Home > Uncategorized > Uncertainty, learning, and rational expectations

Uncertainty, learning, and rational expectations

from Lars Syll

The rational expectations hypothesis presupposes — basically for reasons of consistency — that agents have complete knowledge of all of the relevant probability distribution functions. And when trying to incorporate learning in these models — trying to take the heat of some off the criticism launched against it up to date — it is always a very restricted kind of learning that is considered. A learning where truly unanticipated, surprising, new things never take place, but only rather mechanical updatings — increasing the precision of already existing information sets – of existing probability functions.

Nothing really new happens in these ergodic models, where the statistical representation of learning and information is nothing more than a caricature of what takes place in the real world target system. This follows from taking for granted that people’s decisions can be portrayed as based on an existing probability distribution, which by definition implies the knowledge of every possible event (otherwise it is in a strict mathematical-statistically sense not really a probability distribution) that can be thought of taking place.

But in the real world it is — as shown again and again by behavioural and experimental economics — common to mistake a conditional distribution for a probability distribution. Mistakes that are impossible to make in the kinds of economic analysis — built on the rational expectations hypothesis — that mainstream economists are such adamant propagators for. On average rational expectations agents are always correct. But truly new information will not only reduce the estimation error but actually change the entire estimation and hence possibly the decisions made. To be truly new, information has to be unexpected. If not, it would simply be inferred from the already existing information set.

In rational expectations models new information is typically presented as something only reducing the variance of the parameter estimated. But if new information means truly new information it actually could increase our uncertainty and variance (information set (A, B) => (A, B, C)).

Truly new information give birth to new probabilities, revised plans and decisions – something the rational expectations hypothesis cannot account for with its finite sampling representation of incomplete information.

In the world of rational expectations, learning is like being better and better at reciting the complete works of Shakespeare by heart — or at hitting bull’s eye when playing dart. It presupposes that we have a complete list of the possible states of the world and that by definition mistakes are non-systematic (which, strictly seen, follows from the assumption of ‘subjective’ probability distributions being equal to the ‘objective’ probability distribution). This is a rather uninteresting and trivial kind of learning. It is a closed world learning, synonymous to improving one’s adaptation to a world which is fundamentally unchanging. But in real, open world situations, learning is more often about adapting and trying to cope with genuinely new phenomena.

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 and Mervyn King sum it up pretty well:

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The disregard of radical uncertainty by a generation of economists condemned modern macroeconomics to near irrelevance … Keynes’ critique of ‘getting on the job’ without asking ‘whether the job is worth getting on with’ would prove to be as true of the new macroeconomic theorising as of the older econometric modeling …

Over forty years, the authors have watched the bright optimism of a new, rigorous approach to economics dissolve into the failures of prediction and analysis which were seen in the global financial crisis of 2007-08. And it is the pervasive nature of radical uncertainty which is the source of the problem.

  1. Michael Matheron
    August 28, 2020 at 3:47 am

    As a Junior Assistant Professional Epistemologist your essay is thrilling, in the sense that epistos understand the word. Also, I hold a dual Junior Professional Assistantship in Political Economy and therefore virtually everything confuses me. Nevertheless, one of the factors undermining behavioral economic models is the rather cavalier and simplistic assumption that “all” relevant market knowledge is (somehow) known. Of course, this ignores the fact that a huge slice of this knowledge is purposely and secretly kept from view both through, for example, dodgy accounting practices that until discovered, as in the 2008 recession, are considered and labeled “best practices.” Most obvious of all, criminal activity like front running is utterly withheld from common knowledge for obvious reasons yet has often caused abrupt and hideous damage a la Bernie Madoff. Given these overarching unknown unknowns of virtually all endeavors, it seems inescapable that any system that ignores the capriciousness of human agency is a perpetual non starter.

    I really enjoyed your essay and will see if I can find the recommended book on the black market. Failing that, I’ll have to legally purchase it.

    Finally, being an epistemologist of sorts I realize that what I wrote above is simultaneously completely correct and incorrect. Best regards!

  2. Ikonoclast
    August 30, 2020 at 12:23 am

    “Graham Priest advocates the view that under some conditions, some statements can be both true and false simultaneously, or may be true and false at different times. Dialetheism arises from formal logical paradoxes, such as the Liar’s paradox and Russell’s paradox.” – Wikipedia.

    It’s an amusing case of synchronicity. I just wrote on another thread:

    “(The) hint about paradox intrigues me. I take very seriously a re-examination of the so-called “Law of noncontradiction”. It’s a principle in logic but I strongly suspect that reality itself does not always obey the “Law of noncontradiction”. It seems to me a sub-set of reality (at the level of the so-called classical laws of science) does obey the Law of noncontradiction, otherwise we would not have been led to derive the law (which I believe has empirical roots). However, our logic works in the “classical” world of classical physics and human physical scale. Such “classical” logic does not necessarily work at the quantum or cosmic scales.”

    I ought to have added, “Also, such logic (the law of noncontradiction) probably does not operate in relation to emergence and evolution in complex systems.”

    • Craig
      August 30, 2020 at 3:16 am

      Correct. That’s why the temporal universe can be both “a veil of tears” and yet also be in a state of grace. Both are necessary or there would be no real understanding of either.

      Bliss is directly, effortlessly and yet intensely experiencing each flowing moment where space and objects are still space and objects except space has virtual palpa-bility and you experience the solidity of objects at a distance. You also experience colors with a vibrancy you’ve long forgotten because the last time you experienced them as such was when you were 1 year old. Been there, done that, and not with any pharmaceutical help.

      It’s like the T. S. Eliot quote I’ve posted here before about the end of one’s search has always been where you started….just slightly more personally informed.

      The dualism intellectuals get caught up in their acculturated abstract figure-figure-figuring is generally the final hurdle they have to overcome to properly experience such integration.

      • Ikonoclast
        August 30, 2020 at 5:13 am

        Craig,

        Each to his own of course. I don’t take “logic can’t explain existence” to mean “dogma can explain existence”. I question the principle of sufficient reason as much as I question the principle of non-contradiction. They are both simply human logical precepts or hypotheses. In any case, I am not sure if you are suggesting revelation or gnosis as a source of truth.

      • Craig
        August 30, 2020 at 7:12 am

        It’s gnosis. As I have many times said here I’m not positing any religious dogmas, only experiences. And it isn’t about one or the other mode of experience in opposition to each other as much as it is an integration of the two which results in a higher more present thirdness.

        And that thirdness is imminently applicable to any system or body of knowledge because they all exist within the temporal universe reality and human experience which can be described as an integrated duality within a trinity-unity-oneness higher consciousness process. And all of that process and experience is natural I might add, and yet none of the ecstatic nature of the experience is lost by knowledge of that fact.

      • August 30, 2020 at 1:16 pm

        The wise man is he who knows he knows nothing. (He has to choose what he is going to believe, preferably understanding why).

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