Home > Uncategorized > Rational expectations — the triumph of ideology over science

Rational expectations — the triumph of ideology over science

from Lars Syll

Senate Banking Subcommittee On Financial Institutions Hearing With Stiglitz For more than 20 years, economists were enthralled by so-called “rational expectations” models which assumed that all participants have the same (if not perfect) information and act perfectly rationally, that markets are perfectly efficient, that unemployment never exists (except when caused by greedy unions or government minimum wages), and where there is never any credit rationing.

That such models prevailed, especially in America’s graduate schools, despite evidence to the contrary, bears testimony to a triumph of ideology over science. Unfortunately, students of these graduate programmes now act as policymakers in many countries, and are trying to implement programmes based on the ideas that have come to be called market fundamentalism … Good science recognises its limitations, but the prophets of rational expectations have usually shown no such modesty.

Joseph Stiglitz 

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 has tried to show in On the use and misuse of theories and models in economics 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 give 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. Meta Capitalism
    November 30, 2021 at 1:42 am

    Steve Keen’s _Debunking Economics_ (2011, 205-206) in a section titled _Macroeconomics and the reductionist fallacy_ addresses what is already widely known in evolutionary biology (aside from those who spoof biology for shallow appeals to authority); that _methodological reductionism_ only takes science so far and that _philosophical reductionism_ (aka _strong reductionism_) frequently blinds its adherents to the limitations of the former. Modern scientists worth their salt, whether in biology or physics or economics, are aware of “The discovery that higher-order phenomena cannot be directly extrapolated from lower-order systems is a commonplace conclusion in genuine sciences today: it’s known as the ‘emergence’ issue in complex systems (Nicolis and Prigogine, 1971; Ramos-Martin, 2003).” (Keen 2017, 31-32, in Can We Avoid Another Financial Crisis?)

    As Keen notes (2017) “macroeconomics cannot be derived from microeconomics”:

    The fallacy in the belief that higher-level phenomena (like macroeconomics) have to be, or even could be, derived from lower-level phenomena (like microeconomics) was pointed out clearly in 1972 – again, before Lucas wrote – by the Physics Nobel Laureate Philip Anderson: (Keen, Steve. Can We Avoid Another Financial Crisis? (The Future of Capitalism) (p. 32). Wiley. Kindle Edition.)

    The main fallacy in this kind of thinking is that the reductionist hypothesis does not by any means imply a ‘constructionist’ one: The ability to reduce everything to simple fundamental laws does not imply the ability to start from those laws and reconstruct the universe. (Anderson, 1972, p. 393, emphasis added) (Keen, Steve. Can We Avoid Another Financial Crisis? (The Future of Capitalism) (pp. 32-33). Wiley. Kindle Edition.)

    The main fallacy in this kind of thinking is that the reductionist hypothesis does not by any means imply a ‘constructionist’ one: The ability to reduce everything to simple fundamental laws does not imply the ability to start from those laws and reconstruct the universe. In fact, the more the elementary particle physicists tell us about the nature of the fundamental laws the less relevance they seem to have to the very real problems of the rest of science, much less to those of society. (Anderson 1972: 393) (Keen, Professor Steve. Debunking Economics (Digital Edition – Revised, Expanded and Integrated): The Naked Emperor Dethroned? (Kindle Locations 5138-5141). Zed Books. Kindle Edition. p. 207)

    How do smart people fall into the reductive ad absurdum trap? Keen recounts an interesting comment made by Solow when he commented on how his own ‘real business cycle’ models was stretched beyond what he intended. Solow noted about his “roughly ‘Keynesian.’” understanding of Keynes, “I use that label for convenience; I have absolutely no interest in ‘what Keynes really meant.’ To be more specific, the framework I mean is what is sometimes called ‘American Keynesianism’ as taught to many thousands of students by Paul Samuelson’s textbook and a long line of followers. (Ibid.: 21)” (Keen 2011, 258)

    I cannot help but juxtapose Keen’s insight about the irony of Solow complaining how his scholarship was misunderstood, yet himself, poorly understanding Keynes by his own admission, and recent comments made on RWER:

    Lars Syll talks a lot about Keynes and his Treatise of Probability but what is lacking in his argument is the right weight of his arguments. He reads Keynes and does not understand Keynes. (RWER, Shiozawa, 11/28/2021)

    How bizarre! Solow is decrying that poor scholarship led to his growth cycle model being used for a purpose for which it was not designed, and yet he is blasé about whether or not the models of the economy he helped develop, and which he labels Keynesian (albeit with the qualifier ‘American’), have anything to do with Keynes’s ideas.

    The old saying ‘As ye sow, so shall ye reap’ applies here. The poor scholarship that let American economists delude themselves into believing that they were Keynesians, when in fact they were extending models originated by – and later disowned by – John Hicks, now let them use Solow’s growth model as a foundation for models of the business cycle, even though Solow himself disowned the enterprise on two very valid grounds. (Keen 2011, 258)

    Keen et. al., like Lars and other authors on RWER, have not misinterpreted Keynes. And the weight of history is evidence of this fact and truth. Keynes in his philosophical insights articulated the limits of probability theory based solely upon “logic” (i.e., mathematics), thereby using the real deep human experience (aka wisdom) to provide the “right weight” to the degrees of confidence we should allow ourselves to give to “pure theory” in the face of real human experience to the contrary.

  2. yoshinorishiozawa
    November 30, 2021 at 5:29 am

    Lars Syll is again attempting to mislead readers of this blog. I wonder how many readers are mislead in reality, because most of them are highly critical minded persons who are well versed of the actual situation of both mainstream and heterodox economics.

    Lars Syll does not mention that there are many macroeconomics of heterodox conviction. Does his repeated criticism contribute in any positive way to advance even one of many macroeconomics in heterodox orientations? I would like to say no. He may not bother with this fact, because it seems he is satisfied only by accusing mainstream economics. I cannot understand why he does not consider contributing to heterodox economics.

    Here is my recent paper The Principle of Effective Demand: A new formulation, just made public. As it is an open access paper, everyone can download it. Please compare, dear readers, my humble microfoundational contribution and Lars’s sweeping criticism. Which contribute better to change actual state of economics to a better situation?

  3. December 1, 2021 at 6:18 am

    I quote from a recent article by an American central banker, “Mainstream economics is replete with ideas that ‘everyone knows’ to be true, but that are actually arrant nonsense…..I leave aside the deeper concern that the primary role of mainstream economics in our society is to provide an apologetics for a criminally opressive, unsustainable and unjust social order.” I could not say it any better.

    • yoshinorishiozawa
      December 1, 2021 at 4:32 pm

      It is agreed that mainstream economics is totally misleading and ideological. What we need is a true economics that may orient in a good way our thinking over how economy works.

      • December 2, 2021 at 2:12 pm

        I believe post-keynesian economics turbo charged with stock flow consistent and/or agent based modeling, and backed up with relevant econometrics can provide all we need.

    • Meta Capitalism
      December 1, 2021 at 11:51 pm

      A citation reference would be wonderful. That one worth keeping.

      • December 2, 2021 at 2:04 pm

        Rudd. Jeremy B. (2021). “Why Do We Think That Inflation Expectations Matter for Inflation (And Should We ?). Finance and Economics Discussion Series 2021-062. Washington: Board of Governors of the Federal Reserve System.

      • Meta Capitalism
        December 3, 2021 at 10:48 pm

        Thank you. Archived away.

    • Meta Capitalism
      December 6, 2021 at 12:13 am

      Nobody thinks clearly, no matter what they pretend. . . . That’s why people hang on so tight to their beliefs and opinions; because, compared to the haphazard way they’re arrived at, even the goofiest opinion seems wonderfully clear, sane, and self-evident.

      Dashiell Hammett, The Dain Curse (1928)

      I Introduction

      Mainstream economics is replete with ideas that “everyone knows” to be true, but that are actually arrant nonsense. For example, “everyone knows” that:

      • Aggregate production functions (and aggregate measures of the capital stock) provide a good way to characterize the economy’s supply side;

      • Over a sufficiently long span—specifically, one that allows necessary price adjustments to be made—the economy will return to a state of full market clearing; and,

      • The theory of household choice provides a solid justification for downward-sloping market demand curves.

      None of these propositions has any sort of empirical foundation; moreover, each one turns out to be seriously deficient on theoretical grounds.1 Nevertheless, economists continue to rely on these and similar ideas to organize their thinking about real-world economic phenomena. No doubt, one reason why this situation arises is because the economy is a complicated system that is inherently difficult to understand, so propositions like these—even though wrong—are all that saves us from intellectual nihilism. Another, more prosaic reason is Stigler’s (1982) equally nihilistic observation that “it takes a theory to beat a theory.”

      Is this state of affairs ever harmful or dangerous? One natural source of concern is if dubious but widely held ideas serve as the basis for consequential policy decisions. (Rudd. Jeremy B. (2021). “Why Do We Think That Inflation Expectations Matter for Inflation (And Should We ?). Finance and Economics Discussion Series 2021-062. Washington: Board of Governors of the Federal Reserve System. https://www.federalreserve.gov/econres/feds/files/2021062pap.pdf)

      Great paper. One good quote deserves another:

      Economics is about how people organise and manage the production of goods and services, as well as the resources that are used in the process of production. The subject matter of economics covers enormous range of issues, problems, and questions, including questions about how production is organised; why particular activities are undertaken and whether they should be; the nature and functions of the institutions that are associated with organising and carrying out production activities — from banks and manufacturers to shipping and training; and the efficiency of the production process — what criteria should be used to evaluate them, what purposes they serve, and so on. It is the task of economic theory to elucidate these problems and issues which all have to do with people’s activities and, at the root of their activities, their decisions and plans. (Addelson 1995, 3)

      Although it did not matter much at the time, from my earliest encounter with neoclassical economics I remember feeling uneasy about this portrayal of decision-making and choice. The ‘theory of consumer choice’, unfortunately, was the undergraduate’s introduction both to economics and to a neoclassical model. Explaining the purpose of this model, our lecturer spoke about selecting an optimal shopping basket. In spite of the penchant that undergraduates are supposed to have for swallowing whole whatever they are told, the analogy of compiling an optimal basket when faced with an income constraint, while detailing a huge range of possible things on which one might spend money, seemed a long way from the experience of going shopping or from buying the things that family members want. I imagine that students still feel this way about the models, and in teaching economics to graduate management students (who are a critical bunch as the best of times) I used to try to make these models more palatable, arguing — using Hayek’s terminology — that one could think of them as attempting to bring out the logic of what is involved in making effective (optimising) decisions, i.e., as a ‘pure logic of choice’. (Addelson 1995, 3)

      I now think that this sort of rationalisation is specious. Part of the purpose of this book is to substantiate the assertion that neoclassical models of ‘decision-making’ and ‘choice’ will always be unpalatable, because they have nothing to contribute to our understanding of how people make decisions about managing resources. Orthodox or ‘mainstream’ economics is unable to explain choice and conduct because its methodology demands that the scholar look at problems in a way that makes it impossible to understand choice. What a person does and the choices that she makes — whether it is a spouse, a new car, or a career that she is choosing — depends on how she understands her social circumstances. This consideration is formally recognised in social theory in the tradition of Verstehem [see: https://en.wikipedia.org/wiki/Verstehen%5D, or subjective understanding. A theory that purports to explain people’s conduct — what they do and why they do it, including the choices and decisions they make — which is certainly a central task of social science, must be based on a satisfactory explanation of how they themselves understand. Yet the ‘perspective’ of an agent that is embedded in neoclassical theory, as a determinate equilibrium theory, has no bearing on how an individual does ‘see’ things; nor could a person conceivably understand in the way that the rational agent is supposed to ‘know’ about the world. (Addelson 1995, 3-4)

  4. Ken Zimmerman
    December 11, 2021 at 9:23 am

    I’ll reword your title from “Rational expectations — the triumph of ideology over science” to ‘Rational expectations — the triumph of one ideology over another.’ After all, science itself is an ideology. Each science is ‘a system of ideas and ideals which form the basis of a study discipline.’ Each science focuses on empirical and conceptual understanding of events and objects people find of interest. Religious ideologies focus on stating and elaborating the tenets of supernatural foundations for humans and the world. Political ideologies focus on presenting and explaining governing principles for human societies.

    Ideologies are more or less useful for people in constructing their ways of life and in making these ways sustainable. While not leading to harmful results that directly or indirectly harm the efforts. In the end these are all judgments by people. Over which people do and always will struggle. And that’s human history. And unavoidable.

  5. December 11, 2021 at 7:28 pm

    Fair enough, but trying to live our lives and trying to explain the world we live in are two very different things. We need science not ideology for the latter.

  6. yoshinorishiozawa
    December 12, 2021 at 1:39 am

    Dear reallifeeconomics,

    I agree with you. Please read my comment on Ken Zimmerman’s post on December 11, 2021.

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