Wren-Lewis and the chicken defence of rational expectations

28 Nov, 2013 at 17:11 | Posted in Economics | 4 Comments

chickenCommenting on the critique of his earlier attempt at defending rational expectations, Simon Wren-Lewis has come up with a new line of defense — chickens:

The chicken that is fed by the farmer each morning may well have a theory that it will always be fed each morning – it becomes a ‘law’. And it works every day, until the day the chicken is instead slaughtered …

Now you might say that no chicken is an economist, but suppose that chickens were as intelligent as the farmer who keeps them, so they could be an economist … So if (the)  chicken had been an economist, they would not simply have observed that every morning the farmer brought them food, and therefore concluded that this must happen forever. Instead they would have asked a crucial additional question: why is the farmer doing this? … And of course trying to answer that question might have led them to the unfortunate truth …

You can see why the habit of introspection would make economists predisposed to assume rationality generally, and rational expectations in particular … It only works to use your own thought processes as a guide to how people in general might behave, if you think other people are essentially like yourself. So if your own thoughts lead you to postulate some theory about how the economy behaves, then others similar to yourself might be able to do something like the same thing …

Economists may also be fooled into thinking their introspection is representative, because they are surrounded by other economists. So this conjecture about introspection does little to show that assuming agents have rational expectations is right (or wrong), but it may be one reason why most economists find the concept of rational expectations so attractive.

This is actually the second example yours truly has come across this month where a mainstream economist uses story-telling trying to defend rational expectations.

Earlier this month Mark Thoma — in an article in The Fiscal Times  — argued like this (emphasis added):

The rationality assumption is reasonable in some cases. For example, even young children have rational expectations in the sense that economists use the term. Think, for example, of a game where a parent is tickling a child and following a fixed rule. Tickle the armpit, tickle the knee, tickle the armpit, tickle the knee, and so on in a repeating pattern.

If the child is following the simplest type of adaptive expectations in trying to cover up and avoid being tickled, i.e. expect whatever happened last period, he or she will always be one step behind and will never block a tickle. But if the child understands the rule the parent is following and also fully understands the nature of the game, it is easy to rationally anticipate where the next tickle attempt will be and take evasive action.

Although there is some healthy skepticism on rational expectations  in both Wren-Lewis’s and Thoma’s storytelling, I still think that their picture of the extent to which the assumption of rational expectations is useful and valid, is inadequate and unwarranted.

When John Muth first developed the concept of rational expectations — in  an Econometrica article in 1961 — he framed rational expectations in terms of probability distributions:

Expectations of firms (or, more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the “objective” probability distributions of outcomes).

To Muth the hypothesis of rational expectations was useful because it was general and applicable to all sorts of situations, irrespective of the concrete and contingent circumstances at hand. The concept was later picked up by New Classical Macroeconomics, where it soon became the dominant model-assumption and has continued to be a standard assumption made in many neoclassical (macro)economic models – most notably in the fields of (real) business cycles and finance (being a cornerstone of the “efficient market hypothesis”).

The rational expectations hypothesis basically says that people on the average hold expectations that will be fulfilled — which of course makes the economist’s analysis enormously simple, since it means that the model used by the economist is the same as the one people use to make decisions and forecasts of the future.

The perhaps most problematic part of Wren-Lewis’s and Thoma’s argument is that they both maintain that chicken-economists and young children (emphasis added)

have rational expectations in the sense that economists use the term.

This is the heart of darkness. Of course Wren-Lewis’s and Thoma’s portrayal of the economists’s meaning of rational expectations — which actually is far from real people’s common sensical meaning — is not as innocent as it may look. Rational expectations in the neoclassical economists’s world implies that relevant distributions have to be time independent. This amounts to assuming that an economy is like a closed system with known stochastic probability distributions for all different events. In reality it is straining one’s beliefs to try to represent economies as outcomes of stochastic processes. An existing economy is a single realization tout court, and hardly conceivable as one realization out of an ensemble of economy-worlds, since an economy can hardly be conceived as being completely replicated over time. It’s really straining one’s imagination trying to see any similarity between these modelling assumptions and the expectations of rational chicken-economists or children playing the “tickling game.” In the world of the rational expectations hypothesis we are never disappointed in any other way than as when we lose at the roulette wheels. But real life is not an urn or a roulette wheel.

So — the rational expectations modeled by economists are not at all the kind of expectations real youngsters — and chickens — have. That also means that — if we want to have anything of interest to say on real economies, financial crisis and the decisions and choices real people make — we have to replace the rational expectations hypothesis with more relevant and realistic assumptions concerning economic agents and their expectations. And that goes for chickens and children too …

4 Comments

  1. Couldn’t you turn the chicken example to your advantage. Imagine a chicken that, while intelligent, lacks inherited concepts of farmers, and so imagines that she might be being kept to eat, or as a pet. Moreover, suppose that she has no clues as to which is the case, and has no access to relevant statistics. How could she form a probability distribution? So how could she (or the child) be rational in Muth’s restrictive sense? She could perhaps just make up a distribution, but where is the sense in that?

  2. What I find absurd about economists who advocate rational expectations is the extent to which they prefer their theories to the empirical evidence as what actually happens in the real world.

    For example, there’s the idea (advocated by Scott Sumner amongst others) that fiscal stimulus has no effect because households will assume that the debt incurred by government in order to effect that stimulus will have to be repaid at some stage via increased taxes. So households allegedly hoard stimulus money so as to be able to afford those taxes.

    The idea that the average household, which has virtually no knowledge of economics does that sort of complex calculation is utterly absurd. Moreover, the empirical evidence is that when households notice an increase in their income, they spend a significant proportion of it fairly quickly: i.e. they don’t go in for what might be called “100% income smoothing” as is implied by the above fiscal stimulus argument.

    I did a post on the above absurd Sumner type rational expectation idea, and cited some empirical evidence, here:

    http://mikenormaneconomics.blogspot.co.uk/2013/11/guest-post-ralph-musgrave-scott-sumner.html

  3. I have been looking over this argument with interest but think it is all a bit moot. The theory of rational expectation seems to have been undone by the success of central banks’ efforts in fighting inflation. The result being that people in general no longer worry about inflation. Things such as hikes to energy bills or train fares make headlines but the rising cost of living is just a fact of life at such low levels that it is not a concern. It is only economists (and bond investors) that seem to worry about inflation and it warps their sense of priorities due to their reliance on rational expectations theory which has been shown to be increasingly outdated. An increase in the scope of oversight by central banks is a good thing and even more might help ensure more stability and a better understanding of the workings of the economy. For more on this argument, see http://yourneighbourhoodeconomist.blogspot.co.uk/2013/11/not-so-great-expectations.html


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