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Phelps’ smackdown on Lucas’ rational expectations

from Lars Syll

The tiny little problem that there is no hard empirical evidence that verifies rational expectations models doesn’t usually bother its protagonists too much. Rational expectations überpriest Thomas Sargent has defended the epistemological status of the rational expectations hypothesis arguing that since it “focuses on outcomes and does not pretend to have behavioral content,” it has proved to be “a powerful tool for making precise statements.”

Precise, yes, but relevant and realistic? I’ll be dipped!

In their attempted rescue operations, rational expectationists try to give the picture that only heterodox economists like yours truly are critical of the rational expectations hypothesis.

But, on this, they are, simply … eh … wrong. 

Question: In a new volume with Roman Frydman, “Rethinking Expectations: The Way Forward for Macroeconomics,” you say the vast majority of macroeconomic models over the last four decades derailed your “microfoundations” approach. Can you explain what that is and how it differs from the approach that became widely accepted by the profession?

rethinkAnswer: In the expectations-based framework that I put forward around 1968, we didn’t pretend we had a correct and complete understanding of how firms or employees formed expectations about prices or wages elsewhere. We turned to what we thought was a plausible and convenient hypothesis. For example, if the prices of a company’s competitors were last reported to be higher than in the past, it might be supposed that the company will expect their prices to be higher this time, too, but not that much. This is called “adaptive expectations:” You adapt your expectations to new observations but don’t throw out the past. If inflation went up last month, it might be supposed that inflation will again be high but not that high.

Q: So how did adaptive expectations morph into rational expectations?

A: The “scientists” from Chicago and MIT came along to say, we have a well-established theory of how prices and wages work. Before, we used a rule of thumb to explain or predict expectations: Such a rule is picked out of the air. They said, let’s be scientific. In their mind, the scientific way is to suppose price and wage setters form their expectations with every bit as much understanding of markets as the expert economist seeking to model, or predict, their behavior. The rational expectations approach is to suppose that the people in the market form their expectations in the very same way that the economist studying their behavior forms her expectations: on the basis of her theoretical model.

Q: And what’s the consequence of this putsch?

A: Craziness for one thing. You’re not supposed to ask what to do if one economist has one model of the market and another economist a different model. The people in the market cannot follow both economists at the same time. One, if not both, of the economists must be wrong. Another thing: It’s an important feature of capitalist economies that they permit speculation by people who have idiosyncratic views and an important feature of a modern capitalist economy that innovators conceive their new products and methods with little knowledge of whether the new things will be adopted — thus innovations. Speculators and innovators have to roll their own expectations. They can’t ring up the local professor to learn how. The professors should be ringing up the speculators and aspiring innovators. In short, expectations are causal variables in the sense that they are the drivers. They are not effects to be explained in terms of some trumped-up causes.

Q: So rather than live with variability, write a formula in stone!

A: What led to rational expectations was a fear of the uncertainty and, worse, the lack of understanding of how modern economies work. The rational expectationists wanted to bottle all that up and replace it with deterministic models of prices, wages, even share prices, so that the math looked like the math in rocket science. The rocket’s course can be modeled while a living modern economy’s course cannot be modeled to such an extreme. It yields up a formula for expectations that looks scientific because it has all our incomplete and not altogether correct understanding of how economies work inside of it, but it cannot have the incorrect and incomplete understanding of economies that the speculators and would-be innovators have.

Q: One of the issues I have with rational expectations is the assumption that we have perfect information, that there is no cost in acquiring that information. Yet the economics profession, including Federal Reserve policy makers, appears to have been hijacked by Robert Lucas.

A: You’re right that people are grossly uninformed, which is a far cry from what the rational expectations models suppose. Why are they misinformed? I think they don’t pay much attention to the vast information out there because they wouldn’t know what to do what to do with it if they had it. The fundamental fallacy on which rational expectations models are based is that everyone knows how to process the information they receive according to the one and only right theory of the world. The problem is that we don’t have a “right” model that could be certified as such by the National Academy of Sciences. And as long as we operate in a modern economy, there can never be such a model.

Bloomberg

Phelps’ critique is much in line with the one yours truly put forward in On the use and misuse of theories and models in economics.

  1. October 21, 2015 at 6:33 pm

    Not quite as simple as either you or Phelps present it. You see theoretical physicists use a process similar to that of “theoretical” economists. For example, a theoretical physicist may begin … assume a universe with only linear scalars. Based on that assumption the physicists would then work out what the actions in that universe might look like based on existing (or even new) mathematics and known (or even new) observations. It might take years but eventually the physics “community” would come to consensus on the usefulness of working with the assumption of a universe with only linear scalars. The assumption of a linear scalars universe would then be rejected in whole or in part, modified and then tested again, or fully accepted. Apparently, however theoretical economists have no patience for the scientific process. They either skip it altogether, use only “thought” experiments to assess their assumptions, or immediately assume their assumptions are correct and begin using them to design how we ought to interact with the world. This immediately rules out economists who take such actions as scientists. Question: what role then are they playing? Politicians, activists, doomsayers, business persons, celebrities, etc. I suspect it’s some combination of these.

    • October 22, 2015 at 8:14 am

      Perhaps you are just using an example (say, similar to chomsky’s famous one on how ‘colorless green ideas sleep furiously’—which i take to be an undisputed scientific fact) but what exactly is a ‘linear scalar’? (scalars are often associated with linear transformations, but this sounds more like a ‘thrown rock’—some rocks have been thrown, but usually one says something like ‘sedimentary’ or ‘volcanic ‘ rock–a property, not a history; there is an approach i barely remember called logic without quantifiers which may be in line with the syntax of a linear scalar).

      phelps essay reminds me a bit of some of krugman’s stuff. i was looking at the disputes over NAFTA and found a Krugman essay in Scientific American in which he used the stolper-samuelson theorem to argue basically ‘free trade’ was good and wouldnt contribute to inequality, etc. (he didnt mention that theorem assumes conditions of full employment, and a few other things—maybe he knew these are trivial details; in one his last papers samuelson wrote that theorem his name was on he disagreed was applicable to this real world ). In another paper in a technical econ journal, krugman pointed out with a math model that actually ‘free trade’ under nonideal, but real circumstances could lead to outcomes which critics of free trade say will happen (and in the case of NAFTA, apparently did—unless perhaps one likes the mexican cartels—who interestingly seem to have franchises in my area). he just said while theoretically its possible markets fail, it seems unlikely.

      phelps has an article in the august 13 new york review of books in which he seems to argue for his new book ‘mass flourishing’—ie unbridled capitalism, more is better, who cares about anything else except malcontent environmentalists, social justice types, etc. my view is this is more or less along the lucas line.

      the one by phelps above seems to be sort of moving back or rather rewriting history from some of his original views—‘dont blame me for rational expectations, i was for adaptive ones’. i call that a difference without much of a difference. (from his wikipedia page it may be he had some ok articles—eg the 70’s one on the statistical theory of sexism and racial discrimination—lester thurow had one like that too in an old book.) also, the very good and sophisticated papers in this area are written by well known people who dont get prizes and are in more mathemtical journals. they are sort of updates on SMD.

    • October 31, 2015 at 7:30 pm

      Good analogy. One that I use compares ‘economics’ to a ‘scientific’ biology of the dynamic behavior of non-life forms posited to exhibit the ‘studied’ behavior. Though a science of biology bereft of life forms would hardly stand much scrutiny, for some strange reason an ‘economics devoid of human beings is supposed to make sense.

      The primary achievements of the ‘marginalist’ revolution in economics were 1) to remove human beings from the study of economic activity; and 2) to apply formal mathematics to what remained. What remained, of course, was a body of axioms about the behavior of a posited being which is not a life form, much less a human being.

  2. October 22, 2015 at 12:39 pm

    Not yet in and not yet out of the wood
    Comment on Lars Syll on ‘Phelps’ smackdown on Lucas’ rational expectations’

    (i) “In their mind, the scientific way is to suppose price and wage setters form their expectations with every bit as much understanding of markets as the expert economist seeking to model, or predict, their behavior.” (See intro)

    (ii) Expert economists have no scientific understanding of how the market economy works.

    (iii) Well-informed and rational agents do not take orthodox economics seriously. The rational expectations approach is self-contradictory.

    It is crystal clear by now that Orthodoxy badly missed ‘the scientific way’ or, as Schumpeter already realized “We are not yet out of the wood; in fact, we are not yet in it.” (1994, p. 7)

    Unfortunately, Heterodoxy, too, is not out of the wood because it wastes too much time with debunking silly behavioral assumptions instead of putting economics on methodologically sound foundations and thereby leading it out of the proto-scientific wood of Lucas, Frydman, Phelps and all the quacking rest.

    The scientific way has been shown by Joan Robinson: ‘Scrap the lot and start again.’*

    Egmont Kakarot-Handtke

    References
    Schumpeter, J. A. (1994). History of Economic Analysis. New York, NY: Oxford University Press.
    * For the new curriculum see cross-references
    http://axecorg.blogspot.de/2015/04/new-curriculum-cross-references.html

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