Home > Uncategorized > ‘Rational expectations’ is wrong

‘Rational expectations’ is wrong

from Lars Syll

Lynn Parramore: It seems obvious that both fundamentals and psychology matter. Why haven’t economists developed an approach to modeling stock-price movements that incorporates both?

Roman Frydman: It took a while to realize that the reason is relatively straightforward. Economists have relied on models that assume away unforeseeable change. As different as they are, rational expectations and behavioral-finance models represent the market with what mathematicians call a probability distribution – a rule that specifies in advance the chances of absolutely everything that will ever happen.

In a world in which nothing unforeseen ever happened, rational individuals could compute precisely whatever they had to know about the future to make profit-maximizing decisions. Presuming that they do not fully rely on such computations and resort to psychology would mean that they forego profit opportunities.

LP: So this is why I often hear that supporters of the Rational Expectations Hypothesis imagine people as autonomous agents that mechanically make decisions in order to maximize profits?

fubYes! What has been misunderstood is that this purely computational notion of economic rationality is an artifact of assuming away unforeseeable change.

Imagine that I have a probabilistic model for stock prices and dividends, and I hypothesize that my model shows how prices and dividends actually unfold. Now I have to suppose that rational people will have exactly the same interpretation as I do — after all, I’m right and I have accounted for all possibilities … This is essentially the idea underpinning the Rational Expectations Hypothesis …

LP: So the only truth is the non-existence of the one true model?

RF: It’s the genuine openness that makes our ideas – and education – more exciting. Students can think about things in an open, yet structured way. We don’t lose the structure; we just renounce the pretense of exact knowledge …

Economists may fear that acknowledging this limit would make economic analysis unscientific. But that fear is rooted in a misconception of what the social scientific enterprise should be. Scientific knowledge generates empirically relevant regularities that are likely to be durable. In economics, that knowledge can only be qualitative, and grasping this insight is essential to its scientific status.  Until now, we have been wasting time looking for a model that would tell us exactly how the market works.

LP: Chasing the Holy Grail?

RF: Yes. It’s an illusion. We’ve trained generation after generation in this fruitless task, and it leads to extreme thinking.

Huffington Post

2-format2010Roman 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 articleTowards 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 representations 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 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 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.

Cassidy: What about the rational-expectations hypothesis, the other big theory associated with modern Chicago? How does that stack up now?

Heckman: I could tell you a story about my friend and colleague Milton Friedman. In the nineteen-seventies, we were sitting in the Ph.D. oral examination of a Chicago economist who has gone on to make his mark in the world. His thesis was on rational expectations. After he’d left, Friedman turned to me and said, “Look, I think it is a good idea, but these guys have taken it way too far.”

CarriedAwayIt became a kind of tautology that had enormously powerful policy implications, in theory. But the fact is, it didn’t have any empirical content. When Tom Sargent, Lard Hansen, and others tried to test it using cross equation restrictions, and so on, the data rejected the theories. There were a certain section of people that really got carried away. It became quite stifling.

Cassidy: What about Robert Lucas? He came up with a lot of these theories. Does he bear responsibility?

Heckman: Well, Lucas is a very subtle person, and he is mainly concerned with theory. He doesn’t make a lot of empirical statements. I don’t think Bob got carried away, but some of his disciples did. It often happens. The further down the food chain you go, the more the zealots take over.

John Cassidy/Th

  1. October 7, 2016 at 5:28 pm

    Three lethal nonentities
    Comment on Lars Syll on ‘Rational expectations is wrong’

    It is long known that economists violate well-defined scientific standards: “In economics we should strive to proceed, wherever we can, exactly according to the standards of the other, more advanced, sciences, where it is not possible, once an issue has been decided, to continue to write about it as if nothing had happened.” (Morgenstern, 1941, p. 369)

    A case in point is rational expectations. Strictly speaking, the concept is already dead since Walras: “Walras approached Poincaré for his approval. … But Poincaré was devoutly committed to applied mathematics and did not fail to notice that utility is a nonmeasurable magnitude. … He also wondered about the premises of Walras’s mathematics: It might be reasonable, as a first approximation, to regard men as completely self-interested, but the assumption of perfect foreknowledge ‘perhaps requires a certain reserve’.” (Porter, 1994, p. 154)

    This was a polite thumb down but Walras did not get the point and neither did those who came after him. Not only this: “So RE survives. In Lakatos’ jargon, it’s part of the ‘hard core’ of modern macro.” (Noah Smith’s post)

    And this proves the utter scientific incompetence of economists. While it is, of course, legitimate to fool around with hypotheses in the analytical superstructure, it is NOT legitimate for the adherents of a research program to change the hard core. Methodology tells us that it is the hard core which DEFINES the paradigm. A change of the hard core amounts to the abolition of the paradigm. This is allowed, of course, but for the proponents of a paradigm it is equivalent to unintended suicide.

    Orthodox economics is built upon this hard core set of axioms: “HC1 economic agents have preferences over outcomes; HC2 agents individually optimize subject to constraints; HC3 agent choice is manifest in interrelated markets; HC4 agents have full relevant knowledge; HC5 observable outcomes are coordinated, and must be discussed with reference to equilibrium states.” (Weintraub, 1985, p. 147)

    Methodologically, these premises are forever unacceptable. It is pretty obvious that the neo-Walrasian axiom set contains THREE nonentities: (i) constrained optimization (HC2), (ii) rational expectations (HC4), (iii) equilibrium (HC5). Every model that contains only one nonentity is A PRIORI false. The discussion of models that contain nonentities is not different from a medieval angels-on-a-pinpoint discussion. And this is essentially what happens in the quality journals and on the blogs.

    It is pointless to try to repair RE and keep the rest. The WHOLE thing has to go out of the window. The microfoundations approach has already been dead in the cradle 140 years ago. To put new lipstick on long defunct RE will not work. Face the fact: economics is a failed science and economists are incompetent scientists. The issue has been decided!

    Egmont Kakarot-Handtke

    Morgenstern, O. (1941). Professor Hicks on Value and Capital. Journal of Political Economy, 49(3): 361–393. URL http://www.jstor.org/stable/1824735.
    Porter, T. M. (1994). Rigor and Practicality: Rival Ideals of Quantification in Nineteenth-Century Economics. In P. Mirowski (Ed.), Natural Images in Economic Thought, pages 128–170. Cambridge: Cambridge University Press.
    Weintraub, E. R. (1985). Joan Robinson’s Critique of Equilibrium: An Appraisal. American Economic Review, Papers and Proceedings, 75(2): 146–149. URL

  2. October 10, 2016 at 9:52 am

    Three comments. First, there is a serious misstatement in the article. “Economists may fear that acknowledging this limit would make economic analysis unscientific. But that fear is rooted in a misconception of what the social scientific enterprise should be.” No that fear is rooted in a misconception of what the “scientific” enterprise is. No science is based on the assumption that with the right model nothing unforeseen can ever happen, and that rational individuals can compute precisely whatever they need to know about the future. This sentence is filled with things and events that need to be explained, not used to explain, i.e., assumption, right, model, future, science, happen, and rational. Through observation and testing we can learn the history of these terms and their use, which of course change with time and relationships. And even these we still can’t use as economists do to willy-nilly explain events or actors. That depends on the history of the terms and the history of the events/actors we propose to explain with them. Economists face two big problems. First, they’re generally cowards. They’re afraid to face the actual complexity of the events/actors they say they want to study. Second, since they’re cowards, they prefer simple and mathematical models. Simple because they can’t deal with complexity. Mathematical to pretend complexity to impress journal reviewers and tenure committees. It’s a game not focused on knowledge and understanding but on controlling the playing field and gaining power and prestige. I keep reaching the same conclusion regarding economics and economists – better to scrap the entire enterprise. Not needed.

    • robert locke
      October 11, 2016 at 9:03 am

      “I keep reaching the same conclusion regarding economics and economists – better to scrap the entire enterprise. Not needed.”

      German discussants made a distinction, when looking at education, between education and training to make people ready to work (praxisfertig) and education to make them capable of quickly learning on the job (praxisfaehig). Professors usually say that academic education is not intended to make students praxisfertig, that is done in the workplace, but to give them a schooling of the mind, a Denkschulung, that makes them capable of quickly understanding when on the job. This distinction is useful, but there are problems with it, because the theoretical Denkschulung in academia can actually hinder the ability of people learning on the job.

      • October 12, 2016 at 7:16 am

        Robert, which brings a question to my mind. What is the job of an economist? How does s/he learn that job? Wikipedia describes an economist as ‘… a practitioner in the social science discipline of economics.” Maybe the Bureau of Labor Statistics’ definition is better. “Economists study the production and distribution of resources, goods, and services by collecting and analyzing data, researching trends, and evaluating economic issues.” This is supposedly the definition used by employers wanting to hire an economist. Any of this sound like what the economists you know do for a living?

  3. October 10, 2016 at 8:52 pm

    Egmont and Ken,

    “If we are to break the hold of neoclassical economics, we must radically reform economics education. But don’t expect this to be a fair fight – it has never been (Lee 2009, passim). Bacon’s call for a new age is most appropriate for economics. It is imperative to redirect economics away from syllogisms and the rationalists “who like spiders spin webs from themselves” (Bacon 2000 [1620] Book I, XCV, p. 79) and begin with the “true order of experience [which] first lights the lamp, then shows the way by its light, beginning with experience digested and ordered, not backwards or random, and from that it infers
    axioms, and then new experiments on the basis of the axioms so formed.” (Bacon 2000 [1620] Book I, LXXXII, p. 67). Thus, “from both results and experiments to draw causes and axioms, and from causes and axioms in turn to draw new results and experiments” (Bacon 2000 [1620] Book I, CXVIII, p. 90).

    “Reformation of economics education is our most important endeavor and the best investment we can make for the next generation. Schumacher wrote that education is “the most vital of all resources” (Schumacher 1989, p. 84) and indeed “education is our most important function as human beings: it is an investment in ourselves, future generations and the planet” (Reardon 2009, p. 267). To paraphrase C.P.Snow, “there is no excuse for letting another generation be as vastly ignorant” (Snow 1998, p. 61). We need a radical reformation in economics education”.

    Jack Reardon at http://curriculumconference2013.weaconferences.net/wp-content/uploads/sites/5/2013/05/WEA-CurriculumConference2013-REARDON.pdf

    Bacon, Francis (2000 [1620]): The New Organon. Cambridge: Cambridge University Press.
    Schumacher, E.F. (1989, [1973]): Small is Beautiful – Economics as if People Mattered. New York, Harper Perennial.
    Snow, C.P. (1998[1959]): The Two Cultures. London,UK: Cambridge University Press
    Lee, Frederic (2009): A History of Heterodox Economics- Challenging the Mainstream in the Twentieth Century, London, Routledge.
    Reardon, Jack (2009): “Conclusion” in Jack Reardon, ed. The Handbook of Pluralist Economics Education, London, Routledge, pp. 267-268.

  4. October 11, 2016 at 9:55 am

    When I earned my PhD in Anthropology, Structural-functionalism (SF) controlled the discipline. This theoretical framework depicts society as a complex system whose parts work together to promote solidarity and stability. SF considers society through a macro-level orientation, which is a broad focus on the social structures that shape society as a whole and the functions each serve. SF teaches that society evolves like organisms. The goal of society is stability. This is achieved by the constituent elements (norms, customs, traditions, and institutions) functioning correctly. In the 1950s through 1970s SF was absolutely dominant in Anthropology. It is no longer dominant. The story of that decline is instructive for the current situation in economics. SF declined in three parts. First, SF failed in efforts to explain events and actions such as development of societies and difference societal achievements. Second, SF did not include any way to explain social change. This gaping hole sort of reminds me of the gaping hole in current mainstream economics for explaining non-neoliberal events. Third, SF failed to consider let alone attempt to .explain inequality of any sort (racial, economic, political, gender, etc.). SF had the appeal of sounding useful and complete. It was neither. Some anthropology departments still hold onto SF. But most have moved on. And anthropology is better for it.

    • October 12, 2016 at 8:06 pm

      I’m glad you asked this, as researching SF proved very interesting, and from the relative timings may have contributed to my television analogy in the blog on “The Main Problem with Mainstream Economics”, to which it actually seems more relevant. Of course the SF analogy stretches back at least as far as St Paul (1 Cor 12), but the goal of the Mystical Body is not control in the sense of social stability, but that what is true for all is true for any, with social stability emerging from self-control enabled by understanding one’s own limitations and purpose:

      “As it is, the parts are many but the body is one. The eye cannot say to the hand, ‘I have no need of you’, and nor can the head say to the feet, ‘I have no need of you’. What is more, it is precisely the parts of the body that seem to be the weakest ones which are the indispensible ones. It is the parts of the body which we consider least dignified that we surround with the greatest dignity”. [This presumably relating children to genitals].

  5. October 14, 2016 at 1:03 pm

    Three important terms in SF. 1) the integrity of the system. The most important thing is to maintain the integrity of the system (e.g., society, the clan, the institution). Each part of the system performs functions that do this. Otherwise the parts would not exist. 2) this means our focus as anthropologists should be on the “holistic, integrated system.” Not all SF advocates supported the notion that this system is “self-perpetuating.” But most do. 3) empirically, the structural functionalists are often preoccupied with political and economic issues, with an almost non-existent focus on meaning and symbolism. Their studies of kinship and lineage networks are detailed and informative and became a staple of anthropology from 1910 to the 1960s. Of course the notions expressed by SF are not new. Wholes and the roles their parts played are important in most system approaches, including biological anatomy and mathematics. SF has been offered at times as an alternative to evolutionary theory. But in the end evolutionary theory largely absorbed SF. Systems working toward harmony and equilibrium in functions and parts also is not new. Ask any engineer. SF combined these and other elements and applied them to social/human science. And SF has been associated at times with right-wing, anti-democratic ideas and movements. Herbert Spencer, for example developed a type of SF that emphasized evolution. Spencer considered evolution the progressive development of the physical world, biological organisms, the human mind, and human culture and societies. And this development was definitely a battle where the best survived and others perished. He even coined a phrase to describe this battle,”survival of the fittest.” Combining Darwin’s “Origin of Species” and Lamarckism (the notion that abilities and characteristics acquired during one’s lifetime can be passed on to offspring) with a brutal form of social “natural” selection he justified poverty and oppression of the lower classes as merely the working of natural forces, requiring no moral consideration. SF faded due to the reasons I’ve already cited. Evolutionary theory and sociological theories took its place in anthropology (cultural) with physical anthropology finding new ways in biology and chemistry as well.

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