Tuesday, February 12, 2013

Edmund Phelps trashes rational expectations

I'm not generally one to enjoy reading interviews with macroeconomists, but this one is an exception. Published yesterday in Bloomberg, it features an interview by Caroline Baum of Edmund Phelps, Nobel Prize winner for his work on the relationship between inflation and unemployment. This focus of the interview is on Phelp's views of the rational expectations revolution. He is not a big fan:
Q (Baum): So how did adaptive expectations morph into rational expectations?

A (Phelps): 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.
I think this is exactly the issue: "fear of uncertainty". No science can be effective if it aims to banish uncertainty by theoretical fiat. And this is what really makes rational expectations economics stand out as crazy when compared to other areas of science and engineering. It's a short interview, well worth a quick read.

Highly ironic also that, nearly half a century after Lucas and others began pushing this stuff, the trend is now back toward "adaptive expectations." Is rational expectations anything other than an expensive 50 year diversion into useless nonsense?

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