LARS P. SYLL

Rational expectations — the triumph of ideology over science

 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.

The Sonnenschein-Mantel-Debreu Theorem

SMD theory means that assumptions guaranteeing good behavior at the microeconomic level do not carry over to the aggregate level or to qualitative features of the equilibrium. It has been difficult to make progress on the elaborations of general equilibrium theory that were put forth in Arrow and Hahn 1971 …

Fifteen years after General Competitive Analysis, Arrow (1986) stated that the hypothesis of rationality had few implications at the aggregate level. Kirman (1989) held that general equilibrium theory could not generate falsifiable propositions, given that almost any set of data seemed consistent with the theory. These views are widely shared. Bliss (1993, 227) wrote that the “near emptiness of general equilibrium theory is a theorem of the theory.” Mas-Colell, Michael Whinston, and Jerry Green (1995) titled a section of their graduate microeconomics textbook “Anything Goes: The Sonnenschein-Mantel-Debreu Theorem.”

S. Abu Turab Rizvi

And so what? Why should we care about Sonnenschein-Mantel-Debreu?

Because  Sonnenschein-Mantel-Debreu ultimately explains why New Classical, Real Business Cycles, Dynamic Stochastic General Equilibrium (DSGE) and New ‘Keynesian’ microfounded macromodels are such bad substitutes for real macroeconomic analysis!

These models try to describe and analyze complex and heterogeneous real economies with a single rational-expectations-robot-imitation-representative-agent. That is, with something that has absolutely nothing to do with reality. And — worse still — something that is not even amenable to the kind of general equilibrium analysis that they are thought to give a foundation for, since Hugo Sonnenschein (1972),​ Rolf Mantel (1976) and Gerard Debreu (1974) unequivocally showed that there did not exist any condition by which assumptions on individuals would guarantee neither stability nor uniqueness of the equilibrium​ solution. A century and a half after Léon Walras founded neoclassical general equilibrium theory, modern mainstream economics hasn’t been able to show that markets move economies to equilibria. This if anything shows that the whole Bourbaki-Debreu project of axiomatizing​ economics was nothing but a delusion.

You enquire whether or not Walras was supposing that exchanges actually take place at the prices originally proposed when the prices are not equilibrium prices. The footnote which you quote convinces me that he assuredly supposed that they did not take place except at the equilibrium prices … All the same, I shall hope to convince you some day that Walras’ theory and all the others along those lines are little better than nonsense!

Letter from J. M. Keynes to N. Georgescu-Roegen, December 9, 1934

Opting for cloned representative agents that are all identical is of course not a real solution to the fallacy of composition that the Sonnenschein-Mantel-Debreu theorem points to. Representative agent models are — as I have argued at length in my On the use and misuse of theories and models in mainstream economics — rather an evasion whereby issues of distribution, coordination, heterogeneity are swept under the rug.

Of course, most macroeconomists know that to use a representative agent is a flagrantly illegitimate method of ignoring real aggregation issues. They keep on with their business, nevertheless, just because it significantly simplifies what they are doing. It reminds not so little of the drunkard who has lost his keys in some dark place and deliberately chooses to look for them under a neighbouring street light just because it is easier to see there …

Economy Studies: A Guide to Rethinking Economics Education

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La théorie du ruissellement 

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