Winner of the New Statesman SPERI Prize in Political Economy 2016


Thursday 7 November 2013

Defending rational expectations

Whenever I post anything which suggests that the idea of rational expectations was a useful innovation in macroeconomics, Lars Syll writes something to the effect that I am (and therefore most mainstream macroeconomists are) “so wrong, so wrong”. Now why does this bother me? Well, to be honest, it does not bother me very much. As Bob Dylan sang: ‘Yes, I received your letter yesterday (About the time the doorknob broke)’.

But it does bother me a bit. Professor Syll does write very eloquently, and this kind of eloquent prose can appeal to the occasional young economist, who is inclined to believe that only the radical overthrow of orthodoxy will suffice. I meet one or two each year I teach. I remember the feeling: been there, done that. It also appeals to people like Aditya Chakrabortty who are understandably unhappy by the current state of things economic. (See this nice recent post by Diane Coyle on both this particular article but also heterodox critiques more generally.) There is plenty to legitimately criticise about mainstream economics (and its textbooks), so it is a shame Professor Syll wastes his talents on one of its major achievements, which is rational expectations. On this he is, well, so wrong.

This discussion can easily get populated with straw (super)men, so let's be clear about some things. It is not a debate about rational expectations in the abstract, but about a choice between different ways of modelling expectations, none of which will be ideal. This choice has to involve feasible alternatives, by which I mean theories of expectations that can be practically implemented in usable macroeconomic models. In the past, I have attempted to try and start a dialog with heterodox economists on the level of practical macroeconomics, to get beyond the fine words and phrases. It did not seem to work. I tried again in that recent post, asking for practical alternatives to rational expectations. Professor Syll referred me to behavioural economics, or Frydman and Goldberg’s ‘Imperfect Knowledge Economics’. But perhaps I did not make it clear what I meant by practical.

If I really wanted to focus in detail on how expectations were formed and adjusted, I would look to the large mainstream literature on learning, to which Professor Syll does not refer. (Key figures in developing this literature included Tom Sargent, Albert Marcet, George Evans and Seppo Honkapohja: here is a nice interview involving three of them.) Macroeconomic ideas derived from rational expectations models should always be re-examined within realistic learning environments, as in this paper by Benhabib, Evans and Honkapohja for example. No doubt that literature may benefit from additional insights that behavioural economics and others can bring. However it is worth noting that a key organising device for much of the learning literature is the extent to which learning converges towards rational expectations.

However most of the time macroeconomists want to focus on something else, and so we need a simpler framework. In practice that seems to me to involve a binary choice. Either we assume that agents are very naive, and adopt something very simple like adaptive expectations (inflation tomorrow will be based on current and past inflation), or we assume rational expectations. My suspicion is that heterodox economists, when they do practical macroeconomics, adopt the assumption that expectations are naive, if they exist at all (e.g. here). So I want to explain why, most of the time, this is the wrong choice. My argument here is similar but complementary to a recent piece by Mark Thoma on rational expectations.

Suppose we have an equation determining wage or price inflation (a Phillips curve), where inflation expectations appear on the right hand side of the equation. We need some way of determining those expectations. Lots of nice words like ‘non-ergodic’ will not do: we need something simple that can be used to solve the model. To assume, as mainstream macroeconomists once did, that these expectations just depend on past observations about inflation seems to assume that agents are stupid. These agents ignore everything that economists and the media say about inflation: they ignore monetary policy, and whether the economy is in a boom or recession. Now if getting expectations right did not matter too much to these agents, then maybe such naivety would be understandable. But in this case making expectations errors can mean getting real wages or profits wrong, so it matters.

Perhaps you think the alternative is equally unbelievable. Rational expectations, often called model consistent expectations, implies that agents know the model that the modeller has constructed, and use it to generate expectations. This is where the elegant prose comes in - you can make this sound incredible. Of course it will not be literally true, but I think it is a lot nearer the truth than the adaptive expectations alternative. The reason why mainstream economics replaced adaptive expectations with rational expectations in the 1970s was because the new approach was consistent with what economists did elsewhere. Firms may not know the true demand curve for their product and work out the price that maximises profits each period, but that is a better approximation to how they choose prices than a model where they have a fixed mark-up on costs. So it just seemed consistent to also assume that agents used relevant and available information to generate expectations when those expectations mattered. The closest we can get to that, without assuming an elaborate learning model, is to assume rational expectations.

This is an empirical claim. But how else do you make sense of a whole forecasting industry, and the newsworthy character of macro forecasts. Rational expectations at least acknowledges that endeavour, while adaptive expectations pretends it does not exist. And how else do you make sense of the response of Japanese inflation expectations to little more than a policy change: see Carola Binder’s discussion. How can you make sense of all the discussion of forward guidance without the concept of rational expectations?

Most of the references I make to rational expectations in posts are in the context of the history of macroeconomic thought. I suspect the problem some people have is that they associate rational expectations with the New Classical critique of Keynesian economics, and therefore think rational expectations must be anti-Keynesian. This confuses who fought wars with the weapons they used. I see it quite differently. Before rational expectations, mainstream Keynesian theory that incorporated the Phillips curve depended on a rather fragile story of why economic booms (downturns) could occur, which was that workers kept under (over) estimating inflation. New Keynesian theories based on rational expectations are more compelling, and can include the fact that information is both costly and incomplete.

So I just do not get this obsession that some heterodox economists have with rational expectations. I think its fine to criticise mainstream theory (particularly macro theory) for being too wedded to rationality in general: I seem to remember some remarks of my own along those lines. But mainstream macro does take learning, and the problem of costly and limited information, seriously. However for the foreseeable future, rational expectations will remain the starting point for macro analysis, because it is better than the only practical alternative. 

The choice really matters. An economy where agents form their expectations in a naive adaptive way is like an elaborate machine which takes no account of what policymakers are doing. In reality the economy appears more intelligent than this: policy is difficult because people in the economy take actions which anticipate what policymakers might do. This makes designing good policy difficult, but the concept of rational expectations has allowed macroeconomists to tackle this problem. To throw all that away by abandoning rational expectations would not improve macroeconomics, it would impoverish it.  

50 comments:

  1. A very good post. Thanks. I was making the same point to my students recently, I will probably refer them to this post.

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  2. I would agree rational expectations is better than adaptive expectations, but I think the problem with both of them is that they assume expectations are independently formed. I believe that most people in reality form their expectations of the economy's future from talking to each other, and thus their expectations are socially influenced.

    Such effects would likely result in positive feedback loops, which would explain how the economy can swing from irrational exuberance to irrational pessimism, or what Keynes would probably call animal spirits. Indeed, it is not clear that irrationality has much to do with it, as Banerjee and others have created models of rational agents that exhibit herding.

    Plus let's not forget that economics is, after all, a social science.

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  3. SWL:

    "so it is a shame Professor Syll wastes his talents on one of its major achievements, which is rational expectations. On this he is, well, so wrong."

    Willem Buiter:

    "Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works – let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck."

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    1. A little over the top, as Willem can occasionally be, but I would not disagree with the point that macroeconomics became too concerned with internal consistency relative to external consistency, because I have said this myself many times. But what exactly has that got to do with rational expectations? Have you ever looked at any of Buiter's work?!

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    2. Point is macroeconomics is too important to worry about internal consistency and ignore solving practical matters. These things may have been important if it were to come with having some positive impact on society but that hasn't been the case so I do not understand why you call rational expectations one of the "major achievements" - zero relevance to the real world.

      Read a lot of Buiter - he has some interesting things to say about practical matters whether right or wrong.

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    3. "I do not understand why you call rational expectations one of the "major achievements""

      He explains in the article why he calls rational expectations on of the major achievements. Reread from:
      "The reason why mainstream economics replaced adaptive.."

      to

      "..and can include the fact that information is both costly and incomplete."
      You claim RE has

      " - zero relevance to the real world."

      In the real world people think about what the central bank is going to do when they take decisions. As pointed out, there are industries using such information to predict inflation (etc.) who then sell this information to firms, governments and so on. This is happening in the real world and it is a feature of the world approximated by RE better than adaptive expectations.

      RE has shortfalls, but it certainly has some relevance to the real world.

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    4. "In the real world people think about what the central bank is going to do when they take decisions. As pointed out, there are industries using such information to predict inflation (etc.) who then sell this information to firms, governments and so on. This is happening in the real world and it is a feature of the world approximated by RE better than adaptive expectations."

      Is that really true? Take, for example, the influence of the new Help To Buy policy against the warnings of possible imminent interest rate rises. Is it a rational decision to take out a loan on a deposit of 5% when you couldn't afford a deposit of 10% if interest rates might rise? Or more esoterically, when the unwinding of Help to Buy might depress future house prices. Do consumers look much further than their immediate "needs"?

      gastro george

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  4. SW-L
    To assume, as mainstream macroeconomists once did, that these expectations just depend on past observations about inflation seems to assume that agents are stupid.

    Maybe agents really are stupid. Or maybe they are not. Maybe they are heterogeneous along multiple dimensions, with heterogeneous models and expectations consistent with their models.

    In any case what does what does the experience of the last five years suggest about peoples views on inflation? Are they homogeneous? Are they consistent with some canonical NK model with nominal rates at the ZLB? Are people (including certain academic economists) really continuously updating their views in light of evidence?

    And surely you are not denying inflation inertia? The post certainly seems to incorrectly suggest this. The NKPC is probably not the best example of the superiority of RE over AE.

    I am not a heterodox economist, or someone who claims RE are always and everywhere a bad idea. Rather, someone who finds the blind insistence on RE and claims about its *necessary* superiority misguided. The NKPC is one example where simple RE comes off worse than simple AE.

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    1. Two points. First, I was not claiming that RE is necessarily better: as I said its an empirical issue, and will depend on context. Second, inflation inertia could be due to AE, but it might be the result of something else.

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    2. SW-L:
      "...inflation inertia could be due to AE, but it might be the result of something else."

      "To assume ... that these expectations just depend on past observations about inflation seems to assume that agents are stupid."

      I suspect we might be talking somewhat at cross-purposes when discussing AE. Maybe my views are eccentric, but I see AE as a simple heuristic for introducing inertia / lags in the behaviour of the aggregate or the representative agent . In the case of AE, but *not* RE, the representative agent has nothing to do with any individual agent. In particular, it does not follow that any individual agent has adaptive expectations in the sense of the representative agent.

      Thus, 'adaptive expectations' are a property of the aggregate, not individuals. And so,

      1. The frequently heard suggestion that AE implies that individuals are stupid is a non sequitur

      2. The claim that inflation inertia could be due to factors other than AE is both trivially true (for the individual), and meaningless (for the aggregate)

      It is entirely possible that my view on AE is idiosyncratic or even mistaken. I wouldn't mind being corrected if that is so.

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    3. Why isn't what economists have thought and done in the past not included your AE inputs?

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    4. Sorry, bad chest cold. That should read: Why isn't what economists have thought and done in the past included your AE inputs?

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  5. While the attempt to build a dialogue between RE and etherodox macro is very positive, I think there are some overlooks in the post - also based on empirical observations. RE can hardly explain hoarding in financial markets, unless we redefine the very concept of RE. Which is not, then, having a knowledge of the model itself but just of his most immediate consequences. Hence, cutting interest rates propels inflation (bubbles) in the financial markets which may well bring fat profit in the short run but would also burst at some point, leaving most of not-so-rational agents with huge losses. When agents crowd is regardless of fundamentals - more readily available than actual interpretations of government policies - can we call it RE?
    Let's also not forget that orthodox interpretations of RE have been used to impose a certain type of monetary policy. As there is no proven negative correlation between growth and a moderate/middle level of inflation, what exactly again does RE says about agents' behaviour?
    Many thanks for your post anyway

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    1. "RE can hardly explain hoarding in financial markets"

      This is not true. See, for example, Kiyotaki-Moore 2012 for a rational expectations model with hoarding of liquid assets. It is not the only one. The reason hoarding is less common in standard models is because we do not have a good model of money, the use of rational expectations is not the issue.

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  6. A basic problem with this defense, which seems to fall back on a Sargent-Evans-Honkapohja worldview, is that it depends on long run equilibrium remaining stable, or constant, or at worst oscillating around some constant point due to Gaussian noise over time. So, one can have this learning that asymptotically converges on that nice equilibrium. But, we live in a world of multiple equilibria, where what other peoples' expectations are help determine which equilibrium is dominating, only to have the fact that the darned equilibria are constantly changing just further mess things up. So, what we see in reality in these models is in fact agents using some sort of adaptive expectations that are constantly being adjusted through learning to chase after constantly shifting equilibria, even if all or most of the agents are reasonably coordinated on the same equilibrium, whatever they are doing. They are never in the state of actual rational expectations. It is in fact empirically incorrect and in the end impractical and highly misleading.

    That said, obviously certain ideas from rational expectations are important and must be taken account, such as that people respond to policy changes and change their expectations, even if those expectations are not rational, either before or after the policy change. What people are expecting is clearly very important to understand if one can, most certainly if one is a policymaker such as those central bankers struggling to impose some forward guidance, for which indeed ratex would really come in handy if it really held, but we see that it does not always work out so well as the botched move to move towards a taper last spring in the US showed.

    And indeed, I suspect that what is dominating the thoughts of many central bankers, including those with much training and publishing using ratex, such as some of the prestigious figures at the US Fed, is more like some sort of behavioral macro that is not so strongly believing in ratex, with the open flight of people like Kotcherlakota from their pasts all too telling. It is probably appropriate that Janet Yellen is coming to lead the Fed, who has certainly written papers that fit into the ratex version of new Keynesian macro, but who is probably more seriously wedded to the more openly behavioral macro ideas of her husband, George Akerlof.

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  7. This is probably a stupid question. But why don't you do some proper empirical work on how people form their expectations?
    Also - if what matters in these models is behaviour - why do you assume that it's expectations that are key for behaviour, when it's well known that people often behave inconsistently with their beliefs even to the extent of harming their own interests?
    The argument that making this assumption enables you to construct elegant models runs the risk of confirming the worst stereotypes of economists I.e. That their interest is in constructing elegant mathematical models rather than studying how the economy works.

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    1. "why don't you do some proper empirical work on how people form their expectations? "

      There is a lot of work on this: using experimental data and survey data.

      "why do you assume that it's expectations that are key for behaviour"

      "The argument that making this assumption enables you to construct elegant models runs the risk.."

      I hope nobody does make that argument. The correct argument is:

      Most of the time it is correct to assume that if A causes B and a person values B more than the cost of doing A then they will do A. For example, I want food, housing etc. I believe if I work I will get paid for my work and that the amount I get paid will be sufficient to provide me with food, housing etc. Consequently, I choose to work. If I did not believe that the work would provide me with sufficient money to buy these things then I would not work.

      We are not always rational, but most of the time we are.


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    2. Danny,

      There is a vast empirical and experiment lit on this, some of it published in JEBO when I edited the journal. The answer is very simple and has been known for a long time to anybody who has spent more than three seconds looking at it. Rational expectations does not hold, except for a minority of the population some of the time. Those insisting on continuing to assume ratex are doing so for reasons other than empirical evidence, such as trying to use theoretical models that themselves at most suggest people are using adaptive expectations on an asymptotic path to a state where they will eventually use rational expectations. Why someone (who am I talking about???) would make such a completely silly and ridiculous argument is quite beyond me.

      Barkley Rosser

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    3. @weareastrangemonkey

      Danny:"The argument that making this assumption enables you to construct elegant models runs the risk.."

      weareastrangemonkey: "I hope nobody does make that argument. The correct argument is ..."

      Sorry to dash your hopes, but this has been a fairly standard argument.

      Sargent (AER, May1982):
      Research in rational expectations and its dynamic macroeconomics has a momentum of its own. That momentum stems fom the logical structure of rational expectations as a modelling strategy ..."

      SW-L is neither making nor defending this line of reasoning, but it has been and, in many circles, still remains a core argument for ratex.

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    4. Just for the record, Herman, in case you did not know, Sargent gave up on that line of argument in 1993 with his book on Adaptive Expectations in Macroeconomics.

      Barkley Rosser

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    5. @ Barkley Rosser,

      Yes, I know. But this was a common enough justification from Chicago/Minnesota, and while Sargent moved on, Lucas and Prescott did not. Sargent later even called ratex religion, and this I am told was one the the main reasons for the rift between Lucas and him.

      Incidentally, thanks for the pointer to the Lovell paper. He quotes Sargent.

      Learning:I might be wrong on this but my understanding is that learning is mostly used to rule out certain ratex equilibria or as a test for stability. For at least some economists, the 'infinity' presumably comes instantly, so the system is always in some RE equilibrium.

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  8. Shiller's article at project syndicate NOV 6, 2013 'Is Economics a Science?' looks at mathematics and behavioural economics. He doesn't say anything about sharing the platform with Fama - you build 'em up, and I'll knock 'em down - but maybe there's a little bit of that in there somewhere.

    In praise of little models.

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  9. Prof Simon,

    You advocate “theories of expectations that can be practically implemented in usable macroeconomic models”. My answer is that I couldn’t care less if “theories of expectations” are compatible with “usable macroeconomic models”. I’m primarily concerned with whether “theories of expectations” are based on REALITY: i.e. are based on empirical evidence.

    There are too many academics sitting in their ivory towers playing with their models, and with little concern for the real world.

    As you yourself put it 18 months ago, “Internal consistency rather than external consistency is the admissibility criteria for microfounded models. Which means in ordinary English that academic papers presenting macroeconomic models will be rejected if some parts are theoretically inconsistent with other parts, but not if some model property is inconsistent with the data.”

    Later, you say “we need something simple that can be used to solve the model.” Nope. If economists are to solve REAL WORLD problems, then they can stop adopting ideas simply because those ideas make their models soluable.

    I.e. if the REAL WORLD is extremely messy, then economists need to face that fact.

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    1. If the end model can tell us something useful about the REAL WORLD, for example about inflation dynamics, that is supported by empirical evidence, why does it matter that a simplifying assumption is used to create this model?

      What is the benefit of "extremely messy" modelling of expectations formation, if the end result doesn't allow us to examine anything of significant social consequence?

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    2. It's all a question of degree, I think. Everyone makes simplifying assumptions. But I just get the impression from some of the material produced by economists that they're interested primarily in erecting pretty models, and have next to no regard for the empirical evidence or the real world.

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  10. "…we need something simple that can be used to solve the model." leads to the equivalent of people trusting their GPS more than their eyes ending up in an abyss.

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  11. Simon,

    I'm pretty sure the Godley & Lavoie paper you link to doesn't mention expectations, so I guess this is an example of what you mean when say "if they exist at all". Now it's reasonable to assume that there are differences in the underlying assumptions of that model and those of more mainstream models. But is there some reason why you believe that you would get qualitatively different results simply by including an explicit rational expectations assumption but without also adopting the whole mainstream framework?

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  12. Central banks (well, at least the ECB) and economists (well, at least Thomas Sargent) focus on consumer price inflation. Consumer prices are however not the only 'final demand' prices in the economy. Prices of investments and government consumption figure too. And these can behave quite a bit different than consumer prices which means that domestic demand inflation is a superior metric of inflation: http://rwer.wordpress.com/2013/09/15/inflation-in-the-eurozone-second-quarter-2013-an-anomaly/#more-13540 At this moment, this metric shows, for the UK, much lower inflation than the consumer price metric. The point: how rational are theories which assume that rational people use a flawed metric of the increase of the price level of total domestic demand? But it is of course consistent with the model. We might also look at the price level of 'frequent out of pocket purchases' which influence actual inflation expectations much more than consumer price inflation or, for that matter, domestic demand inflation. Seems to me that Sargent c.s. have some work to do.

    Merijn Knibbe

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  13. I'm not an economist, so may well be off the mark, but there's an interesting paper (http://www.pnas.org/content/early/2012/05/16/1206569109.abstract) by Press & Dyson, showing that in the Prisoner's Dilemma, if one player is operating with something very like Naive Expectations, and the other is operating with something like Rational Expectations, the second player impoverishes the first player. Although the economy is not a prisoner's dilemma and as you say, people are not 100% Naive, I do wonder if something similar could be found in how the financial sector operates vis the rest of the economy, given that it can devote more cognitive resources to modelling.

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  14. For those who think an approach to modelling the economy that involves rational expectations is unlikely to give useful answers should visit website economyuk.co uk. There, a model of the uk economy is featured which has had some twenty years of development and which has been successfully predicting the behaviour of the nation’s economy for some time. As this model consists entirely of algebraic and differential equations, together with linking logic modules, it is about as rational as one could be. What might be of particular interest in the context of this blog is to see some results from the model concerning Philips Curves ( go to Page 6 of the website).

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  15. In the link you post by Diane Coyle:

    "What it really needs, instead, is to move away from abstraction and engage deeply with evidence – both in terms of data collection and econometrics, and non-quantitative evidence in the shape of history and context."

    Is this the direction that Sargent and other American macro-economists (and therefore every one else) have taken the discipline? Would you agree that this has led to better policy and social justice which is what Chakrabortty is ultimately interested in?

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  16. In Chakrabortty
    "Economics ought to be a magpie discipline, taking in philosophy, history and politics ... ...In the 1970s... Cambridge, the economics faculty still boasted legends such as Nicky Kaldor and Joan Robinson. "There were big debates, and students would study politics, the history of economic thought." And now? "Nothing. No debates, no politics or history of economic thought and the courses are nearly all maths."

    Is that true? Is that the way we should educate people who are going to make major decisions that impact on people's lives?

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  17. While I'm really sympathetic to the practicality argument---and that incorporating expectations into models via RE + Bayesian learning outperforms naive adaptive expectations---but I'm afraid that that's still an argument against a straw man. The more fundamental question is whether we can actually better model expectations than with RE + learning. What I'd like to see if a case where the current status quo is clearly superior, from a practical modeling choice point of view, than the other alternatives---such as behavioral tweaks and IKE---keeping in mind that RE + learning has enjoyed a head start in refining its application, while the others are still gradually being adapted (if you'll pardon the pun).

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  18. Prof. Wren-Lewis

    I think it is undeniable that RE is a useful tool regarding modeling, that it can work under normal conditions of temperature and pressure and that, in general, it offers better results than AE. You are completely right when you say so.

    What have been bothering me lately, and probably bother most heterodox economists, is the fact that we don't really know how to deal exceptional circumstances where RA models seem not to work. I believe that simply claim agent's irrationality is not a really scientific approach to the issue ...

    In the past few months, I have done a review of basic macro, and took a good look in the monetary aggregates, which shows a classification of the money offer in classes determined by how liquid they are (this issue fascinates me, I don't know why ...). The thing is that the banking multiplier applies heavily in each of these classes. I mean, the largest part of M1 are live deposits, and of M4 is derivatives. Which means that the financial sector role of multiplying the money offer is, in effect, a key factor in oiling economic activity.

    The thing is that this multiplication of the money offer is done in such a way that it is poorly lastreated so that, for every monetary aggregate, if all agents decide to take their resources out of the banking sector at the same time, the whole system will collapse.

    The problem is that this fact is so well known that it is obviously one source of market risk, or in other words, systemic risk. This is the context of RE to say that expectations matter. I mean, a debt crisis occurs when market expects government default on his debt and a banking crisis occur when market expects the bank not to be able to fulfill its liabilities. This simple explanation tool can go on ad nausea and design in a very simple and schematic way the main crisis of the XXth century.

    The thing is that this systemic risk approach does not get in conflict with complete, monotonic, transitive and continuous preferences. Which means that crisis, as a consequence of the systemic risk caused by the money multiplication by the financial sector is not that hard to model if you allow some degree of ad hoc discretionarity.

    My problem is that I have never seen this approach to the issue anywhere. I would love to hear your opinion ...

    Stays the suggestion for an interesting post.

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  19. Can you both be right? I don't think the discussion of RE would have been noticed outside of Econ wonks IF the use of RE was restricted to what you describe as a tractable modeling assumption which may not be right, but is the best we got at the moment.

    The problem with RE is that it is often used as a starting point to assert some conclusion.
    The argument goes something like this well RE is TRUE therefore we can conclude that....

    And what are the conclusions that are logical conclusions when starting from the premise that RE is true? a bunch of ideological quackery such as bubbles not being possible and the government always being the problem, and the market always being the solution - all of which suggest we are at the mercy of economic determinism rather than agents with vision and imagination that can determine better (and worse) future outcomes.

    So I don't think anyone minds RE being used as you have defended it. However, RE is being used in a way that is outrageous wrong dangerous and needs to be stopped.

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    1. I think this is a good example of confusing who is doing the fighting with the weapons being used. There is nothing in rational expectations that says bubbles do not exist. Indeed, the technology of RE can be used to explain bubbles: so called rational bubbles. So I suspect the arguments you are worried about are just incorrect.

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    2. Yes, Simon, and I even used it once in an empirical paper. The theory of rational bubbles if agents are risk averse leads to a particular empirical prediction, that such bubbles accelerate rapidly prior to peaking, after which they crash all the way down. The problem, is that very few bubbles ever observed have conformed to this. So, yes, there is a theory, but it does not remotely explain the reality of actual bubbles. Thank you very much.

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  20. Indeed, the technology of RE can be used to explain bubbles: so called rational bubbles.

    I am sure it can. I guess what may concern non-economists is whether reality is being conveniently interpreted to suit a model (or two intersecting diagonal lines or a mathematical theorem), rather than going to primary historical facts and evidence and then building up the explanation from that. Ie is the balance too much on the former rather than the latter?

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  21. Its good that you are engaging in alternative views but you ruin the effect somewhat with a condescending manner. If adaptive expectations is "naive" then how would you describe a theory that people can see the future before it happens?

    It is unfair to criticise the heterodox school for lacking a literature to match that of rational expectations. When you are excluded from the main academic centers and academic papers this is alternative. Also, no one will listen to an alternative before they are convinced we need one. Step one is to show why rational expectations is flawed. Step two is replacing it. You can't get to step two before step one.

    "seems to assume that agents are stupid"
    When you come out with comments like this perhaps the mystery of why heterodox economist don't engage with you becomes a bit clearer. Are you telling me there is no middle ground? Either people can accurately predict the future or else they are "stupid"? Perhaps it is because I am one of those idealistic students who wants to change economics, that you deride but I don't think we are limited to such extremes. Maybe we are predictably irrational as Dan Ariely has written. Maybe we use heuristics, not because we are stupid or random but because there is a limit on our computing powers. After all, we are human not computers.

    "These agents ignore everything that economists and the media say about inflation: they ignore monetary policy, and whether the economy is in a boom or recession."

    When was the last time you spoke to ordinary non-economists? I don't mean that as a samrt arse comment, but a genuine point. I was talking to my friends who don't study economics the last day. They don't know any economic theories, can't name any major economists, don't read newspapers or watch the news. They find economics talk a mixture of boring, irritating and depressing (the last point is specific to Ireland and our youth unemployment). They don't even know what monetary policy is, let alone what the ECB is doing and whether it is good or bad. Let me clear that these are not ignorant backwoodsmen, they're all college students and smarter than me in their own way (at science not economics). The point is that vast majority of people don't understand economics and don't even care.

    "Now if getting expectations right did not matter too much to these agents, then maybe such naivety would be understandable. But in this case making expectations errors can mean getting real wages or profits wrong, so it matters."

    Something I found surprising was that the concept of real wages is very important in economics but is unknown to ordinary people who suffer from the money illusion. They also may not be able to do anything about their real wage without a union, but that's another issue.

    "This is an empirical claim."

    I would agree that we should look to the real world, however I think it reveals the opposite answer. I would recommend the blogger Lord Keynes who blogs on the topic a lot. For example this post has a nice example of businessmen saying how they actually set prices (short answer, fix price mark up beats marginal cost).
    http://socialdemocracy21stcentury.blogspot.ie/2013/08/lees-post-keynesian-price-theory_17.html

    "But how else do you make sense of a whole forecasting industry,"

    Perhaps I have a different concept of the forecasting industry, but surely if people have rational expectations they don't need a forecasting industry as they already know what will happen?

    Anyway this reply is longer than I intended, hope you give it some consideration and thanks for at least engaging with heterodox economics rather than ignoring it like most.

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    1. There are a lot of important points here so let me respond to a few

      1) I'm sorry you do not like my use of terms like stupid or naive to describe adaptive expectations, but this is just the mirror image of terms like 'superhuman' that heterodox economists use all the time.

      2) Of course we are not limited to these two extremes, but the learning literature bridges that gap. Within that literature you can make assumptions about the availability of information or the frequency with which it is used.

      3) Yes, I do speak to non-economists! But people do not need to know about economic models in order to make rational predictions: they can read the newspapers. And here I think you fall into a trap that the heterodox rhetoric encourages. You say "but surely if people have rational expectations they don't need a forecasting industry as they already know what will happen". Of course not! The forecasting industry is how rational expectations get made.

      4) You say it "is unfair to criticise the heterodox school for lacking a literature to match that of rational expectations". I think it is very fair. Rational expectations replaced adaptive expectations 40 years ago: not because of any horrible conspiracy, but because economists saw that it made more sense. The concern within that mainstream that RE was too extreme led to the learning literature. So what heterodox economists should be doing is applying their insights and those of behavioural economics to that literature. No one is excluding them from doing that. Yet what I read from most heterodox economists is the same misguided criticisms that were directed at RE 40 years ago.

      5) If I want to find the strongest and most effective criticisms of, say, current macro policy in the EZ - and hence Ireland - I think you will find it within the mainstream, not heterodox economics. The most telling criticisms of any orthodoxy come from those inside who really understand it.

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    2. Simon,

      Please answer two questions: 1) What is the empirical evidence for ratex? and 2) Does the learning lit you cite actually say that agents are currently using ratex?

      The answer to 1) has been around for a long time. An early summary of the widespread evidence available then was Michael C. Lovell's March 1986 paper in the AER, "Evidence on the Rational Expectations Hypothesis." His survey found that it had been overwhelmingly rejected. The subusequent lit has done nothring to overturn what was found in that now rather old paper.

      2) Maybe you read different papers than I did, but that entire learning lit has people using AR during the transition to ratex, which comes about asymptotically at infinity, in short, not during any time we are actually observing. Am I misinterpreting this lit?

      So, really, I do not see how you have provided even a remotely serious argument for ratex. Even if I have misinterpreted the theoretical learning lit, there remains the hard empirical evidence lit. Ratex is simply empirically false. Were you one of the economists that the Queen was annoyed with, perchance, sir?

      Barkley Rosser

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  22. The real problem is that rational expectations becomes "real" among the political class and they use it to assume that nothing needs to be done to adjust, from a policy standpoint. You may realize it is just the most useful assumption for modeling that we have at this time, but politicians and pundits don't. They are abusing the concept.

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  23. What if economic agents form their expectations in a random manner where some expectations are rational while others are irrational. In the light of this mixture of rational and irrational expectations, can we possibly consider expectations as a random or stochastic variable? Do random expectations have any practical usefulness?

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  24. I guess it comes down to this. We have had RE for three decades. Has this led to better policy formulation? If these models have been used and they have clearly failed (macro-policy is not clearly not successfully dealing with structural long term unemployment - and I doubt they would if you ended austerity and called for an AD expansion right now), case closed. If these models have not even been used by governments or central banks or international agencies for policy formulation because basically they are useless and they have been using things like the equally discredited ISLM model, the case against it is even stronger. How many more decades do we need?

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  25. One interesting thing I would note is that MMT economists (at least, not sure about the rest of the Post-Keynesians) do believe in expectations with regards to interest rates. They argue that expectations of the path of short rates is the main determinant of bond yields. Interestingly enough, it's often been the more pro-capitalism economists who have been worrying about how rising debt levels will raise interest rates.

    But let's return to the problem of models providing policy guidance. As an example, take a look at what happened in the U.S. pre-2008, and Canada now. The economy is unbalanced by massive construction of housing units. Growth will continue as long as an excess of units is built. When the music stops, you end up with a massive surplus of workers in construction that somehow have to find employment elsewhere.

    I believe that the final result from the mainstream approaches is to end up with a analysis like this: "if we shock input x by 1%, the impulse response of economic variable y will look like trajectory z over two years". Decisionmakers have been conditioned to expect analysis like this; it sounds very authoritative. However, it skips over the fact that we do not really have a good grasp of the trajectory the economy is going to take absent the shock. If we return to the example of the Canadian housing market, I have not seen this style of analysis offering much in the way of useful policy guidance. The advantage of a Godley-style stock-flow consistent model is that you can at least set up an ad hoc model to examine scenarios without being locked into a rigid framework that is needed to support the rationality assumption.

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  26. Throughout human history, at least as long as there have been market oriented economies, there have been cycles of boom and bust corresponding with credit-fueled speculation into assets financial and otherwise. Without fail during these periods of time, large quantities of savings have been directed toward investment with little or no economic value (or at least, none where no such spigot is wide open), guaranteeing socially expensive losses. In practice, these episodes are of paramount importance to any understanding of the functioning of an economy, both because their answers hold out the promise of more enlightened policy regarding boom and bust, but also because these extremes should be revealing about the nature of things, like a particle accelerator is to physicists.

    Given that is the case, one might think it meaningful to a post such as this that these most pertinent and beguiling of economic phenomena are entirely inconceivable in a world where RE determines the expectations of representative agents. And yet, this is nowhere to be found in Professor Wren-Lewis’s case for “one of [mainstream economics’] greatest achievements” (granted, that could’ve been damning with faint praise). Something tells me that when Buitler talks about, “Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works – let alone how the economy works during times of stress and financial instability”, exactly this is what he had in mind.

    Of course to the extent that they do, heterodox economists are wrong to focus on RE, in part for the issues raised here. How information is assimilated by the representative agents of represent agent models does not account for the catastrophic model failure of those models nearly so much as the (mis)specification wrought of the original abstraction. Put another way, there's a reason why hoocoodanode counts as sardonic humor.

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  27. For what it’s worth, Keynes appears to pretty clearly reject the ‘rational expectations’ of ‘representative agents’ as a worthwhile exercise in his response to Viner’s criticism of The General Theory (as quoted by Hyman Minsky in his book, “John Maynard Keynes”):

    "By uncertain knowledge…, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability waiting to be summed. ” [QJE, pp. 213-14]

    Thus the use of certainty equivalents,- much beloved by academics- is to practical men a convention, to which lip service may be paid, but which is abandoned when evidence inconsistent with the polite convention emerges.

    In the face of uncertainty and “the necessity for action and for decision” (QJE, p. 214), we devise conventions: we assume the present is a “serviceable guide to the future” we assume that existing market conditions are good guides to future markets and “we endeavor to conform with the behavior of the majority or the average” (QJE, p. 214). Given these flimsy foundations, the view of the future “is subject to sudden and violent changes” (QJE, pp.214-15). “All these pretty, polite techniques made for a well-paneled Board Room and a nicely regulated market, are liable to collapse” (QJE, p. 215)

    Also, in The General Theory, “Business men play a mixed game of skill and chance, the average results of which to the players are not known by those who take a hand” (GT, p.150)

    George Soros obviously got the memo Of course, he is no philosopher, and certainly no economist, but one should never underestimate the power of accountability to ground an intellectual exercise in reality.

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  28. How about this kind of thing, Simon?

    http://faculty.som.yale.edu/nicholasbarberis/bgjs9.pdf

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  29. The theory of rational expectation seems to have been undone by the success of central banks' efforts in fighting inflation. The result being that people in general no longer worry about inflation. Things such as hikes to energy bills or train fares make headlines but the rising cost of living is just a fact of life at such low levels that it is not a concern. It is only economists (and bond investors) that seem to worry about inflation and it warps their sense of priorities due to their reliance on rational expectations theory which has been shown to be increasingly outdated. An increase in the scope of oversight by central banks is a good thing and even more might help ensure more stability and a better understanding of the workings of the economy. For more on this argument, see http://yourneighbourhoodeconomist.blogspot.co.uk/2013/11/not-so-great-expectations.html

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