Home > The Economics Profession > Rational expectations — totally incredible bogus

Rational expectations — totally incredible bogus

from Lars Syll

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 representation 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 where they belong – in the dustbin of history. 

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 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.

In one of their recent books on rational expectations, Roman Frydman and his colleague Michael Goldberg write:

Beyond_Mechanical_MarketsThe belief in the scientific stature of fully predetermined models, and in the adequacy of the Rational Expectations Hypothesis to portray how rational individuals think about the future, extends well beyond asset markets. Some economists go as far as to argue that the logical consistency that obtains when this hypothesis is imposed in fully predetermined models is a precondition of the ability of economic analysis to portray rationality and truth.

For example, in a well-known article published in The New York Times Magazine in September 2009, Paul Krugman (2009, p. 36) argued that Chicago-school free-market theorists “mistook beauty . . . for truth.” One of the leading Chicago economists, John Cochrane (2009, p. 4), responded that “logical consistency and plausible foundations are indeed ‘beautiful’ but to me they are also basic preconditions for ‘truth.’” Of course, what Cochrane meant by plausible foundations were fully predetermined Rational Expectations models. But, given the fundamental flaws of fully predetermined models, focusing on their logical consistency or inconsistency, let alone that of the Rational Expectations Hypothesis itself, can hardly be considered relevant to a discussion of the basic preconditions for truth in economic analysis, whatever “truth” might mean.

There is an irony in the debate between Krugman and Cochrane. Although the New Keynesian and behavioral models, which Krugman favors, differ in terms of their specific assumptions, they are every bit as mechanical as those of the Chicago orthodoxy. Moreover, these approaches presume that the Rational Expectations Hypothesis provides the standard by which to define rationality and irrationality.

In fact, the Rational Expectations Hypothesis requires no assumptions about the intelligence of market participants whatsoever … Rather than imputing superhuman cognitive and computational abilities to individuals, the hypothesis presumes just the opposite: market participants forgo using whatever cognitive abilities they do have. The Rational Expectations Hypothesis supposes that individuals do not engage actively and creatively in revising the way they think about the future. Instead, they are presumed to adhere steadfastly to a single mechanical forecasting strategy at all times and in all circumstances. Thus, contrary to widespread belief, in the context of real-world markets, the Rational Expectations Hypothesis has no connection to how even minimally reasonable profit-seeking individuals forecast the future in real-world markets. When new relationships begin driving asset prices, they supposedly look the other way, and thus either abjure profit-seeking behavior altogether or forgo profit opportunities that are in plain sight.

Beyond Mechanical Markets

And in a recent article the same authors write:

Contemporary economists’ reliance on mechanical rules to understand – and influence – economic outcomes extends to macroeconomic policy as well, and often draws on an authority, John Maynard Keynes, who would have rejected their approach. Keynes understood early on the fallacy of applying such mechanical rules. “We have involved ourselves in a colossal muddle,” he warned, “having blundered in the control of a delicate machine, the working of which we do not understand.”

In The General Theory of Employment, Interest, and Money, Keynes sought to provide the missing rationale for relying on expansionary fiscal policy to steer advanced capitalist economies out of the Great Depression. But, following World War II, his successors developed a much more ambitious agenda. Instead of pursuing measures to counter excessive fluctuations in economic activity, such as the deep contraction of the 1930’s, so-called stabilization policies focused on measures that aimed to maintain full employment. “New Keynesian” models underpinning these policies assumed that an economy’s “true” potential – and thus the so-called output gap that expansionary policy is supposed to fill to attain full employment – can be precisely measured.

But, to put it bluntly, the belief that an economist can fully specify in advance how aggregate outcomes – and thus the potential level of economic activity – unfold over time is bogus …

Roman Frydman & Michael Goldberg

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.

  1. paul davidson
    May 4, 2015 at 10:19 pm

    You should read “Rational Expectations: A Fallacious Foundation For Studying Crucial Decision Making Processes”, JOURNAL OF POST KEYNESIAN ECONOMICS, Winter 1982-83 issue. by Paul Davidson. This article shows that rational expectations requires the axiom of an ergodic stochastic system where the future is already predetermined and not uncertain/

    • MRW
      May 5, 2015 at 12:48 am

      How do we get our mitts on it?

      • paul davidson
        May 5, 2015 at 4:21 pm

        if you can not get a copy of the
        Journal of Post Keynesian Economics where it is printed in, it is reproduced in volume 2
        (of 4 volumes) of The Collected Writings of Paul Davidson. Volume 2 is entitled INFLATION, OPEN ECONOMIES AND RESOURCES published by Macmillan, in 1991.and edited by Louise Davidson.

        j

      • Paul Schächterle
  2. May 5, 2015 at 2:08 am

    One simple argument against rational expectation comes from models with multiple equlibria. Expectations are self-fulfilling and so achieving a particular equillibrium requires coordination. Coordination can be done IMPLICITLY by assuming some mechanism, or EXPLICITLY by the agents discussing and agreeing to a particular method. I learned all of this in the process on attempting to model Krugman’s Baby Sitting Cooperative model, which he has used to show that reduction of money supply can lead to a recession. I learned that his conclusions were closely tied to an implicit and assumed method of expectation formation. Changing the expectation formation mechanism leads to different equilibrium. Rational expectations is not very useful since one can coordinate on many different possible equilibria all of which have rational expectations which differ from each other. This possibility is ubiquitous in monetary models — multiple equilibria arise even in the simplest such models. See my paper on
    Sunspot Equilibria of Baby Sitting Cooperatives: http://ssrn.com/abstract=2482928

  3. May 5, 2015 at 10:05 am

    From PsySoc to SysHum
    Comment on ‘Rational expectations — totally incredible bogus’

    The student of economics either understands at his very first encounter with econ101
    • that behavioral assumptions like utility, optimization, rational expectation, supply/demand functions and equilibrium are nonentities;
    • that in mathematics there exists a ‘whole crop of monster-structures, entirely without application’ (Bourbaki, 2005, p. 1275, fn. 9);
    or unfortunately not.

    The student with a modicum of scientific guts becomes by logical necessity a heterodox economist. He will avoid nonentities and inapplicable monster-structures and debunk them wherever they appear.

    This is right and good, but it is not good enough.

    What everybody wants and needs is the correct theory and the congenial math. What nobody needs is another surrealistic discussion about rational expectations, ergodicity, the fixpoint theorem, or multiple equilibria.

    The reason why Heterodoxy has only been marginally successful is that it shares the foundational blunder with Orthodoxy.

    The crucial point is that economics deals — in the first place — NOT with individual human behavior or society at large. This is the realm of psychology, sociology, anthropology, history, politics, etcetera. Insofar as economics deals with behavioral assumptions like utility maximization, greed, power grabbing, etcetera, it is a dilettantish variant of Psycho-Sociology or PsySoc.

    What is the real subject matter of economics?

    As a first approximation, one can agree on the general characteristic that the economy is a complex system.

    However, with the term system one usually associates a structure with components that are non-human. In order to stress the obvious fact that humans are an essential component of the economic system the market economy should be characterized more precisely as a complex hybrid human/system entity or SysHum.

    The scientific method is straightforwardly applicable to the sys-component but not to the hum-component. While it is clear that the economy always has to be treated as an indivisible whole, for good methodological reasons the analysis has to START with the objective system-component.

    In gestalt-psychological terms the economic system is the foreground, individual behavior the background. Common sense wrongly insists that the hum-component must always be in the foreground. This fallacy compares to geo-centrism. The economic system has its own logic which is different from the behavioral logic of humans. The systemic logic is what Adam Smith called the Invisible Hand.

    Heterodoxy will be inextricably tied to failed Orthodoxy as long as it is content with making homo oeconomicus ‘more realistic.’ The student with a modicum of scientific guts goes beyond flat behavioral common sense, quits PsySoc altogether, and turns to SysHum.*

    Egmont Kakarot-Handtke

    References
    Bourbaki, N. (2005). The Architecture of Mathematics. In W. Ewald (Ed.), From
    Kant to Hilbert. A Source Book in the Foundations of Mathematics, volume II,
    pages 1265–1276. Oxford, New York, NY: Oxford University Press. (1948).

    * For the new curriculum see
    http://axecorg.blogspot.de/2015/04/new-curriculum-cross-references.html

  4. Franklin Chiemeka Agukwe
    May 6, 2015 at 5:21 pm

    Absolutely right. I couldn’t have agreed less. many economists neglect uncertainty in their works forgetting that uncertainty is the foundation of knowledge. Knowing how to incorporate uncertainty into economic models with uncertain outcomes and not making the outcomes %100 certain will make a model more accurate

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