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Rational expectations scam

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“One of the most remarkable errors in the history of economic thought”

 Robert Shiller, 1984

So-called Rational Expectations Hypothesis (REH) is pseudo scientific junk theory that is influencial for the last 30 years mainly due to support of the US and other governments as a part of "free markets" neoliberal doctrine.  So you need to understand it as an ideological construct which have little to do with reality. As Professors Roman Frydman (New York University) and Michael D. Goldberg (the University of New Hampshire) wrote in Times

The centerpiece of this standard of rationality, the so-called Rational Expectations Hypothesis (REH), presumes that economists can model exactly how rational individuals comprehend the future. In a bit of magical thinking, it supposes that each of the many models devised by economists provides the “true” account of how market outcomes, such as asset prices, will unfold.

The economics literature is full of different models, each assuming that it alone adequately captures how all rational market participants make decisions. Although the free-market Chicago school, neo-Keynesianism and behavioral finance, for example, are quite different in other respects, each assumes the same REH-based standard of rationality. In other words, REH-based models ignore the very raison d’être of markets: no one, as Friedrich Hayek pointed out, can have access to the totality of knowledge and information dispersed throughout the economy. Similarly, as John Maynard Keynes and Karl Popper showed, we cannot rationally predict the future course of our knowledge. Today’s models of rational decision-making simply ignore these arguments.

The most reputable investment banks and credit-rating agencies used REH finance models to “price” new derivative products. But new derivatives are not engineering breakthroughs. The use of mechanical REH models to price them assumed away the ultimate source of uncertainty in markets. Far from providing a “scientific” rationale, the valuations and ratings that they yielded were bound to have little connection to reality.

The unreasonableness of economists’ standard of rationality also helps to explain why macroeconomists of all camps and finance theorists find it so hard to account for swings and risk in asset prices. Even more pernicious, despite these difficulties, their models supposedly provide a scientific basis for judging the proper roles of the market and the State in a modern economy.

But incoherent premises lead to absurd conclusions: for example, that unfettered financial markets set asset prices nearly perfectly at their true fundamental value. If so, the State should drastically curtail its supervision of the financial system. Unfortunately, many officials worldwide came to believe this claim, known as the efficient markets hypothesis, resulting in the massive deregulation of the late 1990s and early 2000s. That made the crisis more likely, if not inevitable.

Remarkably, the same economists’ flawed standard of rationality also underpins calls for the opposite approach: active state intervention in financial markets. After all, massive state oversight is a logical implication of mathematical behavioral finance models, which, in the aftermath of the crisis, have suddenly been embraced by other economists and non-academic commentators alike.

The reason is simple: although behavioral economists have uncovered piles of evidence that market participants do not act like conventional economists would predict “rational individuals” to act, they have clung to the bogus standard of rationality underlying those predictions. They interpret their empirical findings to mean that many market participants are irrational, prone to emotion or ignore economic fundamentals for other reasons. Once these individuals dominate the “rational” participants, they push asset prices away from their “true” fundamental values.

Thus, the behavioral view suggests that swings in asset prices serve no useful social function. If the State could somehow eliminate them through massive intervention, or ban irrational players by imposing strong regulatory measures, the “rational” players could reassert their control and markets would return to their normal state of setting prices at their true values.

This is implausible, because an exact model of rational decision-making is beyond the capacity of economists — or anyone else — to formulate. Once economists recognise that they cannot explain exactly how reasonable individuals make decisions and how market outcomes unfold over time, we will no longer be stuck with two polar extremes concerning the relative roles of the market and the State.

For the most part, asset prices undergo swings because participants must cope with ever-imperfect knowledge about the fundamentals that drive prices in the first place. So long as these swings remain within reasonable bounds, the State should limit its involvement to ensuring transparency and eliminating market failures. Indeed, the failures of communism amply demonstrated financial markets’ superiority to state regulators in allocating capital.

But sometimes price swings become excessive, as recent experience painfully shows. Even accepting that policy officials must cope with ever-imperfect knowledge, they can implement measures — such as guidance ranges for asset prices and changes in capital and margin requirements that depend on whether these prices are too high or too low — to dampen excessive swings.

This combination of passive and active measures sees the State’s role as intermediate between the two extreme views that hinge on economists’ standard of rationality. It would leave financial markets to allocate capital and yet lower the economic and social costs that follow when asset-price swings become excessive, and then end, as they inevitably do, in sharp reversals.

The global economic crisis has shattered two articles of faith in neo-classical economic theory:

It's really funny and shows true colors of Riksbank  bankers elite that for his rational expectations scam Robert Lucas was awarded in 1995 the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (which incorrectly is called Nobel Prize in Economic Sciences.) 

Rational expectations is actually a very primitive idea for any programmer or electrical engineer: the idea of simplified dynamic system with zero latency and noise free feedback loops.  Such idealized models are usually useless and this is no exception.

Lucas, a professor of economics at the University of Chicago, postulated that people make economic choices based on all the information available to them and learn from their mistakes.  He bravely ignored the legacy of his famous predecessor Thorstein Veblen who coined the term “conspicuous consumption”

If we believe in  this idealized theory of market behavior, then investors expectations about the future such as the price of  Citigroup, Bear Sterns or Lehman stock in the beginning of 2008. or the return on their Bernard Madoff investments for the second half of 2009 - are, on average, accurate.

As an ideological construct, Lucas's "rational expectations" theory did not become a part of  "Great Recession" wreckage. It survives despite all odds. This is actually a well-known phenomena which is systematically observed in religious cults, when a spectacular failure of the doctrine (for example end of the world which did not happen on prescribed date, or coming of the messiah) only force the believers to increase their zeal. Rejection has too high price. We reserve the word cult typically to  a new religious movement or other group whose beliefs or practices are considered abnormal or bizarre. Zablocki defines a cult as an ideological organization held together by charismatic relationships and the demand of total commitment. So it's not completely correct to call believers in "rational expectations" cultists, they are more like intellectual prostitutes. They do it for money. 

The key role of "rational expectations" theory is to  served as a smoke screen for outrageous excesses of financial sector, thus helping to inflate the bubble.  Lucas himself probably overstayed his welcome in economic profession and can be now be viewed as yet another "ideologically charged" neo-conservative clown in the same line of clowns as Kudlow. Lucas went as far as proclaim in 2003 ... that the "central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.".

Rational expectations are based on the notion of permanent static equilibrium in the market. And his connection to Lysenkoism is far from being superficial: in best traditions of Lysenkoism he managed to dismiss The General Theory as "an ideological event."

The key Lucas's idea is completely unrealistic idea of "instant and perfect equilibrium", the idea that investors are rational and that markets are efficient, with prices quickly reflecting all the new information. See The efficient markets hypothesis. The key fallacy that is supported by this view is that investors should hold stocks for the long run, unless new information dictates a change. After all, if  information disseminated instantly and promptly reflected in stock prices, we cannot act fast enough to outperform the market. The fact that financial institutions deform the market to extract the profit and take advantage of " investing plankton" (401K lemmings), as well as the fact that the market oceans are populated with sharks is conveniently ignored.

In a highly critical paper titled, "The Financial Crisis and the Systemic Failure of Academic Economists," eight American and European economists argue that academic economists were too disconnected from the real world to see the crisis forming. The authors are David Colander, Middlebury College; Hans Follmer, Humboldt University; Armin Haas, Potsdam Institute for Climate Impact Research; Michael Goldberg, University of New Hampshire; Katarina Juselius, University of Copenhagen; Alan Kirman, University d'Aix-Marseille; Thomas Lux, University of Kiel; and Brigitte Sloth, University of Southern Denmark. By relying so heavily on the view of humans as rational, the paper's authors argue, economists ignore evidence of irrational behavior that is well documented in other disciplines like psychology and sociology. Even if an individual does act rationally, economists are wrong to assume that large groups of people will react to given conditions as an individual would, because they often do not. "Economic modeling has to be compatible with insights from other branches of science on human behavior," they write. "It is highly problematic to insist on a specific view of humans in economic settings that is irreconcilable with evidence." When certain price and risk models came into widespread use, they led many players to place the same kinds of bets, the authors continue. The market thus lost the benefit of having many participants, since there was no longer a variety of views offsetting one another. The same effect, the authors say, occurs if one player becomes dominant in one aspect of the market. The problem is exacerbated by the "control illusion," an unjustified confidence based on the model's apparent mathematical precision, the authors say. This problem is especially acute among people who use models they have not developed themselves, as they may be unaware of the models' flaws, like reliance on uncertain assumptions.

The problem with  the rational expectations scam is that it starts with the desired results, then constructs an argument to support it. It is, in its essence, a justification of a particular ideology. Here is how Wikipedia defines this scam:

Rational expectations is an assumption used in many contemporary macroeconomic models, and also in other areas of contemporary economics and game theory and in other applications of rational choice theory.

Since most macroeconomic models today study decisions over many periods, the expectations of workers, consumers, and firms about future economic conditions are an essential part of the model. How to model these expectations has long been controversial, and it is well known that the macroeconomic predictions of the model may differ depending on the assumptions made about expectations (see Cobweb model). To assume rational expectations is to assume that agents' expectations are correct on average. In other words, although the future is not fully predictable, agents' expectations are assumed not to be systematically biased and use all relevant information in forming expectations of economic variables.

This way of modeling expectations was originally proposed by John F. Muth (1961) and later became influential when it was used by Robert E. Lucas Jr and others. Modeling expectations is crucial in theories like new classical macroeconomics, new Keynesian macroeconomics, and the efficient market hypothesis of contemporary finance, which study the dynamics of the economy over time. For example, negotiations between workers and firms will be influenced by the expected level of inflation, and the value of a share of stock is dependent on the expected future income from that stock.

Few people called this a scam and generally the critique of the concept was amazingly  benign:

 Sociologists tend to criticize the theory based on philosopher Karl Popper's criterion of falsifiability. They note that many economists, upon being confronted with empirical data that goes against the "rational" theory, can simply modify their theories without ever touching the basic thesis of rational expectation.[citation needed] Furthermore, social scientists in general criticize the movement of this theory into other fields such as political science.

In his book Essence of Decision, political scientist Graham T. Allison specifically attacked the rational expectations theory.

Collapse of Lehman was the last nail in the coffin of rational expectation theory. Here the bus was driven over the cliff by the folks at the very top: illiquid assets were  financed by the use of very short term (overnight) commercial paper, they company used a tremendous amount of leverage and top executives refused to stop acting like drunken fools even when it was clear the subprime disaster was not "contained." If anybody after that can mention "rational expectations" other that in joke, the question of mental treatment probably need to be discussed very seriously. 

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[Nov 16, 2013] 'Ignorance'

November 06, 2013 | Economist's View

Ignorance: Economics, it is said, is the study of scarcity. There is, however, one thing that certainly isn't scarce, but which deserves the attention of economists - ignorance. A recent paper by Richard Zeckhauser and Devjani Roy - which introduces a new method of economic research - shows that this is unjustly neglected in economics.

Conventional economics analyses how individuals choose - maybe rationally, maybe not - from a range of options. But this raises the question: how do they know what these options are? Many feasible - even optimum - options might not occur to them. This fact has some important implications. ...

... In a brilliant post, Will Davies gives a lovely example of this. Academics making funding applications, he says:

have to describe the entire project, its outcomes and 'impact' in advance. These pieces of science fiction serve little purpose of ensuring that money goes to the 'best' recipients, but a great purpose in reassuring the state that nothing unexpected will happen.

But the entire point of economics - and indeed of life - is that the unexpected does happen. An ideology which overlooks ignorance is therefore a fiction. And worse still, a potentially costly one.


Psychology pays a lot of attention to this. Dunning-Kruger effect, anyone? This is another instance where economics really needs to start paying attention o the research results of other social sciences. Alas, their meta ignorance of what they're missing keeps them ignorant even of where to look...

Wisdom Seeker
Yet more proof that "Economics" is not (yet) a science.

Also, the unexpected should not be unexpected. Most of the time the "unexpected" is really just proof that "this time isn't different". But policymakers and other econogandists* must feign ignorance of the "unexpected" in order to avoid receiving career-ending blame.

And yes, grant writing is a stylized exercise in science fiction.

* Econoganda - economic propaganda, see

reason :

People are missing the point of this. Chris Dillow's real target is "managerialism". (And to a lesser extent I suppose the presumptiveness of stock market driven investment - not to mention the strong rational expectations hypothesis).

[Nov 16, 2013] ignorance

November 06, 2013 | Stumbling and Mumbling

Economics, it is said, is the study of scarcity. There is, however, one thing that certainly isn't scarce, but which deserves the attention of economists - ignorance. A recent paper by Richard Zeckhauser and Devjani Roy - which introduces a new method of economic research - shows that this is unjustly neglected in economics.

Conventional economics analyses how individuals choose - maybe rationally, maybe not - from a range of options. But this raises the question: how do they know what these options are? Many feasible - even optimum - options might not occur to them. This fact has some important implications.

1. It matters for labour market mismatch. If people don't know of jobs they could reasonably fill, we'll get a mix of unfilled vacancies and unemployment - a bad Beveridge curve. This is likely to be an especial problem (pdf) in recessions, when job destruction requires people to change careers.

The issue here isn't just a short-run cyclical one. Young people can be ignorant of what careers are possible, and so drift into jobs they are unsuited for whilst neglecting worthwhile options. This is why better careers advice or role models are so important.

2. It matters for investment. If folk are ignorant of the possibility of an impending crisis, they might over-invest. Equally, though, firms' ignorance of technological or market opportunities can cause them to under-invest.

It's in this context that entrepreneurship matters. An entrepreneur is someone who reduces ignorance, by finding a market or technology of which others were ignorant. The conventional economics of "max U from a range of given options" has no place for entrepreneurship. Once we put ignorance at the heart of our thinking, a place emerges.

3. Ignorance can be a corporate resource. Customers who don't know of alternative products get ripped off; potential rivals who don't know the technology or market don't enter the industry.

4. Reducing ignorance can raise long-run economic growth not just by improving labour market matches, but by raising awareness of possibilities. Robin Hanson has said that we can think of really long-run growth as a series of ever-increasing modes. But why might growth rise? One reason could be that in traditional hunter-gatherer or agricultural societies, people's small social circles made them ignorant of economic possibilities, whilst increasing networks - first through mass literacy and latterly through the web - expand people's horizons and reduce their ignorance. One could argue here that social structures and cultures which block such networks - such as presenteeism - thus serve to impede growth.

Now, I suspect (hope) that this will seem trivial to economists in the Austrian tradition, which has tended to recognise (pdf) the role of ignorance. It does, however, clash with the managerialist ideology of our time, which pretends to manage away ignorance. In a brilliant post, Will Davies gives a lovely example of this. Academics making funding applications, he says:

have to describe the entire project, its outcomes and 'impact' in advance. These pieces of science fiction serve little purpose of ensuring that money goes to the 'best' recipients, but a great purpose in reassuring the state that nothing unexpected will happen.

But the entire point of economics - and indeed of life - is that the unexpected does happen. An ideology which overlooks ignorance is therefore a fiction. And worse still, a potentially costly one.

[Nov 08, 2013] Defending rational expectations

Nothing better discredit RE then pathetic defense of its adepts. Here is a nice quote from comments: " 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."

November 7, 2013 | mainly macro

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 criticize 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.

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  1. perfectlyGoodInk7 November 2013 21:08

    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.

  2. Ramanan7 November 2013 21:51


    "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."

    1. Mainly Macro8 November 2013 01:53

      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?!

    2. Ramanan8 November 2013 08:28

      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.

  3. Herman7 November 2013 22:08

    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.

    1. Mainly Macro8 November 2013 01:57

      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.

    2. Herman8 November 2013 05:21

      "...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.

  4. nicola melloni7 November 2013 23:44

    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

  5. [email protected]8 November 2013 01:05

    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.

  6. Danny8 November 2013 01:16

    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.

  7. Anonymous8 November 2013 01:36

    Shiller's article at project syndicate NOV 6, 2013 'Is Economics a Science?' looks at mathematics and behavioral 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.

  8. Ralph Musgrave8 November 2013 01:36

    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.

    1. Will8 November 2013 02:17

      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?

  9. tom8 November 2013 01:49

    "…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.

  10. Nick Edmonds8 November 2013 02:51


    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?

  11. Anonymous8 November 2013 03:48

    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: 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

  12. ingulf8 November 2013 04:19

    I'm not an economist, so may well be off the mark, but there's an interesting paper ( 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.

  13. Anonymous8 November 2013 04:40

    For those who think an approach to modelling the economy that involves rational expectations is unlikely to give useful answers should visit website 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).

  14. Anonymous8 November 2013 06:41

    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?

  15. Anonymous8 November 2013 07:08

    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?

  16. Jamus8 November 2013 09:06

    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).

  17. Eduardo Weisz8 November 2013 09:17

    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.

  18. Dan8 November 2013 09:31

    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.

    1. Mainly Macro8 November 2013 10:14

      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.

Economist's View Phelps on Rational Expectations

Jesse said...

Excellent interview, and I thank you for it.

Phelps brings up many of the points that bother mathematicians like Mandelbrot for example when they examine the math behind the models, and its relationship, often tortured, to the underlying reality, in his 'Misbehaviour of Markets.'

That is not to say that the pursuit is not futile, but that it is not at all easy and has pitfalls, which sometimes are seized upon and the source of great mischief.

And I am still not a fan of Caroline Baum. lol. She writes for pay, and so that does not make her bad, but a source to be weighed on the merits of the argument.

Edward Lambert said...

Phelps says the Fed is guessing about the new normal for the unemployment rate and that maybe they don't even want to think about it. Interesting... Little by little, economists will realize that the natural rate of unemployment has risen. Remember it did rise in Europe. Also, labor share of income has not fallen in Canada like in the US. It is still close to the same level as the late 60's. and their capacity utilization rates are above 81% (2.5% above US) and their unemployment rate is lower at 7%.

Just saying...

Mark A. Sadowski said in reply to Edward Lambert...

"Also, labor share of income has not fallen in Canada like in the US. It is still close to the same level as the late 60's."

That's not true, labor share has also fallen in Canada. In fact the labor share of income during the age of disinflation has declined pretty much everywhere in the advanced world.

Peak Core CPI Rate*, Peak and Recent Labor Share of Income (Total Economy) (*Except Portugal)

Nation------CPI-Year-- Peak-Year-Recent-Year-Change US----------12.4-1980-69.6---1980-63.7---2010--5.9 Japan-------20.2-1974-72.5---1977-56.6---2009-14.9 Germany------6.8-1974-76.3---1974-68.5---2011--7.8 UK----------22.1-1975-75.6---1975-71.3---2010--4.3 France------12.7-1980-79.2---1981-68.4---2010-10.8 Italy-------22.3-1980-83.4---1971-68.1---2010-15.3 Spain-------26.4-1977-76.4---1977-59.9---2011-16.5 Canada------11.1-1980-68.1---1971-59.8---2008--8.3 Australia---12.8-1977-75.5---1975-61.3---2006-14.2 Neth.-------10.5-1975-77.1---1975-68.5---2010--8.6 Sweden------12.5-1980-77.9---1978-63.3---2011-14.6 Switzerland--8.9-1974-67.5---2002-65.9---2010--1.6 Austria-----11.1-1981-98.5---1978-66.3---2011-32.2 Norway------12.2-1981-73.7---1977-55.4---2011-18.3 Portugal*---33.1-1977-83.9---1975-66.4---2010-17.5 Denmark-----10.6-1978-73.7---1980-69.5---2011--4.2 Finland-----17.5-1975-76.9---1991-66.1---2011-10.8 Ireland-----21.2-1981-79.3---1980-60.9---2010-18.4 New Zeal.---17.2-1982-60.7---1975-49.0---2006-11.7

The international labor share data comes from the OECD and is not consistent with BEA data:

Select *Total Economy*.

Although there are many reasons for the increase in inequality that we have seen in the US and in other parts of the world (regressive taxation, weaker unions, lower minimum wages, globalization, Skills-Based-Technological-Change (SBTC) etc.) the leading hypothesis for why there has been such large scale declines in the labor share of factor income is disinflation (i.e. tight monetary policy).

Disinflation during the eighties and the nineties was accompanied by a significant rise in the profit share of national income in most OECD countries or, equivalently, by a reduction in the labor share. This suggests that changes in the rate of inflation are non-neutral with respect to the distribution of factor income. The consequences of inflation upon inequality thus may largely be the indirect result of the effects of inflation upon factor shares. The mechanism by which this comes about is fairly simple. Accelerating inflation is correlated to falling unemployment rates, falling unemployment rates lead to greater labor bargaining power, and greater labor bargaining power is correlated with lower markups. Furthermore, higher inflation rates create greater price dispersion leading to greater competition among producers to limit markups. This hypothesis was tested with a panel of 15 OECD countries over the period from 1960 to 2000 and a robust positive relationship between inflation and the labor share was obtained:

derrida derider said in reply to Edward Lambert...

"Little by little, economists will realize that the natural rate of unemployment has risen."

Of course. Many long ago pointed out to Phelps and Friedman that the natural rate of unemployment has a distressing tendency to rise and fall with the actual rate of unemployment of a year or two ago.

To be fair Phelps conceded the point that the NAIRU should be fully endogenised in models (which rather destroys the monetarist policy case), and one part of the RBC people's schtick is to do just that. But no-one has made such a model that convincingly fits the facts yet (sorry DSGErs, calibrating a model is just fitting it to past facts. Lucasians, of all people, should understand that this is not the same as explaining present facts, let alone predicting future facts).

Honest macro policymakers realise that they are very often still "guessing about the new normal" on all sorts of really important stuff. The reason the disputes in macro have not been resolved is because they are genuinely hard.

[Feb 12, 2013] Expecting the Unexpected An Interview With Edmund Phelps By Caroline Baum

What led to rational expectations was a fear of the uncertainty and, worse, the lack of understanding of how modern economies work. The "rational expectationists" wanted to bottle all that up and replace it with deterministic models of prices, wages, even share prices, so that the math looked like the math in rocket science. The rocket's course can be modeled while a living modern economy's course cannot be modeled to such an extreme. It yields up a formula for expectations that looks scientific because it has all our incomplete and not altogether correct understanding of how economies work inside of it, but it cannot have the incorrect and incomplete understanding of economies that the speculators and would-be innovators have.
Feb 11, 2013 | Bloomberg

In 2006, the Royal Swedish Academy of Sciences awarded the Nobel Memorial Prize in Economic Sciences to Edmund Phelps "for his analysis of intertemporal tradeoffs in macroeconomic policy." Phelps showed that, contrary to the original Phillips curve, there is no long-run trade-off between inflation and unemployment, only a short-term one. Translated into lay speech: You can fool some of the people some of the time and reduce unemployment by paying workers what looks like a higher wage. Eventually, they wise up to the fact that their higher nominal wage is a function of higher inflation, not a higher real wage. Unemployment reverts to its so-called natural rate.

Phelps is the director of Columbia University's Center on Capitalism and Society. I talked with him over the phone on Jan. 25 and Feb. 4 about his views on rational expectations: the notion that people's expectations of economic outcomes are generally right and policy makers can't outsmart the public.

(This interview has been condensed and lightly edited for clarity.)

Question: In a new volume with Roman Frydman, "Rethinking Expectations: The Way Forward for Macroeconomics," you say the vast majority of macroeconomic models over the last four decades derailed your "microfoundations" approach. Can you explain what that is and how it differs from the approach that became widely accepted by the profession?

Answer: In the expectations-based framework that I put forward around 1968, we didn't pretend we had a correct and complete understanding of how firms or employees formed expectations about prices or wages elsewhere. We turned to what we thought was a plausible and convenient hypothesis. For example, if the prices of a company's competitors were last reported to be higher than in the past, it might be supposed that the company will expect their prices to be higher this time, too, but not that much. This is called "adaptive expectations:" You adapt your expectations to new observations but don't throw out the past. If inflation went up last month, it might be supposed that inflation will again be high but not that high.

Q: So how did adaptive expectations morph into rational expectations?

A: The "scientists" from Chicago and MIT came along to say, we have a well-established theory of how prices and wages work. Before, we used a rule of thumb to explain or predict expectations: Such a rule is picked out of the air. They said, let's be scientific. In their mind, the scientific way is to suppose price and wage setters form their expectations with every bit as much understanding of markets as the expert economist seeking to model, or predict, their behavior. The rational expectations approach is to suppose that the people in the market form their expectations in the very same way that the economist studying their behavior forms her expectations: on the basis of her theoretical model.

Q: And what's the consequence of this putsch?

A: Craziness for one thing. You're not supposed to ask what to do if one economist has one model of the market and another economist a different model. The people in the market cannot follow both economists at the same time. One, if not both, of the economists must be wrong. Another thing: It's an important feature of capitalist economies that they permit speculation by people who have idiosyncratic views and an important feature of a modern capitalist economy that innovators conceive their new products and methods with little knowledge of whether the new things will be adopted -- thus innovations. Speculators and innovators have to roll their own expectations. They can't ring up the local professor to learn how. The professors should be ringing up the speculators and aspiring innovators. In short, expectations are causal variables in the sense that they are the drivers. They are not effects to be explained in terms of some trumped-up causes.

Q: So rather than live with variability, write a formula in stone!

A: What led to rational expectations was a fear of the uncertainty and, worse, the lack of understanding of how modern economies work. The rational expectationists wanted to bottle all that up and replace it with deterministic models of prices, wages, even share prices, so that the math looked like the math in rocket science. The rocket's course can be modeled while a living modern economy's course cannot be modeled to such an extreme. It yields up a formula for expectations that looks scientific because it has all our incomplete and not altogether correct understanding of how economies work inside of it, but it cannot have the incorrect and incomplete understanding of economies that the speculators and would-be innovators have.

Q: One of the issues I have with rational expectations is the assumption that we have perfect information, that there is no cost in acquiring that information. Yet the economics profession, including Federal Reserve policy makers, appears to have been hijacked by Robert Lucas.

A: You're right that people are grossly uninformed,, which is a far cry from what the rational expectations models suppose. Why are they misinformed? I think they don't pay much attention to the vast information out there because they wouldn't know what to do what to do with it if they had it. The fundamental fallacy on which rational expectations models are based is that everyone knows how to process the information they receive according to the one and only right theory of the world. The problem is that we don't have a "right" model that could be certified as such by the National Academy of Sciences. And as long as we operate in a modern economy, there can never be such a model.

Q: Do you get a lot of push-back from the economics profession on your views?

A: I am far from being the only economist who has critiqued the premise of rational expectations. I'm just the main victim, since that approach drove people away from my approach -– from my emphasis that expectations are a driver of what happens in modern economies. Several economists saw that the emperor has no clothes. Oskar Morgenstern explained that rational expectations would be untenable in the modern world, and Friedrich Hayek got the point.

Q: I like the fact that the Austrians don't like math.

A: A Danish economist complained about it in the 1940s. Axel Leijonhufvud attacked it. Roman Frydman has made his career uncovering the impossibility of rational expectations in several contexts. He explained that if the data are always bouncing around because expectations are bouncing around, we can't use the data to calculate the right expectations. I have an image in my mind of a dog chasing its tail.

Q: In the world envisioned by rational expectations, there would be no hyperinflation, no panics, no asset bubbles? Is that right?

A: When I was getting into economics in the 1950s, we understood there could be times when a craze would drive stock prices very high. Or the reverse: An economy in the grip of weak business confidence, weak investment, would lead to loss of jobs in the capital-goods sector. But now that way of thinking is regarded by the rational expectations advocates as unscientific.

By the early 2000s, Chicago and MIT were saying we've licked inflation and put an end to unhealthy fluctuations –- only the healthy "vibrations" in rational expectations models remained. Prices are scientifically determined, they said. Expectations are right and therefore can't cause any mischief.

At a celebration in Boston for Paul Samuelson in 2004 or so, I had to listen to Ben Bernanke and Oliver Blanchard, now chief economist at the IMF, crowing that they had conquered the business cycle of old by introducing predictability in monetary policy making, which made it possible for the public to stop generating baseless swings in their expectations and adopt rational expectations. My work on how wage expectations could depress employment and how asset price expectations could cause an asset boom and bust had been disqualified and had to be cleansed for use in the rational expectations models.

Q: And how has that worked out?

A: Not well! The rational expectations treatment of inflation did not perform well in predicting inflation. In the 1990s, we had a boom with none of the inflation that was predicted. In 2004-2006 there was another boom without much inflation.

Q: Let's look at the rational expectations hypothesis in the context of Fed policy. The Fed has been confident it can prevent long rates from rising by, first, laying out a timeline and, more recently, setting thresholds for unemployment and inflation as a prerequisite for raising short rates. What if they're wrong? Will the bond market "behave" during a growth or inflation scare?

A: The bond market would be right to have very little confidence that the Fed has the right model. It's only a small exaggeration to say the Fed doesn't have any important structural forces in its model. It's just guessing about the new normal (for the unemployment rate). It seems to me that they don't even want to think about it.

Q: Do you have a message for policy makers?

A: I would tell them not to assume they have hit upon a model that captures expectations so they don't need to think about expectations anymore. Expectations are a living thing and flighty; beliefs are flimsy, as Keynes said. The Fed is banking that expectations will behave according to the model the Fed wants people to adopt. But no central bank or anyone else should bank heavily on the correctness of its model. Expectations will almost certainly surprise the Fed and surprise Wall Street, too. Furthermore, the Fed model doesn't allow for animal spirits in Silicon Valley or evil spirits on Wall Street. It can't know about those things. Washington is banking on a best-case scenario to bail it out of the entitlements mess in the 2020s. The world is still in a crisis. Not a hospitable place for models based on rational expectations.

(Caroline Baum is a Bloomberg View columnist. Follow her on Twitter.)

[Apr 28, 2012] On Equilibrium, Disequilibrium, and Rational Expectations

April 27, 2012 | Economist's View

Rajiv Sethi continues a recent discussion on macroeconomic models:

On Equilibrium, Disequilibrium, and Rational Expectations, by Rajiv Sethi: There's been some animated discussion recently on equilibrium analysis in economics, starting with a provocative post by Noah Smith, vigorous responses by Roger Farmer and JW Mason, and some very lively comment threads (see especially the smart and accurate points made by Keshav on the latter posts). This is a topic that is of particular interest to me, and the debate gives me a welcome opportunity to resume blogging after an unusually lengthy pause.

As Farmer's post makes clear, equilibrium in an intertemporal model requires not only that individuals make plans that are optimal conditional on their beliefs about the future, but also that these plans are themselves mutually consistent. The subjective probability distributions on the basis of which individuals make decisions are presumed to coincide with the objective distribution to which these decisions collectively give rise. This assumption is somewhat obscured by the representative agent construct, which gives macroeconomics the appearance of a decision-theoretic exercise. But the assumption is there nonetheless, hidden in plain sight as it were. Large scale asset revaluations and financial crises, from this perspective, arise only in response to exogenous shocks and not because many individuals come to realize that they have made plans that cannot possibly all be implemented.

Farmer points out, quite correctly, that rational expectations models with multiple equilibrium paths are capable of explaining a much broader range of phenomena than those possessed of a unique equilibrium. His own work demonstrates the truth of this claim: he has managed to develop models of crisis and depression without deviating from the methodology of rational expectations. The equilibrium approach, used flexibly with allowances for indeterminacy of equilibrium paths, is more versatile than many critics imagine.

Nevertheless, there are many routine economic transactions that cannot be reconciled with the hypothesis that individual plans are mutually consistent. For instance, it is commonly argued that hedging by one party usually requires speculation by another, since mutually offsetting exposures are rare. But speculation by one party does not require hedging by another, and an enormous amount of trading activity in markets for currencies, commodities, stock options and credit derivatives involves speculation by both parties to each contract. The same applies on a smaller scale to positions taken in prediction markets such as Intrade. In such transactions, both parties are trading based on a price view, and these views are inconsistent by definition. If one party is buying low planning to sell high, their counterparty is doing just the opposite. At most one of the parties can have subjective beliefs that are consistent with with the objective probability distribution to which their actions (combined with the actions of others) gives rise.

If it were not for fundamental belief heterogeneity of this kind, there could be no speculation. This is a consequence of Aumann's agreement theorem, which states that while individuals with different information can disagree, they cannot agree to disagree as long as their beliefs are derived from a common prior. That is, they cannot persist in disagreeing if their posterior beliefs are themselves common knowledge. The intuition for this is quite straightforward: your willingness to trade with me at current prices reveals that you have different information, which should cause me to revise my beliefs and alter my price view, and should cause you to do the same. Our willingness to transact with each other causes us both to shrink from the transaction if our beliefs are derived from a common prior.

Hence accounting for speculation requires that one depart, at a minimum, from the common prior assumption. But allowing for heterogeneous priors immediately implies mutual inconsistency of individual plans, and there can be no identification of subjective with objective probability distributions.

The development of models that allow for departures from equilibrium expectations is now an active area of research. A conference at Columbia last year (with Farmer in attendance) was devoted entirely to this issue, and Mike Woodford's reply to John Kay on the INET blog is quite explicit about the need for movement in this direction:

The macroeconomics of the future... will have to go beyond conventional late-twentieth-century methodology... by making the formation and revision of expectations an object of analysis in its own right, rather than treating this as something that should already be uniquely determined once the other elements of an economic model (specifications of preferences, technology, market structure, and government policies) have been settled.

There is a growing literature on heterogeneous priors that I think could serve as a starting point for the development of such an alternative. However, it is not enough to simply allow for belief heterogeneity; one must also confront the question of how the distribution of (mutually inconsistent) beliefs changes over time. To a first approximation, I would argue that the belief distribution evolves based on differential profitability: successful beliefs proliferate, regardless of whether those holding them were broadly correct or just extremely fortunate. This has to be combined with the possibility that some individuals will invest considerable time and effort and bear significant risk to profit from large mismatches between the existing belief distribution and the objective distribution to which it gives rise. Such contrarian actions may be spectacular successes or miserable failures, but must be accounted for in any theory of expectations that is rich enough to be worthy of the name.

John M

Farmer: "A ball rolling down an inclined plane is an example of a physical system in disequilibrium. When it reaches the bottom of the plane, friction ensures that the ball will come to rest. That is an equilibrium. But it is not what we mean by an equilibrium in economics."

I speak as a physics instructor, and I have certain ideas about equilibrium. The physics example above is one example. In chemical equilibrium, a reaction proceeds at equal rates in both directions so the overall numbers of molecules remain constant in time. Static equilibrium has something stationary -- total force and total torque are both zero.

Energy on the earth's surface and atmosphere cycles around, and is on average [i]almost[/i] in dynamic equilibrium -- incoming energy equals outgoing energy on the average, but in the midst of large cycles.

My notion of equilibrium: overall quantities remain constant in time. These include examples of unstable equilibrium, where even a tiny change causes it to fall away.

I couldn't follow the paragraph following the one I cited, but if equilibrium in economics means something different from physical and chemical equilibrium, are we hopelessly confusing ourselves by speaking a different language?

Roger Farmer:

John M: "are we hopelessly confusing ourselves by speaking a different language?"

Perhaps. We use a similar notion to the one you use to describe chemical equilibrium in search theories of the labor market. 10% of the labor force lose a job in a month but an equal number of new entrants find a job. The unemployment remains constant over time. We would refer to that as an equilibrium.

But a different notion of equilibrium has also crept into economic discourse. Two firms each make a plan to set the price of their products over a the next six months. Each firm sets a different price every month. The price sequence chosen by firm A is chosen optimally given the price sequence chosen by firm B, and vice versa. We say that the plan of firm A is a best response to the plan of firm B if neither firm can increase its profits by choosing a different sequence of actions. Together, the plans constitute a Nash Equilibrium, named after the mathematician John Nash.

John M said in reply to Roger Farmer...

It's been over a decade since I studied anything resembling game theory, but I do recall something (a non-economic game) with the result equivalent to this:

Firm A chooses Plan 1. Firm B's optimal response is Plan 2. But A's optimal response to Plan 2 is Plan 3. Then B's optimal response to Plan 3 is Plan 4. Then A's optimal response to Plan 4 is back to Plan 1. In other words, the trajectory of plans is a never-ending square cycle.

I also recall (again, it's vague) that Nash Equilibrium only occurs if both firms use random combinations (with certain probabilities) of their two plans. Of course, such a random combination itself would be considered a plan.

I would find it bizarre if the sequence of bubble-collapse-recovery-bubble-collapse-recovery etc. would be considered an equilibrium situation, when in fact it's chaotic.

Herman said...

On the notions of equilibria in economics and their strengths and limitations this might be relevant:

"The Virtues and Vices of Equilibrium, and the Future of Financial Economics"
J. Doyne Farmer and John Geanakoplos (2008)

"The use of equilibrium models in economics springs from the desire for parsimonious models of economic phenomena that take human reasoning into account. This approach has been the cornerstone of modern economic theory. We explain why this is so, extolling the virtues of equilibrium theory; then we present a critique and describe why this approach is inherently limited, and why economics needs to move in new directions if it is to continue to make progress. We stress that this shouldn't be a question of dogma, and should be resolved empirically. There are situations where equilibrium models provide useful predictions and there are situations where they can never provide useful predictions. There are also many situations where the jury is still out, i.e., where so far they fail to provide a good description of the world, but where proper extensions might change this. Our goal is to convince the skeptics that equilibrium models can be useful, but also to make traditional economists more aware of the limitations of equilibrium models. We sketch some alternative approaches and discuss why they should play an important role in future research in economics. "

"This article is the outcome of an eight year conversation between an economist and a physicist. Both of us have been involved in developing trading strategies for hedge funds, giving us a deep appreciation of the difference between theories that are empirically useful and those that are merely aesthetically pleasing. Our hedge funds use completely different strategies. The strategy the economist developed uses equilibrium methods with behavioral modifications to trade mortgage-backed securities; the strategy the physicist developed uses time-series methods based on historical patterns to trade stocks, an approach that is in some sense the antithesis of the equilibrium method. Both strategies have been highly successful. We initially came at the concept of equilibrium from very different points of view, one very supportive and the other very skeptical. We have had many arguments over the last eight years. Surprisingly, we have more or less come to agree on the advantages and disadvantages of the equilibrium approach and the need to go beyond it. The view presented here is the result of this dialogue."

[May 10, 2010] Friction a non Socratic dialogue by Robert Waldmann

May 9, 2010 | Angry Bear

John Q. Policymaker is driving a minivan. Maynard Keynes is in the passenger seat, Ed Prescott and Robert Lucas are in the second row of seats and Eugene Fama and John Cochrane are in the back seats.

John Q: We are heading for a cliff -- Maynard: slam on the brakes.

Prescott: I don't see how brakes work. Alan Greenspan has had fewer traffic accidents, since he stopped using brakes. I know some people still teach about friction in third rate departments, but they aren't really advancing the science. You'll go just as fast whether you slam on the brake or not. In modern bicycle theory it is assumed that there is no friction so the concept of "braking" is meaningless.

Maynard: Don't listen to him. Slam on the brake pedal. We're all about to die.

John C: Yes this is a stressful situation and in stressful situations it is tempting to turn to the fairy tales of our childhood.

Maynard: It's not a fairy tale. It's a brake. It's worked before.

John C and Eugene in unison: Brakes are supposed to work because the disk spins under the brake shoes. If the disk is spinning we are going forward. Therefore brakes can't slow us down. There is a logical contradiction between saying we should brake and that we shouldn't keep going forward.

John Q: You guys in the back seats, don't just tell me Maynard is wrong. Tell me what to do to avoid going over the cliff.

Robert L: Serious analysis is a difficult process and requires a step by step approach, starting with simple frictionless models. We expect to have a useful model in roughly thirty years.

The Meaning Of A Word Is Its Use In The Language

The economy is never in equilibrium, or so many heterodox economists say. Being a Joan Robinson fan, I'm likely to agree. To understand the implications of the idea, and the use and abuse of equilibrium analysis, one must understand what economists mean by "equilibrium".

Tyler Cowen and Richard Fink provide an example of abuse, that is, a confusion about the implications of the economy not being in equilibrium. In the following passage, Cowen and Fink explicitly put aside income effects, false prices, strategic behavior, etc.:

"all that the Rothbard-Mises analysis implies is that there is a tendency towards equilibrium in a world with frozen data. Of course, this implies little or nothing about whether there is a tendency towards equilibrium in a world where the data are not frozen. All that [Evenly Rotating Economy] theorists are saying is that, if we freeze the disequilibrating forces, then the equilibrating forces will prevail. But on this basis we may likewise assert a tendency towards disequilibrium. By allowing the data to change just as it does in the real world, and 'freezing' all individual learning, we can demonstrate that the economy would degenerate into a series of successively less-coordinated states of disequilibrium. However, this would clearly be an illegitimate proof of a real world tendency towards disequilibrium..." -- Tyler Cowen and Richard Fink, "Inconsistent Equilibrium Constructs: The Evenly Rotating Economy of Mises and Rothbard", m V. 75, N. 4 (Sep. 1985): 866-869
(Hat tip to Matthew Mueller.) If there were a tendency, with frozen data, towards a ERE, the time path of the ERE corresponding to the data at each moment of time would show the tendency of the economy as a function of time. This is not the only point at which Cowen and Fink are confused.

What economists mean by equilibrium is not a simple question. Economists use the word "equilibrium" in many ways. The number of such ways has proliferated with the development of game theory. In this post, I compare and contrast only two uses of the word "equilibrium". And I think I don't fully explicate even these two uses.

The economy can be said to be in equilibrium when the following two conditions are met:

This definition is specific to a particular neoclassical theory (or model).

Another definition comes out of the mathematical abstraction of a dynamical system. A dynamical system specifies how state variables change at any moment of time as a function of the location in state space. For example, a system of differential equations can define a dynamical system:

dx(t)/dt = f(x(t))
A limit point is a location, x, in the state space such that that location does not change with respect to time as function of the system dynamics. In other words, f(x) is zero at a limit point. Certain loci, other than the set of limit points, are of interest in dynamical systems. I am thinking specifically of limit cycles, strange attractors, and non-wandering sets. Consider a model of the economy as a dynamical system. The economy is in equilibrium, by a dynamical systems definition, when it is at a limit point.

The definition of equilibrium as equating supply and demand can be read as a special case of the definition of equilibrium as a limit point in a dynamical system. The tâtonnement process is a model of a type of dynamical system. Equilibrium, in the sense of a limit point in this system, is equilibrium in the sense of no excess demand for goods.

But Keynes can be read as suggesting the dynamical system definition of equilibrium need not equate supply and demand, particularly in the labor market. That is, Keynes' view of the possibility of the existence of an equilibrium with unemployment is more general and points to a non-neoclassical theory of prices.

[Sep 1, 2009] More On Economic Reasoning

August 11, 2009 | Thoughts On Economics
All ten of the letters in the 8-14 August issue of The Economist are responses to the critique of academic economics in the 18-24 July issue. My favorite is from Meghnad Desai:
"SIR - When I was a student we studied business cycles, but the topic disappeared with the rise of mathematical equilibrium theorising. The idea that capitalism is an equilibrium system is common among Keynesian and neoclassical economists; they only differ as to whether the equilibrium is at full employment or under employment. The grand synthesis being taught makes the equilibrium stochastic and dynamic, but that is all.

Capitalism is, however, a disequilibrium dynamic stochastic system as Marx, Wicksell, Schumpeter and Hayek have told us over the past two centuries. Richard Goodwin tried his best to present a mathematical theory of such a disequilibrium system. After the crisis we need to revive that tradition if we are not to be surprised by another crisis."

The on-line Lucas Roundtable at The Economist doesn't have any invited contributions from left-leaning non-mainstream economists.

[Aug 4, 2009] Markets can be wrong and the price is not always right By Richard Thaler

August 4, 2009 |

I recently had the pleasure of reading Justin Fox's new book The Myth of the Rational Market . It offers an engaging history of the research that has come to be called the "efficient market hypothesis". It is similar in style to the classic by the late Peter Bernstein, Against the Gods. All the quotes in this column are taken from it. The book was mostly written before the financial crisis . However, it is natural to ask if the experiences over the last year should change our view of the EMH.

It helps to start with a quick review of rational finance. Modern finance began in the 1950s when many of the great economists of the second half of the 20th century began their careers. The previous generation of economists, such as John Maynard Keynes, were less formal in their writing and less tied to rationality as their underlying tool. This is no accident. As economics began to stress mathematical models, economists found that the simplest models to solve were those that assumed everyone in the economy was rational. This is similar to doing physics without bothering with the messy bits caused by friction. Modern finance followed this trend.

From the starting point of rational investors came the idea of the efficient market hypothesis, a theory first elucidated by my colleague and golfing buddy Gene Fama. The EMH has two components that I call "The Price is Right" and "No Free Lunch". The price is right principle says asset prices will, to use Mr Fama's words "fully reflect" available information, and thus "provide accurate signals for resource allocation". The no free lunch principle is that market prices are impossible to predict and so it is hard for any investor to beat the market after taking risk into account.

For many years the EMH was "taken as a fact of life" by economists, as Michael Jensen, a Harvard professor, put it, but the evidence for the price is right component was always hard to assess. Some economists took the fact that prices were unpredictable to infer that prices were in fact "right". However, as early as 1984 Robert Shiller, the economist, correctly and boldly called this "one of the most remarkable errors in the history of economic thought". The reason this is an error is that prices can be unpredictable and still wrong; the difference between the random walk fluctuations of correct asset prices and the unpredictable wanderings of a drunk are not discernable.

Tests of this component of EMH are made difficult by what Mr Fama calls the "joint hypothesis problem". Simply put, it is hard to reject the claim that prices are right unless you have a theory of how prices are supposed to behave. However, the joint hypothesis problem can be avoided in a few special cases. For example, stock market observers – as early as Benjamin Graham in the 1930s – noted the odd fact that the prices of closed-end mutual funds (whose funds are traded on stock exchanges rather than redeemed for cash) are often different from the value of the shares they own. This violates the basic building block of finance – the law of one price – and does not depend on any pricing model. During the technology bubble other violations of this law were observed. When 3Com, the technology company, spun off its Palm unit, only 5 per cent of the Palm shares were sold; the rest went to 3Com shareholders. Each shareholder got 1.5 shares of Palm. It does not take an economist to see that in a rational world the price of 3Com would have to be greater than 1.5 times the share of Palm, but for months this simple bit of arithmetic was violated. The stock market put a negative value on the shares of 3Com, less its interest in Palm. Really.

Compared to the price is right component, the no free lunch aspect of the EMH has fared better. Mr Jensen's doctoral thesis published in 1968 set the right tone when he found that, as a group, mutual fund managers could not outperform the market. There have been dozens of studies since then, but the basic conclusion is the same. Although there are some anomalies, the market seems hard to beat. That does not prevent people from trying. For years people predicted fees paid to money managers would fall as investors switched to index funds or cheaper passive strategies, but instead assets were directed to hedge funds that charge very high fees.

Now, a year into the crisis, where has it left the advocates of the EMH? First, some good news. If anything, our respect for the no free lunch component should have risen. The reason is related to the joint hypothesis problem. Many investment strategies that seemed to be beating the market were not doing so once the true measure of risk was considered. Even Alan Greenspan, the former Federal Reserve chairman, has admitted that investors were fooled about the risks of mortgage-backed securities.

The bad news for EMH lovers is that the price is right component is in more trouble than ever. Fischer Black (of Black-Scholes fame) once defined a market as efficient if its prices were "within a factor of two of value" and he opined that by this (rather loose) definition "almost all markets are efficient almost all the time". Sadly Black died in 1996 but had he lived to see the technology bubble and the bubbles in housing and mortgages he might have amended his standard to a factor of three. Of course, no one can prove that any of these markets were bubbles. But the price of real estate in places such as Phoenix and Las Vegas seemed like bubbles at the time. This does not mean it was possible to make money from this insight. Lunches are still not free. Shorting internet stocks or Las Vegas real estate two years before the peak was a good recipe for bankruptcy, and no one has yet found a way to predict the end of a bubble.

What lessons should we draw from this? On the free lunch component there are two. The first is that many investments have risks that are more correlated than they appear. The second is that high returns based on high leverage may be a mirage. One would think rational investors would have learnt this from the fall of Long Term Capital Management, when both problems were evident, but the lure of seemingly high returns is hard to resist. On the price is right, if we include the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and, in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be "right", then these bubbles would not occur. But they have, so what are we to do?

While imperfect, financial markets are still the best way to allocate capital. Even so, knowing that prices can be wrong suggests that governments could usefully adopt automatic stabilising activity, such as linking the down-payment for mortgages to a measure of real estate frothiness or ensuring that bank reserve requirements are set dynamically according to market conditions. After all, the market price is not always right.

The writer is a professor of economics and behavioural science at the University of Chicago Booth School of Business and the co-author of Nudge

[Jul 26, 2009] - Comment - Opinion - Economics is in crisis it is time for a profound revamp

We need a new science of macroeconomics. A science that starts from the assumption that individuals have severe cognitive limitations; that they do not understand much about the complexities of the world in which they live. This lack of understanding creates biased beliefs and collective movements of euphoria when agents underestimate risk, followed by collective depression in which perceptions of risk are dramatically increased. These collective movements turn uncorrelated risks into highly correlated ones. What Keynes called "animal spirits" are fundamental forces driving macroeconomic fluctuations.

The basic error of modern macro-economics is the belief that the economy is simply the sum of microeconomic decisions of rational agents. But the economy is more than that. The interactions of these decisions create collective movements that are not visible at the micro level.

It will remain difficult to model these collective movements. There is much resistance. Too many macro-economists are attached to their models because they want to live in the comfort of what they understand – the behaviour of rational and superbly informed individuals.

To paraphrase Isaac Newton, macroeconomists can calculate the motions of a lonely rational agent but not the madness of the crowds. Yet if macroeconomics wants to become relevant again, its practitioners will have to start calculating this madness. It is going to be difficult, but that is no excuse not to try.

The End of Rational Expectations Economics - by Dan Ariely

The End of Rational Economics

Your company has been operating on the premise that people-customers, employees, managers-make logical decisions. It's time to abandon that assumption.

In 2008, a massive earthquake reduced the financial world to rubble. Standing in the smoke and ash, Alan Greenspan, the former chairman of the U.S. Federal Reserve once hailed as "the greatest banker who ever lived," confessed to Congress that he was "shocked" that the markets did not operate according to his lifelong expectations. He had "made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders."

We are now paying a terrible price for our unblinking faith in the power of the invisible hand. We're painfully blinking awake to the falsity of standard economic theory-that human beings are capable of always making rational decisions and that markets and institutions, in the aggregate, are healthily self-regulating. If assumptions about the way things are supposed to work have failed us in the hyperrational world of Wall Street, what damage have they done in other institutions and organizations that are also made up of fallible, less-than-logical people? And where do corporate managers, schooled in rational assumptions but who run messy, often unpredictable businesses, go from here?

We are finally beginning to understand that irrationality is the real invisible hand that drives human decision making. It's been a painful lesson, but the silver lining may be that companies now see how important it is to safeguard against bad assumptions. Armed with the knowledge that human beings are motivated by cognitive biases of which they are largely unaware (a true invisible hand if there ever was one), businesses can start to better defend against foolishness and waste.

The emerging field of behavioral economics offers a radically different view of how people and organizations operate. In this article I will examine a small set of long-held business assumptions through a behavioral economics lens. In doing so I hope to show not only that companies can do a better job of making their products and services more effective, their customers happier, and their employees more productive but that they can also avoid catastrophic mistakes.

Behavioral Economics 101

Drawing on aspects of both psychology and economics, the operating assumption of behavioral economics is that cognitive biases often prevent people from making rational decisions, despite their best efforts. (If humans were comic book characters, we'd be more closely related to Homer Simpson than to Superman.) Behavioral economics eschews the broad tenets of standard economics, long taught as guiding principles in business schools, and examines the real decisions people make-how much to spend on a cup of coffee, whether or not to save for retirement, deciding whether to cheat and by how much, whether to make healthy choices in diet or sex, and so on. For example, in one study where people were offered a choice of a fancy Lindt truffle for 15 cents and a Hershey's kiss for a penny, a large majority (73%) chose the truffle. But when we offered the same chocolates for one penny less each-the truffle for 14 cents and the kiss for nothing-only 31% of participants selected it. The word "free," we discovered, is an immensely strong lure, one that can even turn us away from a better deal and toward the "free" one.

For the past few decades, behavioral economics has been largely considered a fringe discipline-a somewhat estranged little cousin of standard economics. Though practitioners of traditional economics reluctantly admitted that people may behave irrationally from time to time, they have tended to stick to their theoretical guns. They have argued that experiments conducted by behavioral economists and psychologists, albeit interesting, do not undercut rational models because they are carried out under controlled conditions and without the most important regulator of rational behavior: the large, competitive environment of the market. Then, in October 2008, Greenspan made his confession. Belief in the ultimate rationality of humans, organizations, and markets crumbled, and the attendant dangers to business and public policy were fully exposed.

Unlike the FDA, for example, which forces medical practitioners and pharmaceutical companies to test their assumptions before sending treatments into the marketplace, no entity requires business (and also the public sector) to get at the truth of things. Accordingly, it's up to firms to begin investigating basic beliefs about customers, employees, operations, and policies. When organizations acknowledge and anticipate irrational behavior, they can learn to offset it and avoid damaging results. Let's take a closer look at a few examples.

The Dark Side of Teamwork

A few years ago, my colleagues and I found that most individuals, operating on their own and given the opportunity, will cheat-but just a little bit, all the while indulging in rationalization that allows them to live with themselves. (See "How Honest People Cheat," HBR, February 2008.) We also found that the simple act of asking people to think of their ethical foundations-say, the Ten Commandments-or their own moral code before they had the opportunity to cheat eliminated the dishonesty.

Why Both Bulls and Bears Can Act So Bird-Brained By JONATHAN FUERBRINGER

March 30, 1997 | The New York Times

MARKETS must be rational: most distinguished economists have bet their careers on that.

Still, your gut may be telling you something quite different -- that investors can be just plain irrational.

You are not alone.

To measure just how quirky investors can be, some insurgent economists are going beyond mathematical equations and computer models and are engaging in some unusual behavior of their own. They are joining psychologists in observing how laboratory humans perform in all sorts of experiments. They have watched normally rational citizens flip coins to test their inclination to gamble. They are consulting old studies of pigeons to learn how people can deceive themselves.

And they are asking: Why do investors do things that are so obviously foolish? Why do they see patterns where there are none? Why do they behave with such overconfidence when common sense says they should behave otherwise?

The answers, these economists believe, can be crucial to understanding the stock market at a time when the chairman of the Federal Reserve shakes the financial world with the frightening words ''irrational exuberance.''

The occasional irrational binges of investors, they argue, have helped explain why the traditional theory of market performance periodically misfires, although last Thursday's 140-point drop in the Dow Jones industrial average may be no more than a rational response to the Fed's increase in interest rates.

More practically, individual investors and money managers can benefit enormously by recognizing their irrational alter egos: the otherwise sensible investor who is prone to excessive, costly trading; who ignores history and is lured by the market action of the moment; who can't stand to take losses but ultimately is humbled into suffering yet bigger losses; whose worst fear is investor's remorse.

''If you know there are fairly consistent patterns of behavior bias and can go against those patterns, you can make money,'' said Susan Belden, the co-editor of the No-Load Fund Analyst, a money-management newsletter based near San Francisco.

Value investing, the investing style most dependent on behavioral quirks, has done this for a long time, capitalizing on the tendency of people to overreact to bad news and to react slowly to good news. This gives the investor a chance to profit by buying stocks sold off by the herd.

''Fundamentally, this approach tells us that human behavior matters in markets just like everywhere else,'' said Richard H. Thaler, a professor of economics at the University of Chicago and a leader in the field of behavioral economics.

N. Gregory Mankiw, a more traditional professor of economics at Harvard and the author of a new introductory economics textbook, agrees.

''Maybe to fully understand market behavior we have to introduce some form of irrationality,'' he acknowledged. The behaviorists have ''opened my eyes to alternative ways of thinking.''

Financial behaviorists, who are being heeded as never before, are building on years of research by psychologists and others with no economic axes to grind, adding their own experiments and new conclusions. But their interpretations of behavior and how it applies to financial markets are less precise than the equations and computer models of traditional economists.


The traditional theory of markets holds that investors are rational and that markets are efficient, quickly reflecting new information and the decisions of millions of investors.

Based on this view, investors should hold stocks for the long term, unless new information dictates a change. After all, history tells us that investing for the long run is the surest route to profit, and that with information disseminated so quickly and then promptly reflected in stock prices, we cannot act fast enough to outperform the market.

Still, investors can exhibit persistent and potentially harmful symptoms of overconfidence, unshaken in their convictions that they can beat the market. Both professional and amateur investors continue to trade actively, suffering needless losses and costing themselves a bundle in commissions.

And professional money managers are thriving because of investors' enduring hopes that the stock pickers ultimately will excel.

This mentality has been tested in surveys of car drivers. Asked if they consider themselves above-average drivers, most people say yes, leaving wide open the question of who all the below-average drivers are.

''One of the hardest things to imagine is that you are not smarter than average,'' said Daniel Kahneman, a professor of psychology and public affairs at Princeton University.

Professor Thaler and Robert J. Shiller, an economics professor at Yale, note that individual investors and money managers persist in their beliefs that they are endowed with more and better information than others, and that they can profit by picking stocks.

Sobering experience can help those who delude themselves. But not always. That people ''do not learn to correct most of their tendencies to overconfidence is apparently just one of the limitations of the human mind,'' Professor Shiller wrote in an article available on the World Wide Web.

Overconfident investors, behaviorists say, also affect the market as a whole. Consider the huge trading volume in stocks. Much of it, some economists believe, can be traced to the behavioral quirks of investors.

High volume is ''the single most embarrassing fact for an efficient market,'' Professor Thaler said. ''People are supposed to be buying and holding.''

Terrance Odean, a behavioral economist who will join the faculty of the University of California at Davis in May, found a stunning pace of buying and selling in his study of trading at an unidentified discount brokerage firm from 1987 to 1993. Examining 10,000 accounts, Mr. Odean found that individual investors had an average annual turnover rate of 78 percent in the securities they owned.

By his calculations, the stocks that they sold outperformed the ones they bought by about three percentage points, before commissions, in the year after the sale. Such a missed opportunity is the price that investors pay for overconfidence about their own investment prowess.

Could overconfidence also foster the ''irrational exuberance'' over stocks that has worried the chairman of the Federal Reserve? Professor Kahneman thinks so. Investors may think they can continue doing well in the market despite warnings from many analysts that stocks are overvalued.

''Optimism has a lot to do with what is going on,'' he said. ''Many more than 50 percent of the people in the market think they are better than average at picking stocks and picking trends, and that contributes to irrational exuberance.''

The Fear of Losses

If stocks are likely to produce a much higher return than bonds over the long run, why do investors still buy bonds?

Because, the behaviorists say, the pain of a small loss is greater than the thrill of a big gain. In addition, it seems that investors become even more averse to losses through apparently irrelevant actions, like frequently checking the value of their portfolios.

As Peter L. Bernstein observed in ''Against the Gods,'' his 1996 book about the history of risk-taking, ''Losses will always loom larger than gains.''

Professor Thaler argues that this fear of losses makes investors ignore the opportunity for gains provided by stocks. Staying out of the stock market during the last two years, he says, has probably meant more ''losses,'' in missed opportunities, than the out-of-pocket losses from the 1987 crash.

Another behavior -- avoiding the pain of regret -- helps explain why investors hold on to losers for too long. By not selling, the investor avoids fully facing the fact that he made a bad decision.

Investors also tend to take much more risk to avoid losses than to secure gains. That behavior is demonstrated in an experiment once conducted by Professor Kahneman and the late Amos Tversky, two leading contributors to the psychology behind behavioral finance.

In the experiment, participants were told that there was a rare disease breaking out and that 600 people were expected to die. Two plans were proposed. Under Plan A, 200 people would survive. Under Plan B, there was a 33 percent chance that everyone would be saved and a 67 percent probability that no one would be saved. Seventy-two percent of the people chose the risk-averse Plan A, with the certainty of saving 200 lives.

Then the participants were offered another set of alternatives. Under Plan C, 400 people would die. Under Plan D, there was a 33 percent probability that no one would die and a 67 percent chance that everyone would die.

Plan A and C have the same outcome (200 people survive), as do Plans B and D (a 33 percent chance that all would survive but a 67 percent chance that no one would). But the way the second set of alternatives was phrased highlighted the loss of life -- the certainty that 400 people would die. And in that circumstance, 78 percent chose to gamble on the 33 percent chance that no one would die.

This discomfort with losses may help explain why some investors buy more shares of their losing stocks when prices fall further. They don't want to confront the loss, so they take added risk -- by buying more of the stock -- in an attempt to avoid the loss.

Magical Thinking

According to the behaviorists, investors can suffer from ''magical thinking.'' They make connections between two occurrences when, in fact, there is no link.

In illustrating such self-deception, behaviorists mention an old study of pigeons. In the 1940's, B. F. Skinner, the psychologist, fed starved, caged pigeons small amounts of food at 15-second intervals, regardless of the birds' behavior. The birds began to behave as if the feeding was a response to their behavior at the time.

One pigeon that happened to have been doing turns at feeding time began its turns again at subsequent feeding times. Another pigeon that had been bobbing its head would repeat its behavior at the next feeding time, expecting more food.

''A lot of what goes on in the markets is no more explainable than those pigeons,'' Professor Shiller argued, highlighting the role of behavior in financial markets.

In the article on his Web home page, Professor Shiller suggested that magical thinking might explain why the stock market has tended to fall in recent years on positive news about economic growth.

The news media, he wrote, have frequently attributed that seemingly perverse reaction to expectations that stronger economic growth would force the Federal Reserve to raise interest rates, which would be bad news for stocks. In fact, Professor Shiller concluded, an entirely random series of dips in the stock market after positive economic news might have convinced the media and investors that there was a connection between the events when none existed.

''The whole belief could be the result of a chain of events that was set off by some initial chance movements of the stock market,'' Professor Shiller wrote. ''Because people believe these theories, they may then behave so that the stock price does indeed behave as hypothesized.''

Mental Accounting

How can two individuals make entirely different decisions when their circumstances are essentially the same? Chalk it up to something called mental accounting, which allows individuals to treat similar results or similar options differently, because of different starting points.

In ''Against the Gods,'' Mr. Bernstein cites an experiment in which Professors Kahneman and Tversky asked the participants to imagine they were theatergoers headed to a Broadway show.

One group has $40 tickets. Upon arriving at the box office, however, they discover that they have lost their tickets. Distressed, most of them decide not to spend another $40 for a replacement ticket, and go home.

Another group arrives at the box office, intending to buy tickets. But they discover that $40 is missing from each of their wallets. Like the first theatergoers, they are each $40 poorer. But most of them still buy tickets and attend the show.

Although both groups arrive at the theater short the same amount of money, they haves mentally accounted for it differently.

Mental accounting is a way for people to organize their experiences, Professor Kahneman says. But he adds that ''it certainly can be used for self-deception.'' That means investors do not always respond to events in the expected rational way.

An experiment with coin tosses conducted by Professor Thaler shows how mental accounting can influence an investor's willingness to gamble.

In one case, each person in a group of students was given $30 and told he could walk away with the money. Or, he could take his chances on a coin toss, winning $9 more if the coin came up heads but losing $9 if it turned up tails. Seventy percent took the gamble, knowing that they would end up with at least $21.

Students in another group were offered a seemingly different gamble. They could flip a coin; heads would equal $39 and tails would equal $21. Or, they could just take $30 with no coin toss. Only 43 percent chose the gamble.

A little arithmetic shows that the two outcomes are identical, but the students made different choices. Why? Because, as behaviorists note, it is not just the information that determines behavior, but also how it is processed. That is mental accounting.

Professor Thaler says mental accounting may help explain why the 1987 market crash did not have the negative impact on the economy that many had forecast. Investors, he said, might not have seen it as a troubling actual loss of wealth, but instead viewed it less alarmingly, as the disappearance of a new-found gain. And so, no panic.

The economics establishment has come a long way in understanding behavioral about-faces and unexpected responses. Twenty years ago, when he was a student at Princeton, Professor Mankiw could not have taken an economics course in irrational behavior. None existed. Now it has become respectable for professors at Harvard, Yale and the University of Chicago to pick holes in the traditional view that investors are rational and markets are efficient.

The National Bureau of Economic Research and the John F. Kennedy School of Government at Harvard will hold separate symposiums in April on behavior and its influence on financial markets; the first meeting is for academics, the second for money managers. Last fall, U.S. Trust, a money management firm for wealthy individuals, asked two of the behavioral thinkers, Professors Kahneman and Thaler, to brief its money managers.

And there are even grudging but respectful nods to behaviorists from the high priests of rational market behavior. In his 1996 edition of ''A Random Walk Down Wall Street,'' Burton Malkiel, a Princeton economics professor, noted the words of Yale's Professor Shiller, who has counseled that ''one must look to behavioral considerations and to crowd psychology to explain the actual process of price determination in the stock market.''

Professor Shiller's encounter some months back with Alan Greenspan, the Federal Reserve chairman, has given behaviorists yet another little lift. Professor Shiller and John Campbell, a professor of economics at Harvard, were invited to join three top Wall Street equity strategists for a meeting with Mr. Greenspan last December. Two days after that session, the Fed chairman, in a speech, posed his now-famous question of whether ''irrational exuberance'' had pushed the stock market too high.

Professor Shiller did not provide Mr. Greenspan with his explosive phrase; the chairman had already inserted it into earlier drafts of his speech. But that didn't mean they weren't on the same wavelength. ''I am pretty sure that I used the word 'irrational,' '' Mr. Shiller said, recalling the December meeting. ''But not 'exuberance.' ''

Later, in Congressional testimony in February, Mr. Greenspan pinpointed who might be irrational. ''It is not markets that are irrational -- markets merely reflect the average, the values of people,'' he said. ''It's people who become irrationally exuberant on occasion and take actions that induce what economists like to call bubbles, which eventually burst.''

Despite his choice of language, Mr. Greenspan apparently remains a believer in the essential efficiency and rationality of markets. And why not? Mainstream economic theory has done a workmanlike job in describing how markets function.

And though the traditional economists cannot explain certain anomalies -- the curious detours from the norm that are so intriguing -- the behavioral crowd has yet to come up with an overarching theory to explain how markets function.

Behaviorists ''have pointed out the defects in the existing model but have not come up with a better model,'' Professor Mankiw said.

Nor does the sniping of behaviorists mean that markets over all, and over the long run, are irrational. ''To say that investors are affected by behavioral motivation does not necessarily mean that markets are not efficient,'' said Mr. Odean, once an undergraduate student of Professor Kahneman.

But that does not deny the application to individual investors, who, if they are honest with themselves, know that they do not always behave rationally.

Dr. Michael Apfel, 47, an oral surgeon from Phoenix, acknowledges that he could be viewed as a case study. He freely confesses that behavioral quirks have undermined his investment performance.

A look at his portfolio suggests that he is the quintessential conservative investor. He dutifully balanced his portfolio with stocks, bonds, mutual funds, savings bonds and real estate partnerships. And yet, he said, ''I used to buy and sell quite regularly.'' The cost of trading alone had cut his gains by 25 percent.

He had trouble getting rid of losing stocks, too. ''One doesn't want to admit defeat,'' he said.

Now he trades only with the idea of making changes in his long-term investment posture. And he jettisons losers as part of a tax strategy to offset capital gains.

''You have to be there all the time to do well,'' he said of active trading. ''Or you have to be a long-term investor. Anywhere in between and you are a loser.''

What he has learned is that investors are better off if they know how behavior can trip them up. But millions of other investors have yet to share Mr. Apfel's epiphany. Perhaps if they were fully rational, they would have by now.

Illustrations by Stuart Goldenberg (Pg. 6)


maxreuter wrote:

July 16, 2009 21:18

"ROBERT LUCAS, one of the greatest macroeconomists of his generation ..."

Surely you jest.
A more accurate description would be "successful economist" or perhaps "leading economist" of his generation

Remember, this is the gentleman who claims that there is no such thing as "involuntary unemployment" - that all unemployment is purely voluntary. No doubt he believes that what happened during the Great Depression, and what is going on now is really an epidemic of laziness.

As the article points out:
"...economists missed the origins of the crisis; failed to appreciate its worst symptoms; and cannot now agree about the cure. In other words, economists misread the economy on the way up, misread it on the way down and now mistake the right way out."

To refer to an economist whose theories were in large part responsible for much of the above as 'great' is a somewhat unorthodox use of the word indeed.

Finally a memorable quote from the 'great' Mr Lucas:

...the central problem of depression-prevention has been solved, for all practical purposes..."

- Robert Lucas, Presidential Address to the American Economic Association 2003.

Perhaps we should leave it to history to judge the greatness of Mr Lucas and the usefulness, if any, of his contributions to economics.

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bampbs wrote:

July 16, 2009 18:33

Has anyone ever tried Keynes' Keynesianism ? It seems that only the pump-it-up deficit side has been run, never the tax increases and spending cuts that are supposed to accompany a strong economy, and pay off the debt incurred in stimulating the economy. That, of course, would take political courage. Rather, since 1981, the US has run a strange Keynsian/anti-Keynesian program of tax cuts and increased spending even when the economy is healthy. Does any macroeconomic theory suggest that a government can spend 21% of GDP and collect taxes of 18% forever ?

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alexlondon wrote:

July 16, 2009 17:23

"Unfortunately, they are also horribly divided about what comes next."


Consensus among biologists is a sign of strength (normally), but among historians it would be a weakness (at least in their conclusions about human nature). No one view is complete, and without dissenting/ challenging voices, no new insight is being learnt. Division among economists is a good thing.

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pdavidsonutk wrote:

July 16, 2009 16:14

Keynes noted that "classical theorists resemble Euclidean geometers in a non Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight --as the only remedy for the unfortunate collisions. Yet in truth there is no remedy except to throw over the axiom of parallels to work out a non-Euclidean geometry. SOMETHING SIMIILAR IS REQUIRED IN ECONOMICS TODAY. " [Emphasis added]

As I pointed out in my 2007 book JOHN MAYNARD KEYNES (Mentioned in this ECONOMIST article as a biography "of the master") Keynes threw over three classical axioms: (1) the neutral money axiom (2) the gross substituion axiom, and (3) the ergodic axiom.

The latter is most important for understanding why modern macroeconomics is dwelling in an Euclidean economics world rather than the nonEuclidean economics Keynes set forth.

The Ergodic axiom asserts that the future is merely the statistcal shadow of the past so that if one develops a probability distribution using historical data, the same probability distribution will govern all future events till the end of time!! Thus in this Euclidean economics there is no uncertainty about the future only probabilistic risk that can reduce the future to actuarial certainty! In such a world rational people and firms know (with actuarial certainty) their intertemporal budget constrains and optimize -- so that there can never be an loan defaults, insolvencies, or banrupcies.

Keynes argued that important economic decisions involved nonergodic processes, so that the future could NOT be forecasted on the basis of past statistical probability results -- and therefore certain human institutions had to be develop0ed as part of the law of contracts to permit people to make crucial decisions regarding a future that they "knew" they could not know and still sleep at night. When the future seems very uncertain, then rational people in a nonergodic world would decide not to make any decisions to commit their real resources -- but instead save via liquid assets so they could make decisions another day when the future seemed to them less uncertain.

All this is developed and the policy implications derived in my JOHN MAYNARD KEYNES (2007) book. Furthermore this nonergodic model is applied to the current financial and economic crisis and its solution in my 2009 book THE KEYNES SOLUTION: THE PATH TO GLOBAL PROSPERITY (Palgrave/Macmillan) where I tell the reader what Keynes would have written regarding today's domestic crisis in each nation and its international aspects.

Paul Davidson

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ghaliban wrote:

July 16, 2009 15:34

I think you could have written a shorter article to make your point about the dismal state of economics theory and practice, and saved space to think more imaginatively about ways to reform.

A bit like biology, economics must become econ-ology - a study of real economic systems. It must give up its physics-envy. This on its own will lead its practitioners closer to the truth.

Like biological systems, economic systems are complex, and often exhibit emergent properties that cannot be predicted from the analysis of component parts. The best way to deal with this is (as in biology) to start with the basic organisational unit of analysis - the individual, and then study how the individual makes economic decisions in larger and larger groups (family/community), and how groups take economic decisions within larger and larger forms of economic organisation. From this, econ-ologists should determine whether there are any enduring patterns in how aggregate economic decisions are taken. If there are no easily discernable patterns, and aggregate decisions cannot be predicted from a knowledge of individual decision-making preferences, then the theory must rely (as it does in biology) on computer simulations with the economy replicated in as much detail as possible to limit the scope for modelling error. This path will illuminate the "physiology" of differnet economies.

A second area of development must look into "anatomy" - the connections between actors within the financial system, the connections between economic actors within the real economy, and the connections between the real and financial economies. What are the precise links demand and supply links between these groups, and how does money really flow through the economic system? A finer knowledge of economic anatomy will make it easier to produce better computer simulations of the economy, which will make it a bit easier to study economic physiology.

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Free markets are not rational
By Aetius Romulous

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.

The markets are rational. From that inviolate truth, a pillar of economic thought for 233 years, flows all else economics understands about markets, men, and money - an unalterable belief that markets can be measured, quantified, cut and pasted in mute acceptance that under it all lies the consistent and undeniable force of rational behavior, a religion gone unquestioned.

The theory of rational markets - that buyers and sellers will always act in their best interests - was given life by Adam Smith in his Wealth of Nations in 1776. The new study of economics, born into a moment between ages, grew and developed with its gospel already written and sanctified. Economics became nothing more than competing studies that tried to squeeze the maximum utility out of the blandness of rational, human behavior. The competition reached a turning point at the end of two brutal wars and an economic depression that sent buildings full of newly minted economists running for their slide rules.

The rational behavior of man had succeeded in removing more than 160 million rational men, women, and children of free will from the market, and with the dull precision of 100 million mallets, rationally pummeled the earth to pieces in its own best interest. Regardless, it still came to pass that "rational", as they say, was written by the victors, and so from the smoke and ruin of trial by fire came the forged steel sword of the American Way, embracing its own best interests by clinging to the myth as flag, an inviolate symbol of the good, the bad and the ugly.

Patriotism - an exceptionally irrational behavior - became welded to the economic cause. Free markets are rational. One choice, two options - we are right, or they are wrong. Walking off the battlefields of Europe and into the womb of America at Bretton Woods, no one questioned the unconscious absolute that free markets are rational, blinded as they were by the sheer joy of having lived to tell. And again, the participants of Bretton Woods, having given birth to the World Bank and the International Monetary Fun and who built the world we thrash around in today were doing so in a single moment of time, between two very different ages.

In the years since 1944, we have clung defiantly to our patriotism, our democracies, our guns, and our religion. Empires have fallen, backward societies been saved, and the planet has become a patchwork of nominally free collections of consumers and producers, all herded into crayon borders that even at the time defied common sense. The nation state was king, dividing the earth into sections of untenable, fortified camps.

However, in the latter half of the 20th century, the rational behaviors of heretofore sequestered buyers and sellers left the confines of their nation states and roamed the earth, commerce unfettered from the chains of dogma. Rational became a moving target. Entire populations were making decisions that were in no way in their best interest (Unless you can explain going into debt for water toys and plasma TVs).

The computer and the Internet sped self-interest around the earth, leveraged 32 to 1 by irrationality itself. Growth became the new dogma, and any behavior that helped the cause became rational. In a simpler age, we congratulated ourselves on the self-interest that had kept our irrational need for nuclear weapons from killing us all. Now, on the cusp of a thermal nuclear financial meltdown, we learn for the first time that indeed man, entrusted with the buttons, will without question slide off the safety and push down hard and fast with all he's worth - and everybody else's while he's at it.

In this, our age - standing as we are in a moment of time between the old and the new - man is no longer rational, nor can he be trusted with free markets. Everything we know about economic behavior must be reviewed and rethought ... right back to the root, back to Adam Smith, back to the beginning. Back before nationalism, socialism, capitalism and blind patriotism. Two hundred years is long enough to live a theory that was clearly wrong.

For after all, we live in a new age of individuals now, connected by the Internet, thrust apart and together by technology. Democracy has arrived to the people of the earth, freed of national boundaries by the World Wide Web. Humans are now at odds with economics, and classically trained economists are as relevant as the steam engine. Regression to the mean does not apply to bell curves of one.

There will be a fight to be sure. In America, there is no question but to do what it takes to get everything back to the past as fast as possible. Americans want to reset the machine and keep on playing. The rest of the world - who trusted their blood and treasure with the world's only superpower - feel differently about things. It wasn't them who killed the golden goose, but they were paying for the crime. A new global era was taking shape while Americans dithered over politics, Barack Obama's election being the last America would make without the input of the world.

There is, finally, a growing consensus (outside America) that in a modern age, individuals, groups and states do not seek to maximize their best interests. In fact, it turns out to be quite the opposite. All too often, and in ways that can demolish civilization itself, rational, free-thinking men with a stupendous concentration of power and wealth have acted in direct contradiction of what should have been their best interests - and ours.

Worse it seems, average workaday people in the millions and millions will do exactly the same thing, making free-market choices with their free will that will almost certainly lead to their undoing. Examples are everyday and everywhere, all the time.

Anybody got a smoke?

As he searched his world for data that would reinforce his theory of rational markets and men, Adam Smith could not have been aware of the phenomenon of tobacco, and the leading role it would play in future worlds. Would Adam Smith have written more or less than five large tomes if, a prophet of one, he wrote the bible of the next two centuries with access to the wealth of quantified and verified data that our age has developed about tobacco? How would Adam Smith have squared the absolute certainty of death, misery, and staggering social cost that smoking entails with the two thousand million free-market consumers who choose, with their own free will and in markets unconstrained, to pay good and ever increasing amounts of their own hard labor in exchange for regular doses of certain and conscious death?

How can states with hegemonic commitments to the scripture of rational markets, both encourage, tax and stand out of the way in the name of absolute theoretical freedom, while at the same time ignore the crushing mortality and exponential costs to society as a whole associated with the results of the same? The reason lies in the savage juxtaposition of an ancient, out-of-date philosophy against advances in natural sciences and the increasing ability for individual choice in a mysterious and complex world.

Rational markets could not have foreseen television, movie stars, and marketing, could not have imagined a plethora of endless choice, an antiquated system of competing nation states that would regress towards behaviors that were unsustainable, in free and open competition to profit from the misery and death of their own, democratic citizens.

On what rational scale can a classic economist argue that the consumption of food by wealthy, non-failed nation states is anything but destructive and self-defeating, when that food is poison at the consumption end of a system of free choice and unfettered markets? Far from acting in their best interests, the Western world's diet is killing its host, trading sustainable health, happiness and manageable costs for spectacular profits for a handful of smiling clowns, faux kings, and creepy old Kentucky Colonels.

In the end, maximum utility turns out to be a Frankenstein monster. In the salad days of the American Dream, it appeared certain that the combination of free, unfettered markets driven by rational, self-interested humans had indeed conquered nature. Wedded as they were to a glorious American Democracy, it didn't take a generation before the American Way had swept clean all remnants of any other time. So successful that all it took was life, liberty, and wads of printed cash to overcome the Soviet hulk in spending, bankrupting any chance to notice the failure of fundamental economics, a million miles below the euphoria.

Carried along by a human explosion, a demographic cohort born into a post-world-war world grew up and prospered as the human embodiment of self-interest, free markets and democracy. But somewhere along the line, the point of equilibrium was reached, passed and toppled over. The technology caught up to and passed the philosophy, the going got global, and the global got weird. Once the Excel spreadsheet hit the flickering workstations of the theoretical man, the invisible hand of Adam Smith had been crushed irreparably on the ladder of human folly.

Massive amounts of invisible capital poured across fibre optics, filling computer screens with uncountable digits impossible for coke-addled humans to imagine or fathom. Nothing less than a computer game ensued, using the invisible capital of the imaginary American Dream - leveraged beyond any common sense - in an online team shooter played in a private and expensive forum. All holy hell was unleashed with a few casual mouse clicks over coffee, by a single person seeking to maximize his utility, without a care or thought for what the result might eventually be.

The markets are not rational.
Civilization is only 10,000 years old, modern economics 200, and the great "success" of American capitalism but 60 of that. The next age will be one that recognizes that man must indeed have protection from himself, his foibles, and his technology. Once this economic storm has passed, the wreckage left behind will have been busted back to humility, and man will take his place amongst - and not above - the world around him. Man has built a civilization so complex and over-reaching that it no longer obeys the rules he wrote for it so very long ago. This, if ever there was one, is not a time for dusty books by dusty men, from another age, and another time.

Aetius Romulous is an historian, economist, accountant, writer and blood-sucking CEO born at the wrong end of the baby-boom generation - too late to enjoy the ride, too early to have missed it, and stuck in the middle with the mess.

(Article reprinted with permission of the author. Copyright retained.)

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.

The Death of 'Rational Man'

By David Ignatius Sunday, February 8, 2009; Page B07

What allowed some people to see the financial crash coming while so many others missed its gathering force? I put that question recently to Nouriel Roubini, who has come to be known as "Dr. Doom" because of his insistent warnings starting in 2006 that we were heading into a global firestorm.

Roubini gave two kinds of answers. The first involves standard number-crunching of the sort that economists routinely do -- and that Roubini just did better and sooner. It's his second answer that's more interesting, because it goes to the heart of what we should take away from this crisis: Roubini decided to discard the assumption of market rationality that underlies most economics and to embrace the psychological insights of what's known as "behavioral economics."

First, the standard analytical explanation: Roubini said that he studied a chart in economist Robert J. Shiller's book "Irrational Exuberance." It showed that U.S. housing prices, adjusted for inflation, had remained essentially flat for a century, until the mid-1990s, when they began to shoot up. What's more, Roubini saw that the most recent housing correction in the late 1980s had a severe effect on the financial system -- leading ultimately to the collapse of the savings and loan industry.

So Roubini knew two things: Housing prices wouldn't keep going up forever, and when they went down, they would take a big piece of the financial system with them. From then on, it was a matter of watching the data.

But everyone else had those same numbers. Why did Roubini act? The answer is that he decided to trust his gut, which told him there was trouble ahead, rather than Wall Street's "wisdom of the crowd," which -- as reflected in stock prices -- said everything was rosy. He concluded that the markets were not pricing in the degree of risk that was actually present in housing.

"The rational man theory of economics has not worked," Roubini said last month at a session of the World Economic Forum at Davos. That's why he and other prominent economists are paying more attention to behavioral economics, which starts from the premise that economic decisions, like other aspects of human behavior, are influenced by irrational psychological factors.

The most compelling rebuttal of the rational model, paradoxically, was delivered by the ultimate rationalist, Alan Greenspan. "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders," the former Fed chairman told Congress last October.

That's why Greenspan didn't see it coming, argues Daniel Kahneman, a Princeton professor who is often described as the father of behavioral economics. His rational-actor model wouldn't let him.

Let me put in a plug here for the godfather of behavioral economics, John Maynard Keynes. His 1936 "General Theory" is often interpreted simplistically as a call for fixing recessions by boosting demand with government spending. But at a deeper level, Keynes was analyzing the role of psychological factors, such as greed and fear, in economic decisions. He understood that markets freeze when people panic and start hoarding cash. ("Extreme liquidity preference," he called it.) Conversely, economies start to roar when investors feel a surge of what Keynes called "animal spirits."

One of the most powerful ideas I heard at Davos was the idea of "pre-mortem" analysis, which was first proposed by psychologist Gary Klein and has been taken up by Kahneman.

A pre-mortem analysis can provide a real "stress test" to conventional thinking. Let's say that a company or government agency has decided on a plan of action. But before implementing it, the boss asks people to assume that five years from now, the plan has failed -- and then to write a brief explanation of why it didn't work. This approach stands a chance of bringing to the surface problems that the decision makers had overlooked -- the "black swans," to use former trader Nassim Nicholas Taleb's phrase, that people assumed wouldn't happen in the near future because they hadn't occurred in the recent past.

One more take-away from this year's Davos forum was a Japanese proverb cited by one speaker: "An inch ahead is darkness." Recognizing the inherent unpredictability of economic life -- the darkness that's just ahead -- should make us wary. But it can also make us smart.

The writer is co-host of PostGlobal, an online discussion of international issues. His e-mail address is [email protected].