Wren-Lewis is not pleased with heterodox critiques of the rational expectations hypothesis. And he seems to be  especially annoyed with yours truly, who “does write very eloquently,” but only “appeal to the occasional young economist, who is inclined to believe that only the radical overthrow of orthodoxy will suffice.”

Since I have already put forward a rather detailed theoretical-methodological critique of the rational expectations hypothesis in Rational expectations – a fallacious foundation for macroeconomics in a non-ergodic world (real-world economics review, issue 62, 2012), I’m not going to recapitulate the arguments here, but rather limit myself to elaborate on a couple of the rather unwarranted allegations Wren-Lewis puts forward in his attempt at rescuing the rational expectations hypothesis from the critique.

In a laboratory experiment run by James Andreoni and Tymofiy Mylovanov, 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 they are exactly that — idiots. 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 usually bother its protagonists too much. Rational expectations überpriest Thomas Sargent — favourably mentioned by Wren-Lewis — has the following to say on the epistemological status of the rational expectations hypothesis (emphasis added):

Partly because it focuses on outcomes and does not pretend to have behavioral content, the hypothesis of rational epectations has proved to be a powerful tool for making precise statements about complicarted dynamic economic systems.

Precise, yes, but relevant and realistic? I’ll be dipped!

And a few years later, when asked in an interview in Macroeconomic Dynamics — in 2005 — if he thought “that differences among people’s models are important aspects of macroeconomic policy debates”, Sargent replied (emphasis added):

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 when in 1984 interviewed by Arjo Klamer  — The New Classical Macroeconomics — he said:

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 and Wren-Lewis’s models, but they certainly aren’t my models.

In his attempted rescue operation Wren-Lewis tries to give the picture that only heterodox economists like yours truly are critical of the rational expectations hypothesis. But, on this, he is, simply, eh, wrong. Let’s listen to Nobel laureate Edmund Phelps — hardly a heterodox economist — and what he has to say (emphasis added):

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?

frydAnswer: 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

And this is what another non-heterodox economist, Willem Buiter, has to say about the state of the standard macroeconomic theory that builds on the twin assumptions of rational expectations and efficient markets:

buiterIn both the New Classical and New Keynesian approaches to monetary theory (and to aggregative macroeconomics in general), the strongest version of the efficient markets hypothesis (EMH) was maintained. This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation. Even during the seventies, eighties, nineties and noughties before 2007, the manifest failure of the EMH in many key asset markets was obvious to virtually all those whose cognitive abilities had not been warped by a modern Anglo-American Ph.D. education. But most of the profession continued to swallow the EMH hook, line and sinker, although there were influential advocates of reason throughout, including James Tobin, Robert Shiller, George Akerlof, Hyman Minsky, Joseph Stiglitz and behaviourist approaches to finance. The influence of the heterodox approaches from within macroeconomics and from other fields of economics on mainstream macroeconomics – the New Classical and New Keynesian approaches – was, however, strictly limited.

But — since Wren-Lewis doesn’t want to take a theoretical discussion about rational expectations as a modelling tool — let’s see how it fares as an empirical assumption. Empirical efforts at testing the correctnes of the hypothesis has resulted in a series of empirical studies that have more or less concluded that it is not consistent with the facts. In one of the more well-known and highly respected evaluation reviews made, Michael Lovell (1986) concluded:

it seems to me that the weight of empirical evidence is sufficiently strong to compel us to suspend belief in the hypothesis of rational expectations, pending the accumulation of additional empirical evidence.

Wren-Lewis also complains that

If I really wanted to focus in detail on how expectations were formed and adjusted, I would look to the large mainstream literature on learning, to which Professor Syll does not refer.

Well you can’t — it really goes without saying — get everything into a little blog post, so let me address the issue here.

The rational expectations hypothesis  presupposes – basically for reasons of consistency – that agents have complete knowledge of all of the relevant probability distribution functions. And when trying to incorporate learning in these models – trying to take the heat of some of the criticism launched against it up to date – it is always a very restricted kind of learning that is considered. A learning where truly unanticipated, surprising, new things never take place, but only rather mechanical updatings – increasing the precision of already existing information sets – of existing probability functions.

Nothing really new happens in these ergodic models, where the statistical representation of learning and information is nothing more than a caricature of what takes place in the real world target system. This follows from taking for granted that people’s decisions can be portrayed as based on an existing probability distribution, which by definition implies the knowledge of every possible event (otherwise it is in a strict mathematical-statistically sense not really a probability distribution) that can be thought of taking place.

But in the real world it is – as shown again and again by behavioural and experimental economics – common to mistake a conditional distribution for a probability distribution. Mistakes that are impossible to make in the kinds of economic analysis – built on the rational expectations hypothesis – that Levine is such an adamant propagator for. On average rational expectations agents are always correct. But truly new information will not only reduce the estimation error but actually change the entire estimation and hence possibly the decisions made. To be truly new, information has to be unexpected. If not, it would simply be inferred from the already existing information set.

In rational expectations models new information is typically presented as something only reducing the variance of the parameter estimated. But if new information means truly new information it actually could increase our uncertainty and variance (information set (A, B) => (A, B, C)).

Truly new information give birth to new probabilities, revised plans and decisions – something the rational expectations hypothesis cannot account for with its finite sampling representation of incomplete information.

In the world of rational expectations, learning is like being better and better at reciting the complete works of Shakespeare by heart – or at hitting bull’s eye when playing dart. It presupposes that we have a complete list of the possible states of the world and that by definition mistakes are non-systematic (which, strictly seen, follows from the assumption of “subjective” probability distributions being equal to the “objective” probability distribution). This is a rather uninteresting and trivial kind of learning. It is a closed world learning, synonymous to improving one’s adaptation to a world which is fundamentally unchanging. But in real, open world situations, learning is more often about adapting and trying to cope with genuinely new phenomena.

The rational expectations hypothesis presumes consistent behaviour, where expectations do not display any persistent errors. In the world of rational expectations we are always, on average, hitting the bull’s eye. In the more realistic, open systems view, there is always the possibility (danger) of making mistakes that may turn out to be systematic. It is because of this, presumably, that we put so much emphasis on learning in our modern knowledge societies.

So, where does all this leave us? I think John Kay sums it up pretty well:

kayProf Sargent and colleagues appropriated the term “rational expectations” for their answer. Suppose the economic world evolves according to some predetermined model, in which uncertainties are “known unknowns” that can be described by probability distributions. Then economists could gradually deduce the properties of this model, and businesses and individuals would naturally form expectations in that light. If they did not, they would be missing obvious opportunities for advantage.

This approach, which postulates a universal explanation into which economists have privileged insight, was as influential as it was superficially attractive. But a scientific idea is not seminal because it influences the research agenda of PhD students. An important scientific advance yields conclusions that differ from those derived from other theories, and establishes that these divergent conclusions are supported by observation. Yet as Prof Sargent disarmingly observed, “such empirical tests were rejecting too many good models” in the programme he had established with fellow Nobel laureates Bob Lucas and Ed Prescott. In their world, the validity of a theory is demonstrated if, after the event, and often with torturing of data and ad hoc adjustments that are usually called “imperfections”, it can be reconciled with already known facts – “calibrated”. Since almost everything can be “explained” in this way, the theory is indeed universal; no other approach is necessary, or even admissible …

Rational expectations consequently fail for the same reason communism failed – the arrogance and ignorance of the monopolist.

Added November 09: Re the empirical evidence for the rational expectations hypothesis, Nikolay Gertchev, Chris Dillow, Tom Hickey and  Merijn Knibbe take Wren-Lewis’s view  to task herehere, here and here.

Added November 10: Merijn Knibbe has another nice post on the issue here.

Added November 11: Robert Waldmann (Angry Bear) has a piece up today that takes Wren-Lewis’s view  on adaptive vs. rational expectations to task  here.

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6 Comments

  1. “In a laboratory experiment…” Now I’m confused. What about external validity? How do we know that we can generalize results from a “nomological machine” into our “target system”? Or do such criticisms (so often voiced on this blog) suddenly no longer apply?

    The rest is also rather unimpressive. Collecting a bunch of quotes from people who don’t like rational expectations is an appeal to authority, not argument. And it’s not true that with learning, new information cannot increase subjective uncertainty (see e.g. Bernanke QJE 1983). But most importantly, you have failed to address the main point of Wren-Lewis – what is the alternative? What better approach for modelling expectations is offered by heterodox economists, apart from nihilistic hand-waving about how everything is nonergodic?

    • Re experimental epistemology and ontology there is no need for you to be confused — of course the same strictures and qualifications have to be applied here as everywhere else in science (and I have indeed written a lot about those issues elsewhere, but everything has its place and time for elaboration).
      Re alternatives I have repeatedly, here on the blog and elsewhere, pointed to the works of e. g. Frydman/Goldberg, Phelps, Chow and more radical approaches like those propounded by behavioural economists and post keynesians like Sheila Dow (you can read all about it in “Rethinking Expectations,” eds Frydman & Phelps, 2013). But I guess Wren-Lewis and other die hard defenders of rational expectations only pooh-pooh them him like Wren-Lewis did with Willem Buiter and characterize these alternatives as “a little over the top” …
      When mainstream macroeconomists claim that the rational expectations hypothesis is useful in macroeconomics and say that there really is no feasible alternative, they remind me, not so little, about this lovely cartoon:

      (h/t Unlearning Economics)

    • No alternatives to REH, DSGE etc ?Handwaving?Fare from it, there are many alternative approaches and it been around a long while as Lars have pointed out many,many times of his blog.And it´s nothing new ,here is just one approach i qoute what i written elsewhere:

      -Circular cumulative causation is a theory developed by Swedish economist Gunnar Myrdal. It is a multi-causal approach where the core variables and their linkages are delineated. The idea behind it is that a change in one form of an institution will lead to successive changes in other institutions. These changes are circular in that they continue in a cycle, many times in a negative way, in which there is no end, and cumulative in that they persist in each round. The change doesn’t occur all at once but in small changes because that would lead to chaos.
      Gunnar Myrdal developed the concept from Knut Wicksell and developed it alongside with Nicholas Kaldor when they worked together at the United Nations Economic Commission for Europe. Myrdal concentrated on the social provisioning aspect of development, while Kaldor concentrated on demand-supply relationships to the manufacturing sector.
      Dynamics

      In the characteristics that are relevant to the development process of an economy Myrdal mentioned the availability of natural resources, the historical traditions of production activity, national cohesion, religions and ideologies, economic,social and political leadership. Myrdal stated that the immediate effect of closing down certain lines of production in a community is the reduction of employment, income and demand. Through the analysis of the multiplier he pointed out that other sectors of the economy are also affected.
      Then he argued that the contraction of the markets in that area tends to have a depressing effect on new investments, which in turn causes a further reduction of income and demand and, if nothing happens to modify the trend, there is a net movement of enterprises and workers towards other areas. Among the further results of these events, fewer local taxes are collected in a time when more social services is required and a vicious downward cumulative cycle is started and a trend towards a lower level of development will be further reinforced.
      A status of non-equilibrium is shaped, or as he writes:

      “The notion of stable equilibrium is normally a false analogy to choose when constructing a theory to explain the changes in a social system. What is wrong with the stable equilibrium assumption as applied to social reality is the very idea that a social process follows a direction – though it might move towards it in a circuitous way – towards a position which in some sense or other can be described as a state of equilibrium between forces. Behind this idea is another and still more basic assumption,namely that a change will regularly call forth a reaction in the system in the form of changes which on the whole go in the opposite direction to the first change.The idea I want to expound in this book is that, on the contrary, in the normal case there is no such a tendency towards automatic self-stabilisation in the social system.The system is by itself not moving towards any sort of balance between forces,but is constantly on the move away from such a situation. In the normal case a change does not call forth countervailing changes but,instead,supporting changes,which move the system in the same direction as the first change but much further. Because of such circular causation as a social process tends to become cumulative and often gather speed at an accelerating rate”

      (Myrdal, G.,1957,pp. 12–13 Economic Theory and Underdeveloped Regions, London:University Paperbacks, Methuen)

      About Economic Theory and Underdeveloped Regions Myrdal wrote that ‘the argument moves on a general and methodological plane in the sense that the theory is discussed as a complex of broad structures of thought’ (His aim was to submit ‘broad generalisations, as a ‘theory’ is permitted to be, (in order to) grasp the social facts as they organize themselves into a pattern when viewed under a bird’s-eye perspective Into this general vision, the specific characteristic. source:(Myrdal, G. 1957, Economic Theory and Underdeveloped Regions, London: University Paperbacks, Methuen))
      Myrdal developed further the circular cumulative causation concept and stated that it makes different assumptions from that of stable equilibrium on what can be considered the most important forces guiding the evolution of social processes. These forces characterise the dynamics of these processes in two diverse ways.
      Yet, the provision of data or other information regarding single economies was beyond the scope of his work.He claimed that in the normal case there is no such a tendency towards automatic self-stabilisation in the social system.The system is by itself not moving towards any sort of balance between forces,but is constantly on the move away from such a situation Myrdal used the expressions ‘approach’, ‘theory’ and ‘general theory’ as synonyms. In his subsequent writings, however, he mainly referred to ‘approach’, defining it as something containing, among other things, theories. He wrote that by this term he meant a collection of devices,like ‘the concepts, models,and theories we use, and the way in which we select and arrange observations and present the results of our research’.
      In the preface to his Economic Theory and Underdeveloped Regions Myrdal
      wrote that
      ‘the argument moves on a general and methodological plane in the

      sense that the theory is discussed as a complex of broad structures of thought’ (Myrdal, G. (1957), Economic Theory and Underdeveloped Regions, London: University Paperbacks, Methuen vii).)

      Myrdal called for economists to proceed by confronting the ‘facts of life’ with theories.The relation between theory and facts is however not simple.
      Theory … must always be a priori to the observations of facts. Indeed, facts as

      part of scientific knowledge have no existence outside such a frame. … If theory is thus a priori, it is, on the other hand, a first principle of science that facts are sovereign. Theory is, in other words, never more than a hypothesis. When the observations of facts do not agree with a theory, i.e. when they do not make sense in the frame of the theory utilised in carrying out the research, the theory has to be discarded and replaced by another one which promises a better fit (Myrdal, G. (1957), Economic Theory and Underdeveloped Regions, London: University Paperbacks, Methuen p. 160).

  2. It seems to me that there are clear alternatives to rational expectations and I’m not sure why economists seem loath to use them. Simon Wren-Lewis gives one alternative as naive “adaptive expectations”, but this seems like a straw man. Here people seem to believe more or less that trends will continue. That is truly naive. Expectations are important and the psychological literature on learning suggests that people form them in many ways, with heuristic theories and rules of thumb, and then adjust their use of these heuristics through experience. This is the kind of adaptive expectations that ought to be used in macro models.

    From what I have read, however, the vast “learning literature” in macroeconomics that defenders of RE often refer to really doesn’t go very far in exploring learning. It seems afraid to go too far. A prominent review (by people Wren-Lewis mentioned) I read as recently as 2009 used learning algorithms which ASSUMED that people already know the right model of the economy and only need to learn the values of some parameters. I suspect this is done on purpose so that the learning process converges to RE — and an apparent defense of RE is therefore achieved. But this is only a trick. Use more realistic learning behavior to model expectations and you find little convergence at all — just ongoing learning as the economy itself keeps doing new things in ways the participants never quite manage to predict. As Simon Wren-Lewis himself notes, ” it is worth noting that a key organising device for much of the learning literature is the extent to which learning converges towards rational expectations.”

    So again, it seems as if the purpose of the model is to see how we can get the conclusion we want, not to explore the kinds of things we might actually expect to see in the world. This is what makes people angry and I think rightfully about the RE idea.

    I suspect that REAL reason for this is that, if one uses more plausible learning behavior (not the silly naive kind of adaptive expectations), you find that your economy isn’t guaranteed to settle down to any kind of equilibrium, and you can’t say anything honestly about the welfare of any outcomes, and so most of what has been developed in economics turns out to be pretty useless. Economic theory loses its authority and most economists find that too much to stomach.

    • Great comment 🙂

  3. It seems to me that http://scholar.harvard.edu/files/fudenberg/files/self-confirming_equilibrium_0.pdf undermines RE theoretically, and that the slightest experience of booms and busts destroys its empirical credibility.

    An alternative to RE would be to imagine that agents make decisions as best they can, based on the available evidence. But no better. And certainly without requiring them to predict the unpredictable.


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