This guy has some issues with Rational Expectations

I just happened across this interesting panel discussion from a couple years ago featuring a number of economists involved with the Rational Expectations movement, either as key proponents (Robert Lucas) or critics (Bob Shiller). A fascinating exchange comes late on when they discuss Jack Muth -- ostensibly the inventor of the idea, although others trace it back to an early paper of Herb Simon -- and Muth's later attitude on this assumption. It seems that Muth came to doubt the usefulness of the idea after he looked at the behaviour of some business firms and found that they didn't seem to follow the Rational Expectations paradigm at all. He thought, therefore, that it would make sense to employ some more plausible and realistic ideas about how people form expectations, and he pointed, even in the early 1980s, to the work of Kahneman and Tversky.

I'm just going to quote the extended exchange below, including a comment from Shiller who makes the fairly obvious point that if economics is about human behavior and how it influences economic outcomes, then there clearly ought to be a progressive interchange between psychology and economics, and from Lucas who, amazingly enough, seems to find this idea utterly abhorrent, apparently because it may spoil economics as a pure mathematical playground. That's my reading at least:

Lovell
I wish Jack Muth could be here to answer that question, but obviously he can’t because he died just as Hurricane Wilma was zeroing in on his home on the Florida Keys. But he did send me a letter in 1984. This was a letter in response to an earlier draft of that paper you are referring to. I sent Jack my paper with some trepidation because it was not encouraging to his theory. And much to my surprise, he wrote back. This was in October 1984. And he said, I came up with some conclusions similar to some of yours on the basis of forecasts of business activity compiled by the Bureau of Business Research at Pitt. [Letter Muth to Lovell (2 October 1984)] He had got hold of the data from five business firms, including expectations data, analyzed it, and found that the rational expectations model did not pass the empirical test.

He went on to say, “It is a little surprising that serious alternatives to rational expectations have never really been proposed. My original paper was largely a reaction against very näıve expectations hypotheses juxtaposed with highly rational decision-making behavior and seems to have been rather widely misinterpreted. Two directions seem to be worth exploring: (1) explaining why smoothing rules work and their limitations and (2) incorporating well known cognitive biases into expectations theory (Kahneman and Tversky). It was really incredible that so little has been done along these lines.”

Muth also said that his results showed that expectations were not in accordance with the facts about forecasts of demand and production. He then advanced an alternative to rational expectations. That alternative he called an “errors-in-the-variables” model. That is to say, it allowed the expectation error to be correlated with both the realization and the prediction. Muth found that his errors-in-variables model worked better than rational expectations or Mills’ implicit expectations, but it did not entirely pass the tests. In a shortened version of his paper published in the Eastern Economic Journal he reported,

“The results of the analysis do not support the hypotheses of the naive, exponential, extrapolative, regressive, or rational models. Only the expectations revision model used by Meiselman is consistently supported by the statistical results. . . . These conclusions should be regarded as highly tentative and only suggestive, however, because of the small number of firms studied. [Muth (1985, p. 200)]

Muth thought that we should not only have rational expectations, but if we’re going to have rational behavioral equations, then consistency requires that our model include rational expectations. But he was also interested in the results of people who do behavioral economics, which at that time was a very undeveloped area.

Hoover
Does anyone else want to comment on issue of testing rational expectations against alternatives and if it matters whether rational expectations stands up to empirical tests or whether it is not the sort of thing for which testing would be relevant?

Shiller
What comes to my mind is that rational expectations models have to assume away the problem of regime change, and that makes them hard to apply. It’s the same criticism they make of Kahnemann and Tversky, that the model isn’t clear and crisp about exactly how you should apply it. Well, the same is true for rational expectations models. And there’s a new strand of thought that’s getting impetus lately, that the failure to predict this crisis was a failure to understand regime changes. The title of a recent book by Carmen Reinhart and Ken Rogoff—the title of the book is This Time Is Different—to me invokes this problem of regime change, that people don’t know when there’s a regime change, and they may assume regime changes too often—that’s a behavioral bias [Carmen Reinhart and Kenneth Rogoff (2009)]. I don’t know how we’re going to model that. Reinhart and Rogoff haven’t come forth with any new answers, but that’s what comes to my mind now, at this point in history. And I don’t know whether you can comment on it: how do we handle the regime change problem? If you don’t have data on subprime mortgages then you build a model that doesn’t have subprime mortgages in it. Also, it doesn’t have the shadow banking sector in it either. Omitting key variables because we don’t have the data history on them creates a fundamental problem That’s why many nice concepts don’t find their way into empirical models and are not used more. They remain just a conceptual model.

Hoover
Bob, do you want to . . . or Dale. . . .

Mortensen
More as a theorist, I am sensitive to that problem. That is the issue. If the world were stable, then rational expectations means simply agents learning about their environment and applying what they learned to their decisions. If the environment’s simple, then how else would you structure the model? It’s precisely—if you like, call it “regime change”—what do you do with unanticipated events? More generally—regime changes is only one of them—you were talking about institutional change that was or wasn’t anticipated. As a theorist, I don’t know how to handle that.

Hoover
Bob, did you want to comment on that? You’re looking unhappy, I thought.

Lucas
No. I mean, you can’t read Muth’s paper as some recipe for cranking out true theories about everything under the sun—we don’t have a recipe like that. My paper on expectations and the neutrality of money was an attempt to get a positive theory about what observations we call a Phillips curve. Basically it didn’t work. After several years, trying to push that model in a direction of being more operational, it didn’t seem to explain it. So we had what we call price stickiness, which seems to be central to the way the system works. I thought my model was going to explain price stickiness, and it didn’t. So we’re still working on it; somebody’s working on it. I don’t think we have a satisfactory solution to that problem, but I don’t think that’s a cloud over Muth’s work. If Jack thinks it is, I don’t agree with him. Mike cites some data that Jack couldn’t make sense out of using rational expectations. . . . There’re a lot of bad models out there. I authored my share, and I don’t see how that affects a lot of things we’ve been talking about earlier on about the value of Muth’s contribution.

Young
Just to wrap up the issue of possible alternatives to rational expectations or complements to rational expectations. Does behavioral economics or psychology in general provide a useful and viable alternative to rational expectations, with the emphasis on “useful”?

Shiller
Well, that’s the criticism of behavioral economics, that it doesn’t provide elegant models. If you read Kahnemann and Tversky, they say that preferences have a kink in them, and that kink moves around depending on framing. But framing is hard to pin down. So we don’t have any elegant behavioral economics models. The job isn’t done, and economists have to read widely and think about these issues. I am sorry, I don’t have a good answer. My opinion is that behavioral economics has to be on the reading list. Ultimately, the whole rationality assumption is another thing; it’s interesting to look back on the history of it. Back at the turn of the century—around 1900—when utility-maximizing economic theory was being discovered, it was described as a psychological theory—did you know that, that utility maximization was a psychological theory? There was a philosopher in 1916—I remember reading, in the Quarterly Journal of Economics —who said that the economics profession is getting steadily more psychological. {laughter} And what did he mean? He said that economists are putting people at the center of the economy, and they’re realizing that people have purposes and they have objectives and they have trade-offs. It is not just that I want something, I’ll consider different combinations and I’ll tell you what I like about that. And he’s saying that before this happened, economists weren’t psychological; they believed in such things as gold or venerable institutions, and they didn’t talk about people. Now the whole economics profession is focused on people. And he said that this is a long-term trend in economics. And it is a long-term trend, so the expected utility theory is a psychological theory, and it reflects some important insights about people. In a sense, that’s all we have, behavioral economics; and it’s just that we are continuing to develop and to pursue it. The idea about rational expectations, again, reflects insights about people—that if you show people recurring patterns in the data, they can actually process it—a little bit like an ARIMA model—and they can start using some kind of brain faculties that we do not fully comprehend. They can forecast—it’s an intuitive thing that evolved and it’s in our psychology. So, I don’t think that there’s a conflict between behavioral economics and classical economics. It’s all something that will evolve responding to each other—psychology and economics.

Lucas
I totally disagree.

Mortensen
I think that we’ve come back around the circle—back to Carnegie again. I was a student of Simon and [Richard] March and [James] Cyert—in fact, I was even a research assistant on A Behavioral Theory of the Firm [Cyert and March (1963)]. So we talked about that in those days too. I am much less up on modern behavioral economics. However, I think what you are referring to are those aspects of psychology that illustrate the limits, if you like, of perception and, say, cognitive ability. Well, Simon did talk about that too—he didn’t use those precise words. What I do see on the question of expectations—right down the hall from me—is my colleague Chuck Manksi [Charles Manksi] and a group of people that he’s associated with. They’re trying to deal with expectations of ordinary people. For a lot of what we are talking about in macroeconomics, we’re thinking of decision-makers sure that they have all the appropriate data and have a sophisticated view about that data. You can’t carry that model of the decision-maker over to many household decisions. And what’s coming out of this new empirical research on expectations is precisely that: how do people think about the uncertainties that go into deciding about what their pension plan is going to look like. I think that those are real issues, where behavioral economics, in that sense, can make a very big contribution to what the rest of us do.

Lucas
One thing economics tries to do is to make predictions about the way large groups of people, say, 280 million people are going to respond if you change something in the tax structure, something in the inflation rate, or whatever. Now, human beings are hugely interesting creatures; so neurophysiology is exciting, cognitive psychology is interesting—I’m still into Freudian psychology—there are lots of different ways to look at individual people and lots of aspects of individual people that are going to be subject to scientific study. Kahnemann and Tversky haven’t even gotten to two people; they can’t even tell us anything interesting about how a couple that’s been married for ten years splits or makes decisions about what city to live in—let alone 250 million. This is like saying that we ought to build it up from knowledge of molecules or—no, that won’t do either, because there are a lot of subatomic particles—we’re not going to build up useful economics in the sense of things that help us think about the policy issues that we should be thinking about starting from individuals and, somehow, building it up from there. Behavioral economics should be on the reading list. I agree with Shiller about that. A well-trained economist or a well-educated person should know something about different ways of looking at human beings. If you are going to go back and look at Herb Simon today, go back and read Models of Man. But to think of it as an alternative to what macroeconomics or public finance people are doing or trying to do . . . there’s a lot of stuff that we’d like to improve—it’s not going to come from behavioral economics. . . at least in my lifetime. {laughter}

Hoover
We have a couple of questions to wrap up the session. Let me give you the next to last one: The Great Recession and the recent financial crisis have been widely viewed in both popular and professional commentary as a challenge to rational expectations and to efficient markets. I really just want to get your comments on that strain of the popular debate that’s been active over the last couple years.

Lucas
If you’re asking me did I predict the failure of Lehmann Brothers or any of the other stuff that happened in 2008, the answer is no.

Hoover
No, I’m not asking you that. I’m asking you whether you accept any of the blame. {laughter} The serious point here is that, if you read the newspapers and political commentary and even if you read commentary among economists, there’s been a lot of talk about whether rational expectations and the efficient-markets hypotheses is where we should locate the analytical problems that made us blind. All I’m asking is what do you think of that?

Lucas
Is that what you get out of Rogoff and Reinhart? You know, people had no trouble having financial meltdowns in their economies before all this stuff we’ve been talking about came on board. We didn’t help, though; there’s no question about that. We may have focused attention on the wrong things; I don’t know.

Shiller
Well, I’ve written several books on that. {laughter} My latest, with George Akerlof, is called Animal Spirits [2009]. And we presented an idea that Bob Lucas probably won’t like. It was something about the Keynesian concept. Another name that’s not been mentioned is John Maynard Keynes. I suspect that he’s not popular with everyone on this panel. Animal Spirits is based on Keynes. He said that animal spirits is a major driver of the economy. To understand Keynes, you have to go back to his 1921 book, Treatise on Probability [Keynes (1921)]. He said—he’s really into almost this regime-change thing that we brought up before—that people don’t have probabilities, except in very narrow, special circumstances. You can think of a coin-toss experiment, and then you know what the probabilities are. But in macroeconomics, it’s always fuzzy. What Keynes said in The General Theory [1936] is that, if people are really thoroughly rational, they would be paralyzed into inaction, because they just don’t know. They don’t know the kind of things that you would need to put into a decision-theory framework. But they do act, and so there is something that drives people—it’s animal spirits. You’re lying in bed in the morning and you could be thinking, “I don’t know what’s going to happen to me today; I could get hit by a truck; I just will stay in bed all day.” But you don’t. So animal spirits is the core of—maybe I’m telling this too bluntly—but it fluctuates. Sometimes it is represented as confidence, but it is not necessarily confidence. It is trust in each other, our sense of whether other people think that we’re moving ahead or . . . something like that. I believe that’s part of what drives the economy. It’s in our book, and it’s not very well modeled yet. But Keynes never wrote his theory down as a model either. He couldn’t do it; he wasn’t ready. These are ideas that, even to this day, are fuzzy. But they have a hold on people. I’m sure that Ben Bernanke and Austin Goolsbee are influenced by John Maynard Keynes, who was absolutely not a rational-expectations theorist. And that’s another strand of thought. In my mind, the strands are not resolved, and they are both important ways of looking at the world.