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Rethinking 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.

Let’s listen to Nobel laureate Edmund Phelps — hardly a heterodox economist — and what he has to say (emphasis added):  

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?

frydAnswer: 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.

QAnd what’s the consequence of this putsch?

ACraziness 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!

AWhat 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 modelled​ while a living modern economy’s course cannot be modelled​ 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

The rational expectations hypothesis presumes consistent behaviour, where expectations do not display any persistent errors. In the world of rational expectations we are always, on average, hitting the bull’s eye. In the more realistic, open systems view, there is always the possibility (danger) of making mistakes that may turn out to be systematic. It is because of this, presumably, that we put so much emphasis on learning in our modern knowledge societies.

So, where does all this leave us? I think John Kay sums it up pretty well:

A scientific idea is not seminal because it influences the research agenda of PhD students. An important scientific advance yields conclusions that differ from those derived from other theories ​and establishes that these divergent conclusions are supported by observation. Yet as Prof Sargent disarmingly observed, “such empirical tests were rejecting too many good models” in the programme he had established with fellow Nobel laureates Bob Lucas and Ed Prescott. In their world, the validity of a theory is demonstrated if, after the event, and often with torturing of data and ad hoc adjustments that are usually called “imperfections”, it can be reconciled with already known facts – “calibrated”. Since almost everything can be “explained” in this way, the theory is indeed universal; no other approach is necessary, or even admissible …

  1. September 14, 2017 at 1:17 pm

    Rocketry isn’t just about where the rocket will go if all goes well. One also has to consider what might go wrong, where the rocket might go, and what one could do about it. Some economists preached that, unlike rockets, markets could never fail. Others simply couldn’t bring themselves to contemplate possibilities. I think there was a further problem, if that if respected people had started to acknowledge the possibility of a crash the crashes would have come sooner, probably before anyone could have forestalled them.

  2. September 14, 2017 at 5:46 pm

    Still, that’s not the biggest problem with rational expectations. Presumably rational expectations are useful in economics because they are the drivers of directing production toward what will benefit society most. In actuality, even if everybody does have perfect information and a rational decision-making process then rational expectations theory would only be successful in driving production toward what the last round of economic winners wants. Think of a sweatshop in a third world country that effectively has no economy. Rational expectations and market processes according to the math and ignoring the fact that irrational, emotional humans are implementing the process, will drive wages in the sweatshop uniformly toward zero and asymptotically approach an equilibrium of producing solely for export and consuming nothing until it hits a lower wall of the opportunity cost of participating in the third world country instead of the sweatshop.

    In other words, rational expectations and standard market theory provide an excuse for ignoring the destructive processes and negative feedback loops of extreme inequality.

  3. rjw
    September 14, 2017 at 6:47 pm

    Sargent’s justification reads like a textbook example of Friedman’s “as-if” methodology, and if that is his position, it is wholly disingenuous.

    That said, there is a kernel of truth in the argument. If you take a marshallian, or keynesian view of methodological matters, there is nothing really wrong with making an assumption that expectations are roughly right, and seeing where that takes you when you look at variation in other bits of the system, given that assumption.

    Indeed, Keynes himself makes the assumption at some point in the General theory, for expositional purposes, that businessmen correctly guess the extent of market demand for their products. It isn’t ideal, but can be a useful part of a mental model in some circumstances, provided you are aware of the limits.

    The problem is when economists turn it into a working axiom, then use the assumption to build ever more complex models in which the assumption fundamentally drives results. Keynes was more than aware of the dangers, given his views on
    uncertainty, and was appropriately careful.

  4. September 17, 2017 at 12:31 pm

    The fundamental flaw I see in all expectations ‘functions’ is that they implicitly presume that sellers have an ability to arbitrarily set prices in the marketplace…

    …as though the “predictions” of sellers re: future prices will in some crucial way help to determine the prices that are actually arrived at in the marketplace.

    The problem with this simplistic notion is the fact that seller expectations can only ever have an impact on the “offer” prices they submit to the marketplace. That is quite a different thing from determining the actual prices that the marketplace generates.

    Notice what happens to the “power of expectations” premise when we make the simplifying assumption that sellers always sell their offerings at the highest price that the market will bear. It pretty much wipes out the significance of any expectations/hopes that sellers might have regarding the prices they’d like to receive.

    If sellers always sell their product at the highest prices that the market will bear (it typically takes time and many price adjustments in order to arrive at that price), then the single most important variable which determines prices is the number of disposable dollars that the demand side has available to throw at those markets.

    Since all items purchased in the marketplace are effectively auctioned to the highest bidders, price inflation—for any particular income group—is necessarily determined by disposable incomes inflation (+ money wealth accumulations). Both price- and incomes-inflation vary across the entire range of disposable-income brackets.

    From my POV, the “expectations” of economic players can be left out of any serious attempts to model the economy, since doing so would not diminish—and would probably enhance—their accuracy and their usefulness as a conceptualization of economic reality.

    It is a variable which does not properly belong in any macroeconomic model.

  5. September 21, 2017 at 8:56 am

    Rational expectations cannot be verified by empirical evidence, or in any other way. All the dozens of forms of rationalism, rational living, rational expectations that exist today, including economists’ versions at some point in time did not exist. All are the result of human creativity and imagination. To use Harari’s term, humans “make them up.” They are all make-believe. Rather than pursue those histories here, I want to consider rather how those multiple folktales of rationalism have been used. Three of those uses seem particularly relevant for economics. First, rationalism has been used to justify the subjugation of some humans by other humans. It is a rational conclusion, so goes the model that savages and infidels are unable to care for themselves, and tend toward debauchery and license. They must be cared for and controlled by more “advanced” (intellectually and culturally) peoples of the Earth. This is the global “development” model that guided the west through the 18th, 19th, and most of the 20th centuries. Second, it’s rational that some persons will be richer than others. In the ancient world disparities in wealth were generally explained as the will of the gods. Since the Enlightenment such disparities are explained as the result of differences in talent, merit, or diligence. All reflect the cause-effect form of rationalism. Third, rationalism is equated with intelligence, or sometimes with logic. Mr. Spock is more logical than his human shipmates and thus more intelligent. A sort of rationalism that the writers of “Star Trek” ridicule pitilessly. Making them irrational in the minds of many scientists and philosophers. But in no way lessening their insights into the double-edged consequences of some forms of rationalism. Something many physical and social scientists have just begun to recognize in the last 50 years. Economists are not it seems part of this assembly. Which helps clarify the rigidity and irrelevance of work by many economists.

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