Roman Frydman on the ‘rational expectations’ hoax21 November, 2015 at 18:04 | Posted in Economics | 2 Comments
Lynn Parramore: It seems obvious that both fundamentals and psychology matter. Why haven’t economists developed an approach to modeling stock-price movements that incorporates both?
Roman Frydman: It took a while to realize that the reason is relatively straightforward. Economists have relied on models that assume away unforeseeable change. As different as they are, rational expectations and behavioral-finance models represent the market with what mathematicians call a probability distribution – a rule that specifies in advance the chances of absolutely everything that will ever happen.
In a world in which nothing unforeseen ever happened, rational individuals could compute precisely whatever they had to know about the future to make profit-maximizing decisions. Presuming that they do not fully rely on such computations and resort to psychology would mean that they forego profit opportunities.
LP: So this is why I often hear that supporters of the Rational Expectations Hypothesis imagine people as autonomous agents that mechanically make decisions in order to maximize profits?
Yes! What has been misunderstood is that this purely computational notion of economic rationality is an artifact of assuming away unforeseeable change.
Imagine that I have a probabilistic model for stock prices and dividends, and I hypothesize that my model shows how prices and dividends actually unfold. Now I have to suppose that rational people will have exactly the same interpretation as I do — after all, I’m right and I have accounted for all possibilities … This is essentially the idea underpinning the Rational Expectations Hypothesis …
LP: So the only truth is the non-existence of the one true model?
RF: It’s the genuine openness that makes our ideas – and education – more exciting. Students can think about things in an open, yet structured way. We don’t lose the structure; we just renounce the pretense of exact knowledge.
Economics is not mechanistic. It requires understanding of history, politics, and psychology. Some say that economics is an art, but NREH is actually rigorous economics. It simply recognizes that there’s a limit to what we can know.
Economists may fear that acknowledging this limit would make economic analysis unscientific. But that fear is rooted in a misconception of what the social scientific enterprise should be. Scientific knowledge generates empirically relevant regularities that are likely to be durable. In economics, that knowledge can only be qualitative, and grasping this insight is essential to its scientific status. Until now, we have been wasting time looking for a model that would tell us exactly how the market works.
LP: Chasing the Holy Grail?
RF: Yes. It’s an illusion. We’ve trained generation after generation in this fruitless task, and it leads to extreme thinking. Fama and Shiller need not see themselves in irreconcilable opposition. There is no one truth. They both have had critical insights, and NREH acknowledges that and builds on their work.
Roman 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 representations 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 in the dustbin of pseudo-science.