Rational expectations — a monstrous assumption

3 September, 2015 at 09:43 | Posted in Economics | Leave a comment

Cave_monster_speedpainting_by_Dekus‘Rational expectations’ remains for me a sort of monster living in a cave. I have never ventured into the cave to see what he is like, but I am always uneasily aware that he may come out and eat me. If you will allow me to stir the cauldron of mixed metaphors with a real flourish, I shall suggest that ‘rational expectations’ is neo-classical theory clutching at the last straw.

Observable circumstances offer us suggestions as to what may be the sequel of this act or that one. How can we know what invisible circumstances may take effect in time-to come, of which no hint can now be gained? I take it that ‘rational expectations’ assumes that we can work out what will happen as a consequence of this or that course of action. I should rather say that at most we can hope to set bounds to what can happen, at best and at worst, within a stated length of time from ‘the present’, and can invent an endless diversity of possibilities lying between them.

G.L.S. Shackle

It’s difficult not to agree with Shackle on this issue.

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.

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.

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