Chicago economics — only for Gods and Idiots

15 Jan, 2020 at 14:27 | Posted in Economics | 2 Comments

4703325-2If I ask myself what I could legitimately assume a person to have rational expectations about, the technical answer would be, I think, about the realization of a stationary stochastic process, such as the outcome of the toss of a coin or anything that can be modeled as the outcome of a random process that is stationary. I don’t think that the economic implications of the outbreak of World war II were regarded by most people as the realization of a stationary stochastic process. In that case, the concept of rational expectations does not make any sense. Similarly, the major innovations cannot be thought of as the outcome of a random process. In that case the probability calculus does not apply.

Robert Solow

‘Modern’ macroeconomic theories are as a rule founded on the assumption of rational expectations — where the world evolves in accordance with fully predetermined models where uncertainty has been reduced to stochastic risk describable by some probabilistic distribution.

The tiny little problem that there is no hard empirical evidence that verifies these models — cf. Michael Lovell (1986) and Nikolay Gertchev (2007) — usually doesn’t bother its protagonists too much. Rational expectations überpriest Thomas Sargent has the following to say on the epistemological status of the rational expectations hypothesis:

Partly because it focuses on outcomes and does not pretend to have behavioral content, the hypothesis of rational epectations has proved to be a powerful tool for making precise statements about complicated dynamic economic systems.

Precise, yes, in the celestial world of models. But relevant and realistic? I’ll be dipped!

And a few years later, when asked if he thought “that differences among people’s models are important aspects of macroeconomic policy debates”, Sargent replied:

The fact is you simply cannot talk about their differences within the typical rational expectations model. There is a communism of models. All agents within the model, the econometricians, and God share the same model.

Building models on rational expectations either means we are Gods or Idiots. Most of us know we are neither. So, Gods and Idiots may share Sargent’s and Lucas’s models, but they certainly aren’t my models.

2 Comments

  1. Not fair to idiots, I would think.

    In any case, here is my take on the question of expectations, via George Soros’ theory of reflexivity. Soros knows a thing or two about market expectations and outcomes.

    Click to access 2-Reflexivity,%20path%20dependence,%20and%20disequilibrium%20dynamics.pdf

    Comment by shaikh945— 16 Jan, 2020 #

  2. The problem is that economic models assume financial uncertainty, because real world uncertainty. But the only real financial uncertainty is whether the bank at the top of the hierarchy will impose scarcity of money for purely policy reasons that depend on arbitrary personalities. If another personality had been Fed chair in the late 1970s and 1980s, we might not have seen high interest rates.
    .
    Once again, I quote a big bank insider:
    .
    ‘We Short Vol. Knowing We’re Backstopped’
    .
    https://twitter.com/VolatilityWiz/status/1214645278529208322?s=20
    .
    He means backstopped by the defacto bank at the top of the world hierarchy, the Fed.
    .
    This is how real-world finance works: financial uncertainty is due to psychology only. Physical uncertainty is insured. The only question is whether the Fed head will draw on an unlimited supply of reserves to bail out insurers if they get in some trouble.
    .
    Lehman’s did not get bailed out and that probably caused, or at least deepened, a recession. Today, the Fed is happily printing to shore up repo markets, perhaps having learned from Lehman’s.

    Comment by Robert S Mitchell— 15 Jan, 2020 #


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