Rational expectations — the triumph of ideology over science

29 Sep, 2017 at 18:53 | Posted in Economics | 2 Comments

Research shows not only that individuals sometimes act differently than standard economic theories predict, but that they do so regularly, systematically, and in ways that can be understood and interpreted through alternative hypotheses, competing with those utilised by orthodox economists.

Senate Banking Subcommittee On Financial Institutions Hearing With StiglitzTo most market participants — and, indeed, ordinary observers — this does not seem like big news … In fact, this irrationality is no news to the economics profession either. John Maynard Keynes long ago described the stock market as based not on rational individuals struggling to uncover market fundamentals, but as a beauty contest in which the winner is the one who guesses best what the judges will say …

Adam Smith’s invisible hand — the idea that free markets lead to efficiency as if guided by unseen forces — is invisible, at least in part, because it is not there …

For more than 20 years, economists were enthralled by so-called “rational expectations” models which assumed that all participants have the same (if not perfect) information and act perfectly rationally, that markets are perfectly efficient, that unemployment never exists (except when caused by greedy unions or government minimum wages), and where there is never any credit rationing.

That such models prevailed, especially in America’s graduate schools, despite evidence to the contrary, bears testimony to a triumph of ideology over science. Unfortunately, students of these graduate programmes now act as policymakers in many countries, and are trying to implement programmes based on the ideas that have come to be called market fundamentalism … Good science recognises its limitations, but the prophets of rational expectations have usually shown no such modesty.

Joseph Stiglitz

 
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.

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 a 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.

2 Comments

  1. “The real macroeconomic challenge is to accept uncertainty and still try to explain why economic transactions take place”

    My story: quid-pro-quo exchange is driven by a desire to control. Gift economies eschew price, and therefore define value differently than neoliberalism (neoclassicalism, if you want to be politically correct). My belief is that natural relations include sharing freely. The rational expectations theory demotes giving by prioritizing quid-pro-quo exchange in a currency that, it is asserted, objectively measures value. Economists push normative assumptions to get people to behave as they think their masters want everyone to behave …

  2. There is no conflict here. A proper and satisfactory model of our social system should allow for the effects of sudden unexpected changes to be introduced. It may not be able to forecast them, but it can show their independent and also combined effects on the whole system.It is too much to expect more from such a model, but this is plenty if it is done right.


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