Rational expectations — totally incredible bogus

2 May, 2015 at 11:24 | Posted in Economics | 2 Comments

2-format2010Roman Frydman is Professor of Economics at New York University and a long time critic of the rational expectations hypothesis. In his seminal 1982 American Economic Review article Towards an Understanding of Market Processes: Individual Expectations, Learning, and Convergence to Rational Expectations Equilibrium — an absolute must-read for anyone with a serious interest in understanding what are the issues in the present discussion on rational expectations as a modeling assumption — he showed that models founded on the rational expectations hypothesis are inadequate as representation of economic agents’ decision making.

Those who want to build macroeconomics on microfoundations usually maintain that the only robust policies and institutions are those based on rational expectations and representative actors. As yours truly has tried to show in On the use and misuse of theories and models in economics there is really no support for this conviction at all. On the contrary. If we want to have anything of interest to say on real economies, financial crisis and the decisions and choices real people make, it is high time to place macroeconomic models building on representative actors and rational expectations-microfoundations where they belong – in the dustbin of history.

For if this microfounded macroeconomics has nothing to say about the real world and the economic problems out there, why should we care about it? The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic modelbuilding is little more than hand waving that give us rather little warrant for making inductive inferences from models to real world target systems. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around.

In one of their recent books on rational expectations, Roman Frydman and his colleague Michael Goldberg write:

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.

Beyond Mechanical Markets

And in a recent article the same authors write:

Contemporary economists’ reliance on mechanical rules to understand – and influence – economic outcomes extends to macroeconomic policy as well, and often draws on an authority, John Maynard Keynes, who would have rejected their approach. Keynes understood early on the fallacy of applying such mechanical rules. “We have involved ourselves in a colossal muddle,” he warned, “having blundered in the control of a delicate machine, the working of which we do not understand.”

In The General Theory of Employment, Interest, and Money, Keynes sought to provide the missing rationale for relying on expansionary fiscal policy to steer advanced capitalist economies out of the Great Depression. But, following World War II, his successors developed a much more ambitious agenda. Instead of pursuing measures to counter excessive fluctuations in economic activity, such as the deep contraction of the 1930’s, so-called stabilization policies focused on measures that aimed to maintain full employment. “New Keynesian” models underpinning these policies assumed that an economy’s “true” potential – and thus the so-called output gap that expansionary policy is supposed to fill to attain full employment – can be precisely measured.

But, to put it bluntly, the belief that an economist can fully specify in advance how aggregate outcomes – and thus the potential level of economic activity – unfold over time is bogus …

Roman Frydman & Michael Goldberg

The real macroeconomic challenge is to accept uncertainty and still try to explain why economic transactions take place – instead of simply conjuring the problem away by assuming rational expectations and treating uncertainty as if it was possible to reduce it to stochastic risk. That is scientific cheating. And it has been going on for too long now.

2 Comments »

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  1. You should read Noah Smith more. Granted he is too full of himself at times and his knowledge of economic history is too limited (however, it is quite good for things since the 1970s or so), he is still a treasure trove of information. See for example, his reference to this work that moves beyond rational expectations – “Networks and the Macroeconomy: An Empirical Exploration” Daron Acemoglu Ufuk Akcigit William Kerr
    April 5, 2015

  2. Neither truth nor beauty
    Comment on ‘Rational expectations — totally incredible bogus’

    It was one of the Top 20* heterodox economists who observed some time ago:
    “No science has been criticized by its own servants as openly and constantly as economics. The motives of dissatisfaction are many, but the most important pertains to the fiction of homo oeconomicus.” (Georgescu-Roegen, 1971, p. 1)
    .
    The most outstanding characteristic of economists is that they mess virtually everything up. The long standing gossip about realistic/unrealistic behavioral assumptions and the vacuous filibuster about use/abuse of formalization are only two points on a long list. When both topics are mixed, when behavioral realism is played against formal beauty, the apex of surrealism is finally reached.
    .
    What is wrong with economics — in the last instance — is economists. They get neither behavior nor math right.
    .
    The student of economics either understands in his first course of econ101
    • that behavioral assumptions like utility, optimization, rational expectation, supply/demand functions and equilibrium are nonentities;
    • that in mathematics there exists a ‘whole crop of monster-structures, entirely without application’ (Bourbaki, 2005, p. 1275, fn. 9);
    or not.
    .
    The student with a modicum of scientific guts becomes by logical necessity a heterodox economist. He will avoid nonentities and monster-structures and debunk them wherever they appear. But that is not enough, what he desperately wants and needs is the correct theory and the congenial math. This is the central issue of Constructive Heterodoxy.
    .
    What nobody needs is another surrealistic discussion about beauty and truth in economics. There is neither and exactly this is the real problem.
    .
    Egmont Kakarot-Handtke
    .
    References
    Bourbaki, N. (2005). The Architecture of Mathematics. In W. Ewald (Ed.), From
    Kant to Hilbert. A Source Book in the Foundations of Mathematics, volume II,
    pages 1265–1276. Oxford, New York, NY: Oxford University Press.
    Georgescu-Roegen, N. (1971). The Entropy Law and the Economic Process. Cambridge, MA: Cambridge University Press.
    .
    * Top 20 https://larspsyll.wordpress.com/?s=Top+20


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