Home > Uncategorized > The ‘rational expectations’ hoax

The ‘rational expectations’ hoax

from Lars Syll

sun kiIt can be said without great controversy that no other theoretical approach in this century has ever enjoyed the same level of ubiquity throughout the social sciences as the rational choice approach enjoys today. Despite this ubiquity, the success of the approach has been very tenuous. Its advance has been accompanied by an intense debate over its relative merit. The approach has been subject to the usual criticism of blatant inaccuracy given by outsiders to any would-be theoretical hegemon and to a predictable fuzzying of its assumptions as it is adapted to a wider and wider range of empirical phenomena. More notably, however, some of the most virulent mere criticisms of the rational choice approach have come from within its own ranks.

Despite the absence of any clear-cut resolution to this debate, there appears to be a growing consensus about the strengths and weaknesses of the approach. To put it briefly, the main strengths of the approach are that its conventional assumptions about actors are parsimonious and applicable to a very broad range of environments, generating usually falsifiable and sometimes empirically confirmed hypotheses about action across these environments. This provides conventional rational choice with a combination of generality and predictive power not found in other approaches. However, the conventional assumptions of rational choice not only lack verisimilitude in many circumstances but also fail to accurately predict a wide range of human behaviors.

raIn mainstream economics — especially in microeconomics, social choice and game theory — it is taken for granted (by definition) that the actors appearing in the model world, are rational and try to satisfy given preferences. But, confronting the axiomatic model world with the real world, it usually turns out that quite a few actors​ are irrational.

In a classic experiment conducted by Barbara McNeil and colleagues, it was investigated how variations in the way information were presented to patients influenced their choices between alternative therapies. Individuals — randomly assigned — were asked to imagine that they had lung cancer and to choose between two different therapies:

Different groups of respondents received input data that differed only in whether or not the treatments were identified and whether the outcomes were framed in terms of the probability of living or the probability of dying.

The experiment demonstrated that by only changing the ​emphasis from surviving (x) to dying (1-x) in the description of the treatment alternatives, there was a significant change in population preferences. According to ‘rational choice’ theory, the way you ‘frame’ alternatives should be totally inconsequential. Rational people do not change preferences for inconsequential reasons.

So what do we learn from this kind​ of experiments? This: In mainstream ‘as if’ model worlds there are only rational people and in real-life there are a lot of ‘irrational’ people.

Things are obviously not as postulated in mainstream microeconomics. The final court of appeal for models is the real world. As long as no convincing justification is put forward for how the inferential bridging is made from the model world to the real world, ‘rational choice’ models have to be considered little more than hand-waving.

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 repeatedly argued 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 gives us a 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.

  1. Paul Davidson
    September 27, 2019 at 12:27 am

    as I emphasize in my book WHO’S AFRAID OF JOHN MAYMARD KEYNES?, the orthodox Walrasian microfoundations of Macroeconomics , as explicitly described by Paul Samuelson assumes that at each curret period of tim, every income recipient knows his demand [and the market supply price]] for every product today and every day in the future. consequently every decision maker can maximize his/her well being not only for the current period but for every future date –even when the current decision maker is dead and his/her offspring will be consuming goods and services.

    As I demonstrate in my book, rational expectations of the future assumes that the economy’s path over time is described by an ergodic stochastic process so that the probability of future outcomes for every date in the future can be reliably predicted by analyzing historical outcomes. Thus the probability of a bad future date outcome can be insured against by every maximizing decision maker.

    As I demonstrate in my book if the future is uncertain as Keynes defined it in the GT [on p.148 note 1, uncertainty has the property of a nonergodic process] , then in a nonergodic process it is impossible to generate rational expectations about the future.

    So uncertainty about future events prevents decision makers from making optimizing spendng decisions — and the fact that decision makers recognize they can not predict “rationally” future outcomes encourage decision makers to hold money for liquidity purposes -as Keynes also noticed. In Walrasian micro economic theory there is no demand for liquidity per se.

    • September 27, 2019 at 10:00 am

      Dear Paul, thanks for your explanations. I do fully agree accept for the fact that I do not think that there are (objective) processes humans follow be they ergodic or not. But that’s not the point, obviously. The bottom line question, as you correctly point out, is, what decisions do people take in the face of uncertainty. I’d like to add another bottom line question: what are actual decision rules humans follow knowing that the future is fundamentally uncertain and rational expectations, therefore, is a rather hollow conecpt. That’s one of the issues that I tackle in my “Uncertainty and Economics” (Routledge) [Ready to swap books?:-) ]

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