Rational expectations — the triumph of ideology over science

29 Nov, 2021 at 11:46 | Posted in Economics | 7 Comments

Senate Banking Subcommittee On Financial Institutions Hearing With Stiglitz 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.

7 Comments

  1. 《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.》
    .
    Don’t panicking traders in a financial crisis all start to look a lot like like one groupthinking representative agent though?
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    《simply conjuring the problem away by assuming rational expectations and treating uncertainty as if it was possible to reduce it to stochastic risk. 》
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    Without actually investigating risk trades, aren’t you being unscientific in deducing a result before even doing an experiment? Why not construct a proof-of-concept hedged portfolio and report its profit and loss? Is the idea of falsification of hypotheses about risk gone from science, these days?
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    Are you really adopting a very negative faith-based attitude towards finance, which is the antithesis of science, because you don’t even have to look at any hedged risks to declare them positively evil? Are we really dealing with religious fervor here?
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    If we actually look at evidence, can I make a strong case that the central bank at the top of the world hierarchy (the Fed) has within its power the ability to end financial uncertainty for any agent at any time? So your hedges can explicitly include a central bank put?
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    Thus is a fully inflation-protected basic income financially risk-free, as long as central banks insure it?

    • You’re not concerned about moral hazard?

      • Is cherry-picking moral hazards itself a moral hazard?
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        What if we can divert traders harmlessly into financial risk markets, where they devote a lot of energy that would otherwise likely be misspent on some violence, and the Fed insures the rest of us in case their hedges turn out to be vulnerable to something they didn’t foresee, causing a panic that leaks into government budgets, leading to more austerity for the precariat? But, why can’t we explicitly break the links between finance and the real economy, so traders harmlessly barter virtual risk derivatives without affecting my individual, non-ergodic, life?

      • “Is cherry-picking moral hazards itself a moral hazard?”
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        No.
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        If the behaviour you favour was allowed to occur the bail out fund would be regularly dealing with crises.
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        Derivative takers would no longer bother to price in risk and would enter into riskier and riskier trades.
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        A vicious circle.

        • 《If the behaviour you favour was allowed to occur the bail out fund would be regularly dealing with crises.》
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          Why should this matter?

        • I’ll let you ponder the question.
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          Nothing I can say will make a difference.

          • Aren’t you just going to make a crisis out of anything, anyway? Once we perfectly insure financial crises, will you just have to find some other teacup to conjure up a tempest in? Can you even help it, or does dismal come naturally?
            .
            Is bemoaning finance just a current popular way of getting attention? All you have to do is pooh-pooh it with a wave of the hand, without ever figuring out how to make an options trade? Isn’t it easy confirming assumptions with emotional comments, rather than trying to falsify them by devising perfectly hedged portfolios yourself?


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