Rational expectations consequently fail for the same reason Communism failed -- the arrogance and ignorance of the monopolist. John Kay
In physics the Heisenberg uncertainty principle asserts a limit in our ability to simultaneously know certain facts, such as the position and speed of a particle. The theory that captures this idea is a probabilistic theory: in quantum mechanics only the probabilities of outcomes can be known in advance. Strangely, more is expected of economists. Much is made of the inability to forecast the current crisis -- some say it is a crisis of economics; others say that it arises from the assumption of "rational expectations." On the contrary: it is a fundamental principle that there can be no reliable way of predicting a crisis.
The analogy with physics is instructive. The Heisenberg uncertainty principle arises because the observer interferes with the system. This is more pronounced in economics: an analyst who makes forecasts that are believed will have an impact on the behavior of the people she is analyzing. Should there not be an uncertainty principle in economics? There is -- and the much maligned theory of rational expectations is the tool that economists use to account for the relationship between analyst and analyzed.
Of course crises can be predicted. If I say every year "there will be a crisis this year" eventually I will be right. If 100 people each pick a different year then one of them is bound to be right. A reliable method of predicting a crisis must be a rule that anyone (or at least anyone with the requisite technical expertise) can apply and reach the same correct conclusion as anyone else using the same method. The uncertainty principle in economics arises from a simple fact: we are all actors in the economy and the models we use determine how we behave. If a model is discovered to be correct, then we will change our behavior to reflect our new understanding of reality -- and when enough of us do so, the original model stops being correct. In this sense future human behavior must necessarily be uncertain.
Take an example: how we might predict stock market crashes? Suppose that two behavioral psychologists, call them "Kahneman and Tversky," produce a model of "cognitive biases" that predicts when crashes will occur. The model tells us that the stock market will crash on October 28. Since the model is reliable and has a perfect track record, we naturally believe this prediction. So what would you do? You would sell all your stock on October 27. But of course if enough people do this the stock market will crash on October 27 and not October 28. So this apparently reliable model will be proven wrong.
Notice the emphasis here on models, or at least rules, that in principle we can all apply. Beware of oracles. Suppose Warren Buffet can always predict the day of a stock market crash and is kind enough to warn us in advance. If he can't -- or won't -- tell us how he does it we have two problems. First, he will eventually die -- and then where will we be? Second, how can we know if he is really an oracle, or if he is just the lucky one of a hundred (or thousand, or billion) who said something at random and happens to be right? If we know the rule, we can apply it to historical data as well as to incoming data. The likelihood that a rule will have always proven to be correct when it is in fact wrong is naturally quite small. To take an example: the theory of gravity was controversial when it was first proposed. Yet today who thinks that the predicted trajectory of an artillery shell will be wrong? Certainly I wouldn't care to stand where the theory says the shell will land. Do you imagine if Newton had simply made predictions about the impact of artillery shells without revealing his method anyone would have heard of him today?
Stock markets provide many good examples. Have brilliant physicists working with powerful computers figured out how to forecast the stock market and make a buck? Perhaps -- but of course if there are predictable patterns in stock prices -- eventually the brilliant physicists will drive them away. One of the main theoretical observations of finance theory it that stock market prices are relatively unpredictable -- and this is backed up by decades of evidence. That isn't to say you might not be able to turn a profit by a clever observation and insight -- just that the wise investor counts his money quickly and after six months moves on.
The uncertainty principle doesn't just apply to stock markets. Suppose a clever political scientist was able to predict that there would be a revolution in Libya and that it would end on October 11, 2011 with the death of Muammar Gaddafi. Would such prediction come true? Not surely if Gaddafi believed it -- no doubt he would have left the country well in advance of that date, and while the revolution would have been successful it would have ended much more quickly and peaceably.
The uncertainty principle in economics leads directly to the theory of rational expectations. Just as the uncertainty principle in physics is consistent with the probabilistic predictions of quantum mechanics (there is a 20% chance this particle will appear in this location with this speed) so the uncertainty principle in economics is consistent with the probabilistic predictions of rational expectations (there is a 3% chance of a stock market crash on October 28).
Note what rational expectations are not: they are often confused with perfect foresight -- meaning we perfectly anticipate what will happen in the future. While perfect foresight is widely used by economists for studying phenomena such as long-term growth where the focus is not on uncertainty -- it is not the theory used by economists for studying recessions, crises or the business cycle. The most widely used theory is called DSGE for Dynamic Stochastic General Equilibrium. Notice the word stochastic -- it means random -- and this theory reflects the necessary randomness brought about by the uncertainty principle.
In simple language what rational expectations means is "if people believe this forecast it will be true." By contrast if a theory is not one of rational expectations it means "if people believe this forecast it will not be true." Obviously such a theory has limited usefulness. Or put differently: if there is a correct theory, eventually most people will believe it, so it must necessarily be rational expectations. Any other theory has the property that people must forever disbelieve the theory regardless of overwhelming evidence -- for as soon as the theory is believed it is wrong.
So does the crisis prove that rational expectations and rational behavior are bad assumptions for formulating economic policy? Perhaps we should turn to behavioral models of irrationality in understanding how to deal with the housing market crash or the Greek economic crisis? Such an alternative would have us build on foundations of sand. It would have us create economic policies and institutions with the property that as soon as they were properly understood they would cease to function.
Continue here to Part II.
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