What is The Rational Expectations Assumption For
No it is not a guide to proper grammar, and I know perfectly well that a preposition isn’t the sort of thing I’m supposed to end a sentence with.
The case for assuming rational expectations rests on two valid arguments.
1) Expectations matter a lot.*
2) If you allow people to assume whatever they want about expectations, then you allow them to explain anything and nothing and predict anything they want (see the Confidence Fairy).
This leads to the conclusion
3) If we want to use models to prediction what will probably happen, we should assume rational expectations.
The logic is not that actual agents actually have rational expectations, but rather that some discipline is needed to keep people from fiddling away until they have fit the past impressing the gullible but obtaining no ability to predict the future. The rational expectations assumption just has to be the least bad well defined rigid assumption.
My problem with this argument is the hypothesis “If we want to use models to prediction what will probably happen”. Back in the bad old days, economists would use one set of (primitive) models for short term forecasting, but not at all assume that the factors they left out (left as disturbance terms) weren’t important. This is still true of many economists.
Some economists, however, clearly think that the models can be used to determine what might happen. Indeed that if something couldn’t happen if the model were reality, then it couldn’t have happened even though it sure seems to have happened.
My view is that, if we have to make simple assumptions about expectations, then the rational expectations assumption is the least bad assumption. But if we don’t have to make such assumptions, as when we are asked if something might happen, we shouldn’t.
One fan of the rational expectations hypothesis is named O.J. Blanchard. He is a leading new Keynesian. He has recently proposed a target inflation rate of 4% not 2%. The logic is that, if we find ourselves in another deep crisis, it is better for central banks to be able to set the safe short term real interest rate to -4% rather than -2%. He doesn’t have a model which predicts that there will be another deep crisis in say 2018. He doesn’t need to. All the argument requires is that we can’t rule out another deep crisis (or put a low upper bound on the probability) and that the cost of getting caught in a liquidity trap dwarfs the added cost of 4% inflation over 2% inflation.
Over at the investment banks (including those who failed) they claim to practice “stress testing” where, even if a model suggests that a trading strategy will give high risk adjusted returns, they try to think about the lower tail — what would happen in the case of extreme events which haven’t occured in their data set but which might occur in the future.
There doesn’t seem to me to be any stress testing of policy rules based on the idea that things might happen which can’t happen in the model and haven’t happened in the data set. I think this is partly a consequence of ignoring the conditions for usefulness of the rational expectations assumption and that it has caused vast suffering.
* On 1) surprisingly many new Keynesians seem prepared to argue that we have advanced beyond Keynes, because we have figured this out. By Keynes they mean the old hydrolic Keynesian models which are very different from anything Keynes wrote. I think I understand what is going on. Krugman has been praising the IS-LM model. They want to debate Krugman. He is busy. So they sometimes treat me as a junior varsity Krugman. This is flattering, but it is not responding to my challenge to find something introduced to macro theory since Keynes which is demonstrably empirically useful. The key point is that Keynes hedged his bets, so it is hard to take him to the cleaners.
I can’t think of a shred of proof culled from my long experience with the human species that supports the view that people are rational even when it comes to something as important as money. So, the word “rational” used in economic theory must mean something different from what it means in experience.
For example, consider austerity as it’s being experienced today. It’s kicking the shuckings out of the European economies which have adopted it. But, here in the US, we’re told we must do likewise because very rich people benefit from it. And, it’s our moral failings that have got us in our current economic mess. Working until we drop dead will do us good and so will doing without sufficient earnings to break even every month. Better lean than fat.
Thus the question, better for whom? The billionaires have nothing to gain one way or another from austerity other than more money. At some point, money is meaningless and accumulating more is a symptom of greed. Greed is not good nor is it rational. So, why should we suffer the pangs of austerity to feed billionaires’ greed? Especially if there’s no evidence at all that the Confidence Fairy exists. The billionaires will get ever richer with or without austerity.Why do their bidding if it we lose even more by it?
So, Robert. You’re smart. What is wrong with these guys? NancyO
Robert: thank you for posting a calm, thoughtful discussion with no political ranting. 🙂
I am in complete agreement. The economics profession ‘lost me at rationality’ It is counter to human nature and history. What we have is tribalism. Susesptability to propaganda. Rampant greed. Compulsive behavior of the sort that causes rats to consume cocaine to the exclusion of food until they die. Mindless behavior akin to the way yeast reproduces until it reaches its upper limit and is all killed off. Rational. Build that assumption into your models and then stand around and wonder why they suck.
“There doesn’t seem to me to be any stress testing of policy rules based on the idea that things might happen which can’t happen in the model and haven’t happened in the data set. I think this is partly a consequence of ignoring the conditions for usefulness of the rational expectations assumption and that it has caused vast suffering.”
I haven’t followed it very closely, but wouldn’t that fit into the robust control theory of Hansen and Sargent? Not that their approach rejects RE, but I was under the impression that it would minimize the uncomfortable aspects. Agents might be rational, but they recognize that the models they are using are approximations that may be far from the truth. But, again, that’s just from the bits and pieces I’ve seen on it.
Sims’s rational inattention is a nice attempt to allow irrationality in a non-ad hoc way. I’m sure there are other approaches (and will be more), I’m just saying that it’s good to see that type of work being done, even if the math does get somewhat intimidating.
“He doesn’t have a model which predicts that there will be another deep crisis in say 2018. He doesn’t need to. All the argument requires is that we can’t rule out another deep crisis (or put a low upper bound on the probability) and that the cost of getting caught in a liquidity trap dwarfs the added cost of 4% inflation over 2% inflation.”
This is just an expected value argument on a random variable that is an indicator function for the probability of a new crisis being less than some cutoff value. This is what drives me nuts with rational expectation naysayers…. even when you think you’re doing something outside the scope of rational assumptions, you’re probably not.
SW
i agree with you, but I expect you and me and Nancy are thinking about something different from what Robert is talking about. That said, I think there is more to hope for from our way than from “intimidating mathematics.” What’s wrong with rational expectations is that people have them. And once they have them they can no longer think about reality.
“rational” means “what i think.” and “logical” means “i like the way that sounds.” or “i can’t imagine anything else. i can’t even imagine that there might be something else.”
now, jh, below, suggests there might be a very sophisticated literature about all of this. but what it has to do with “economics” as a problem faced by real people in real time in the real world is not at all clear.
meanwhile i am much more interested in the question of why grammarians (very logical people) have never solved the problem of ending a sentence with a preposition. i though Winston Churchill had laid it to rest when one of his secretaries corrected one of his letters so as to remove the offending preposition at the end of a sentence. Churchill said,”This is the sort of nonsense up with which I will not put!”
But still the problem does not go away. I think the answer is that the grammarians don’t recognize that they are not dealing with a “preposition” here. I suspect the real linguists already know the answer, but word hasn’t gotten around.
SW
i agree with you, but I expect you and me and Nancy are thinking about something different from what Robert is talking about. That said, I think there is more to hope for from our way than from “intimidating mathematics.” What’s wrong with rational expectations is that people have them. And once they have them they can no longer think about reality.
“rational” means “what i think.” and “logical” means “i like the way that sounds.” or “i can’t imagine anything else. i can’t even imagine that there might be something else.”
now, jh, below, suggests there might be a very sophisticated literature about all of this. but what it has to do with “economics” as a problem faced by real people in real time in the real world is not at all clear.
meanwhile i am much more interested in the question of why grammarians (very logical people) have never solved the problem of ending a sentence with a preposition. i thought Winston Churchill had laid it to rest when one of his secretaries corrected one of his letters so as to remove the offending preposition at the end of a sentence. Churchill said,”This is the sort of nonsense up with which I will not put!”
But still the problem does not go away. I think the answer is that the grammarians don’t recognize that they are not dealing with a “preposition” here. I suspect the real linguists already know the answer, but word hasn’t gotten around.
He said Blanchard was a “fan of the rational expectations hypothesis”, not a “rational expectation naysayer”. It’s a subtle difference, I know.
EMS
not being of the brotherhood, i can’t really claim to understand what you are talking about. but one thing that strikes me about what you seem to be saying is that you pick an “expected value” out of thin air, and then reason to the third decimal place based on it.
it sounds like arguing about how many economists can dance on the head of a pin, while the guy who plays one on television assures us we will all have to eat turnips when we get old because it’s not inflation if you can find a cheap substitute for what you are used to having for dinner.
As to proper grammar and dangling prepositions I can only echo what Winston Churchill (who though a bred in the bone reactionary knew his way around an English sentence) had to say on the subject at hand:
“That is foolishness up with which I will not put”
I am afraid that all too often scratching a grammarian reveals a fascist with an anal retention problem. Languages yield rules (of sorts), rules don’t determine languages. No matter what Chomsky and Generative Linguists might hold.
Keep this going. Keynes probably did cover everything important in macro. You may provoke someone to actually read the GT carefully but I doubt it.
It would be hard for modern macro types to deny that JM Keynes was one of the greatest minds of his (or any) time. Professor at Cambridge, editor of the Economic Journal, and some one who no politician could ignore(Presidents – FDR – and Prime Ministers felt it necessary to correspond with him.) So it is hard to understand why you have to tell macro people to actually read what he said. But so few have. Moreover, they all dismiss his arguments without actually having read what he has to say. Bizarre.
I have read the GT 12 times (teach a history of macro course). Never really understood everything he is talking about so this is not a statement about what Keynes “really meant”. But some things are clear. Expectations were the the heart of the GT and it is bizarre to read economists claiming he missed forward looking behaviour. And you are right in arguing he had thought of most so called modern innovations in macro theory and discussed them in the GT. I ask again: Why havn’t modern macro people read the GT? If even a minority took the 5 months required to get this they would be better macroeconomists and would at least have to abandon their wrong charicature of Keynes. No claim here that Keynes was correct, only that he is worth a read and taking seriously, and that critiques of Keynes are not based on his arguments.
Modern macro: Rational expectations, K, representative individuals, market clearing, just assume away everything he thought important in a general theory of the macroeconomy.
And Keynes takes methodology seriously. He did not argue economics is a predictive science. He argued againt this philosophy.(You are right that endogenizing expections is necessary for falsification). But expectations are central in Keynes and in his method exogenous for the economist. Expectations can change and the economist should think about what might happen as a result. Thinking not predicting is his method. My ideal is a predictive economic science but right now we do not have this and Keynes’s method seems the best we currently have. Models using K, market clearing, RE, rep individuals amount to assuming away all of his ideas. Dismissing based on assumptions is not a good way to advance knowledge. Macro is depressing. Thank goodness I do empirical labour and pub finance.
“1) Expectations matter a lot.*
“2) If you allow people to assume whatever they want about expectations, then you allow them to explain anything and nothing and predict anything they want (see the Confidence Fairy).
“This leads to the conclusion
“3) If we want to use models to prediction what will probably happen, we should assume rational expectations.”
Caveat: One should not assume that expectations, even rational ones, correspond to mathematical expectations. (I don’t know if that is how they are used, but I have my suspicions. ;))
If expectations matter, then you need a theory of expectations. I suppose that the concept of rational expectations is such, but it does not seem to be well developed, nor, from what I have seen of it, does it seem to have much of an empirical basis. Maybe that just reflects my ignorance. {shrug}
In “A Treatise on Probability” Keynes makes a good case that it is not unusual to have situations in which there is nothing definite that might be called a rational expectation, even if it is possible to put bounds on outcomes. The concept is also questionable with n-person games.
The concept of rational expectations has been used to argue that it is rational to think that gov’t deficit spending will be paid back, with interest, by later taxes. While that is certainly plausible, it seems to fail reality testing, which is one of the hallmarks of rationality. Adam Smith pointed out that gov’ts do not pay back their debts. Andrew Jackson proved him wrong, I suppose, but that lasted only 2 years. We have been rolling over our gov’t debt for 175 years.
Min
i also know nothing. but i have picked up at random a surprising number of books lately that all say the same thing. “gov’t debt is not supposed to be paid back.”
they also say that predatory lending is the way the world works… for the worse.
if you have some time see what you can learn about that. i don’t have the background.
Real linguists do know the answer. Not being one, i don’t remember it. Also, it’s late. Anyway, I think there are two errors in play. 1) The don’t end with a preposition nonsense is Latin grammar, not English. 2) When placed at the terminus, a preposition sometimes transforms into part of a phrasal verb.
Wheter it’s right or wrong depends on context and the choice of words. “Where you at?” is wrong. But not so much becaus of the placement as the redundancy.
More here.
http://grammar.quickanddirtytips.com/ending-prepositions.aspx
I think I just turned into Norm on Cheers!
JzB
“Caveat: One should not assume that expectations, even rational ones, correspond to mathematical expectations. (I don’t know if that is how they are used, but I have my suspicions. ;))“
That’s exactly what rational expectations is, the idea that the expectations of agents in the model correspond to the mathematical expectations that are implied by the model.
On gov’t debt — paying back debt does not mean that current debt equals zero. There’s no contradiction between saying that “gov’t deficit spending will be paid back, with interest, by later taxes” and saying that some positive amount of government debt will exist for eternity.
jh thanks for the witty support, but I think I understand what EMS had in mind. I not Blanchard am the naysayer.
EMS’s point is that if one can tell that a number is less than x, one knows the number. One does not have to know the probability distribution to put a bound on a probability. Confusion of “less than a” and “equal to b” is alarming. Knowing that a probability is less than 1% does not imply knowing the probability. To have rational expectations you have to know all probabilities.
But also, I was talking about Blanchard himself not the agents in the model to which you assume he was referring (I think he had no particular model in mind). For an economist to claim that he can forecants does not imply that he claims that all economic agents have rational expectations. One could attempt to forecast with a model populated by irrational agents. Robert Shiller has a rather good record forecasting and he assumes that irrationality is very important.
My claim about Blanchard was about the proper use of models in general not just of models including the rational expectations assumption. The claim is that, if the model says that something will happen with probability 0 or say 10 to the minus 10, you should worry that all or most of the probability of the event is conditional on your model being seriously wrong. The first thing is to check that the model fits the data in your data set. But this is not very useful. If An event occurs with proability 1% each year, the probability that it never occurs in the data sets used to develope and test Macro models is high. Fitting such small amounts of data should not give us confidence that we haven’t missed something important and rare.
In the case of things like the recent crisis, there are known examples outside of the data sets which macroeconomists use. — the Great Depression, the East Asian Financial Crisis, the Argentine devaluation. It is very possible to argue that those are irrelevant. It should have been impossible to have great confidence in that conclusion. Given economists’s tiny estimates of the cost of 4% inflation rather than 2% inflation, we should have advised a 4% target just in case one of the monsters which we thought we had driven extinct was hiding waiting to pounce.
These comments have lifted my mood up. Right on.
jazz
you are right. but i am a radical linguist. “where you at?” is perfectly “correct” among the people who speak that language. of course, if you don’t want people to know that is your native language you go to school and learn to talk like you went to school.
i went to school, but i am not sure i would not say “where are you at?” if i wanted to know what part of a book someone was reading. while i would say “where are you?” if i was looking for them in a dark place.
The pure form of the “rational expectations” assumption is that human expectations are *on average* correct.
This is where Economics reveals that it has not yet passed the philosophical threshhold of Copernicanism, i.e., that Man is the center of the Universe and imbued with divine powers.
This is a ridiculous assumption, totally unscientific. And all the hemming and hawing about “noise” and other “distortions” is crap.
Economics is a pseudo science with the intellectual maturity of an eighth grader.
cheers,
benign
benign
what if “human assumptions were on average “self fulfilling”?”
given that, pardon me, everything you hear on the news, or read in economics and history, is mostly wrong…
it has struck me, watching the “debate” about something i know about, that everything i hear is nonsense, but that nonsense is what is going to determine the future.
jh: “There’s no contradiction between saying that “gov’t deficit spending will be paid back, with interest, by later taxes” and saying that some positive amount of government debt will exist for eternity.”
No, but that does not make it rational. Anything is possible in eternity. The weight of evidence is that the national debt will fluctuate, but increase over time. There is more chance that it will be repudiated than that it will be paid for by future taxes.
Well, gov’t debt is not supposed to be paid back in full. It is a subsidy for those seeking a safe return.
Well, we certainly have predatory lending, eh? Where is our Pecora Commission? The oldest story of it that I know of is in Genesis. A couple of hundred years ago we might have agreed that slavery is how the world works. Certainly the history of agricultural civilization was the history of slavery. Slaves ran the Roman Empire. But slavery is almost dead now. 🙂 As for predatory lending, debtors prisons are gone and debt peonage is rare. We have made some progress. I have hope. 🙂
coberly: “everything i hear is nonsense, but that nonsense is what is going to determine the future.”
🙂
Courage, mon vieux!
How do you get 1 and 2 to 3. It certainly isn’t obvious.
Its not about money – that is also money illusion. It’s about POWER!
And as repudiation is a sort of redistribution, it is not necessarily a bad thing. But I prefer deliberate rationed redistribution.
what if human assumptions are only partly self-fulfilling (given that human assumptions are mostly wrong and are not the only determinants involved).
Robert,
I don’t seriously see how you can get from 1 and 2 to 3. 3 is one possible alternative, but surely not the only one.
But,
seriously my main problem with rational expectations, is that it asumes
1. We know how the world works
2. We can know how the world works.
I’m not sure about either of those things.
Is this a caricature?
We have model A of the economy. However, model A does not work unless people expect, on average, that it does work. So we add that assumption to get model B, which works, and we call the expectation that it does work rational.
What if (otherwise known as rational expectation) mein bubba had balls, she would then have been mein zaideh. “If this, then that?
That’s what an economist calls science? How does one empirically measure an assumption or an expectation, rational or otherwise? One man’s rational is anothers insanity. We have three front runners for the Republican nomination for the Presidency who are empirical evidence of the irrationality of human behavior. We have thousands of ordinary citizens trying to tell the three apart and expressing a preference for one over the others. More empirical evidence of contagious insanity. So why is a discussion of rational expectations, as that term might apply to human thought, proceeding amongst rational thinkers?