Posted by: Dirk | November 7, 2013

Mark Thoma on rational expectations: same old same old

Mark Thoma writes in a column at the Fiscal Times:

Rational expectations are important for two reasons. First, they serve as a “perfect case” benchmark. In order to understand departures from rationality such as those embraced by Shiller, we need to know how the economy will function if agents fully understand everything about the economy, and can process the information optimally. [..]
Second, there are cases – simple games and financial markets for example – where the assumption of rational expectations may be approximately satisfied. But it’s a mistake, I think, to assume that rational expectations apply in all other settings or to the economy as a whole. – See more at: http://www.thefiscaltimes.com/Columns/2013/11/05/How-Economists-Can-Tame-Irrational-Exuberance#sthash.e4qyXfMU.dpuf
Now this is a very typical economist’s argument, and it has been wrong, it is wrong and it will be wrong. The whole idea developed here is that there is a truth out there that we can discover. That is surely not true, in the 21st century human beings should know that they know nothing. So, for different and quite obvious reasons (limited brain capacity, language being an abstraction, etc.) the idea of perfect information is moot. Then, there is this slight complication of making guesses about the future before rationalizing behavior. My behavior depends to a very large extent not only on my identity, my social cultural surroundings and my mood, but also on my expectations of the future. These are inherently unknowable, which is why Keynesians (and Shiller, among others) pointed out for many decades that fundamental uncertainty rules.
The second argument is very strange. Let me repeat one sentence: “Second, there are cases – simple games and financial markets for example – where the assumption of rational expectations may be approximately satisfied.” With John McEnroe I’d say: “You cannot be serious!” Financial markets are the last place in the world where people are rational. Again, they are betting on future prices, which cannot be known given all present information since they depend on information in the future. This, by the way, is what the efficient market hypothesis originally said and it is a great irony of what has become of it. Apart from this critique there are many more, including asymmetric information, principal agent problems, etc. (see recent newspaper articles on these problems here, here and here.)
To the mainstream economists like Thoma their models might still be working perfectly, but it is up to them to prove that a planet exists where this kind of model is a useful yardstick. If financial markets on planet earth were efficient, why all that regulation? Why is the short-term interest rate set by the central bank? Why is money a state-run thing, and not private? Why are you not allowed to create a new bank just like that? Efficient financial markets in the sense of maximizing welfare of not only bankers is a result of good regulation and not of rational or irrational actors.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Categories

%d bloggers like this: