Home > Uncategorized > The ultimate takedown of teflon coated defenders of rational expectations

The ultimate takedown of teflon coated defenders of rational expectations

from Lars Syll

James Heckman, winner of the “Nobel Prize” in economics (2000), did an interview with John Cassidy in 2010. It’s an interesting read (Cassidy’s words in italics):

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

heckmanI 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.”

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

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.

What about you? When rational expectations was sweeping economics, what was your reaction to it? I know you are primarily a micro guy, but what did you think?

What struck me was that we knew Keynesian theory was still alive in the banks and on Wall Street. Economists in those areas relied on Keynesian models to make short-run forecasts. It seemed strange to me that they would continue to do this if it had been theoretically proven that these models didn’t work.

What about the efficient-markets hypothesis? Did Chicago economists go too far in promoting that theory, too?

Some did. But there is a lot of diversity here. You can go office to office and get a different view …

So, today, what survives of the Chicago School? What is left?

I think the underlying ideas of the Chicago School are still very powerful. The basis of the rocket is still intact. It is what I see as the booster stage—the rational-expectation hypothesis and the vulgar versions of the efficient-markets hypothesis that have run into trouble. They have taken a beating—no doubt about that. I think that what happened is that people got too far away from the data, and confronting ideas with data. That part of the Chicago tradition was neglected, and it was a strong part of the tradition.

When Bob Lucas was writing that the Great Depression was people taking extended vacations—refusing to take available jobs at low wages—there was another Chicago economist, Albert Rees, who was writing in the Chicago Journal saying, No, wait a minute. There is a lot of evidence that this is not true …

When Friedman died, a couple of years ago, we had a symposium for the alumni devoted to the Friedman legacy. I was talking about the permanent income hypothesis; Lucas was talking about rational expectations. We have some bright alums. One woman got up and said, “Look at the evidence on 401k plans and how people misuse them, or don’t use them. Are you really saying that people look ahead and plan ahead rationally?” And Lucas said, “Yes, that’s what the theory of rational expectations says, and that’s part of Friedman’s legacy.” I said, “No, it isn’t. He was much more empirically minded than that.” People took one part of his legacy and forgot the rest. They moved too far away from the data.

Yes indeed, they certainly “moved too far away from the data.”

For more on the issue, permit me to self-indulgently recommend reading my article Rational expectations — a fallacious foundation for macroeconomics in a non-ergodic world in real-world economics review no. 62

  1. Ikonoclast
    June 22, 2020 at 1:15 am

    Let me see if I’ve got this right. Rational expectations is a theory which says if people believe it, it will happen. The standard term for that is magical thinking.

    According to Wikipedia:

    “In economics, “rational expectations” are model-consistent expectations, in that agents inside the model are assumed to “know the model” and on average take the model’s predictions as valid. Rational expectations ensure internal consistency in models involving uncertainty. To obtain consistency within a model, the predictions of future values of economically relevant variables from the model are assumed to be the same as that of the decision-makers in the model, given their information set, the nature of the random processes involved, and model structure. The rational expectations assumption is used especially in many contemporary macroeconomic models.”

    Now I guess I should cautious about taking the Wikipedia definition as gospel but other definitions seem to run along similar lines. I’m intrigued by these “agents” (humans) who are “inside the model”. I don’t know about other people but I know I live in a real world as well as living mentally in my models of it. So, I expect empirical reality to be more complicated than my models and to continually upset my models and expectations.

    To me, what is significant is that the “rational expectations” model is free-standing (impossible) and self-referential (circular logic). It stands free from real world effects and its expectations are expectations of others’ expectations or actions. So it seems to me, at any rate.

    I presume rational expectations explains the current trend to over-valuation of the stock-market by the rational expectation of more Q.E. and more subsidies to big corporations. This is fine as far as it goes but it does not explain dis-junctions or tipping points, including the tipping point where expectations change. At some point, the real world will no longer support the large disconnect between stock-prices and earnings. Yes, “rational expectations” will then change but then a different reality will be the cause behind the rational expectation change. The different reality will be a real system (biophysical system) or real economy event which cannot be ignored by the financial system comprised as it is of agents’ “real expectations” swarm behavior.

  2. June 23, 2020 at 11:34 am

    Spot on, as always!

    “Rational expectations” require superior knowledge on part of some select humans (typically Lucas and disciples) about what is true. This approach might be applicable to science where scientists may have proof of some natural law that other people tend not to understand, not yet know or simply decide to ignore but it has close to zero meaning in the world of social science in which the world’s fabric is made of individual human decisions based on judgement and beliefs nobody can possibly know better than the respective individual.

    It’s uncertainty, stupid!

  3. Ken Zimmerman
    July 6, 2020 at 4:41 pm

    Okay, we all believe that rational expectations is stupid. So, why do so many people, not just economists believe it is the way the world works, actually?

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