Home > Uncategorized > The rational expectations putsch

The rational expectations putsch

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. how-many-irrational-assumptions-are-needed-for-economist-to-use-rational-expectationsRational 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:

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

A: The “scientists” from Chicago and MIT came along … 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 …

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

A: Craziness for one thing … 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 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.


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:

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. deshoebox
    March 27, 2019 at 3:54 pm

    This has been pointed out before, but from formal logic we know that if even one of your premises is false you can rigorously prove anything. Another way of putting it is that from a contradiction you can prove any proposition. Let’s assume people make decisions based on rational expectations. We know, of course, that people don’t make decisions based on rational expectations. Voila! From this little contradiction anything at all can be proved and you can dress it up in opaque formulas to make it more impressive.

  2. lobdillj
    March 27, 2019 at 5:01 pm

    Is there collusion in this situation? Never mind. I know the an$wer.

  3. Frank Salter
    March 27, 2019 at 5:07 pm

    It is NOT that the rational expectations hypothesis is scientific. In actuality, it is NOT scientific an any way. Anything purporting to quantitatively predict human decisions is unlikely to be successful. Only the physical results of a known human intervention, such as building a production plant thus allowing the output to be predicted, will be appropriate. But the building and operation of the plant does not guarantee that the product will be wanted and the plant will continue in operation. This is the nature of consumer choice at one level but food, shelter furnishings etc will always be required.

  4. Robert Locke
    March 27, 2019 at 5:56 pm

    This is familiar if welcome stuff. As Spender and I wrote, in Confronting Managerialism:

    “When we termed the last thirty years the Age of Money, we were in part referring to the dollar influx [into the universities] of research grants, higher tuition, and grander capital improvements.
    But there’s another, more symbolic, aspect to the Age of Money, and one not less powerful for being more symbolic. The mere concept of money turns out to be the secret key to ‘prestige,’ influence, and power in the American academic world. (quoted in Bellah, 2000, 6)
    It turns out at the end of the twentieth century that the issue for higher education is not science versus the humanities but science/humanities versus money/managerialism. The most successful university disciplines, Bellah argues, have to offer (1) a promise of money (“The field is popularly linked … to improved chances of securing an occupation or profession that promises above-average lifetime earnings”) (2) a knowledge of money (“The field itself studies money, whether practically or more theoretically, i.e., fiscal, business, financial and/or economic matters and markets.”) (3) a source of money (“The field receives significant external money, i.e., research contracts, federal grant or funding support, or corporate underwriting.”). If this portrayal is right, Bellah affirms, “then our life together in the university is governed by neither the intellectual nor the moral virtues but by a vice, namely, cupidity, acquisitiveness, or just plain avarice” (Bellah, 2000, 6; see also Amadae and Mesquita, 1999; Amadae, 2003).

    Perhaps more important, for humanists, the content of the subjects studied and the mathematized methodologies devised to study them reinforce the development of the plutocratic university. Bellah particularly singles out Rational Choice Theory (RCT) (Amadae and de Mesquita, 1999). “In America, and to some degree throughout the world,” he observes,
    We seem to have returned in the past thirty years to something from the last decades of the nineteenth century, that is, unconstrained laissez-faire capitalism. And just as the theory of social Darwinism mirrored the strident capitalism of the late nineteenth
    , so the rise of Rational Choice Theory reflects the emergence of neo-laissez-faire capitalism in the last thirty years. (Bellah, 2000, 6)

    RCT is taught to students as “scientific truth.” “Every year 1.4 million undergraduates in the US,” Neva Goodwin, co-director of the Global Development and Environment Institute at Tufts University, affirmed in 2003, “take an introduction to economics course that teaches that only selfishness is rational” (quoted in Monaghan, 2003, 20). “If greed is good,” Bellah concludes, “then we must also concede that we were mistaken all these years, in all the religions and philosophies of mankind, in thinking cupidity a vice instead of our chief virtue” (Bellah, 2000, 6).

  5. Helen Sakho
    March 29, 2019 at 1:11 am

    Even “greedy” animals did not kill for the sake of it, they it did to survive. This voodoo that can predict human behaviour right now should be called “VOODOONOMICS” @me.com.

  6. Ken Zimmerman
    April 5, 2019 at 1:49 am

    Two questions. If model-dependent mainstream economics is so unrealistic and useless, how has it survived and even prospered now for over 50 years? Second, in putting forth such models as “rational expectations” are economists just poor social scientists or are they “snake-oil” hucksters looking for the quick and easy buck?

    • Craig
      April 5, 2019 at 5:36 am

      #1 The financial elite who stand above everyone and everything benefit from it.

      #2 Both. The system is so productive that its actually austere and onerous nature is blunted somewhat until a trend of 40 years of losing economic ground finally manifests itself as a stubborn tribal Trumpian resentment.

      We have a choice continue the austere system we have and risk upheaval or create a new system, a new paradigm/pattern. The too simple for the erudite solution is to make it obviously abundant for all with direct and reciprocal monetary policies at the terminal expression point of all forms of inflation at retail sale, incentivize saving and regulate prudence with your abundance for the individual, and discourage greed and anti-social price rises by commercial agents with no uncertain terms with tax incentives for not raising prices and taxation of price raising that does not have a legitimate increased cost basis.

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