Goodbye rational expectations


Roman Frydman and Michael D. Goldberg, the authors of "Imperfect Knowledge Economics: Exchange Rates and Risk," have a well-argued piece in the Times that amounts to a full-frontal attack on the Rational Expectations Hypothesis (REH) that underlies much of mathematical economics. Their claim is that flawed theories of market 'efficiency' and 'rationality' have led economics and policy astray with recent disastrous results.

Although 'rationality' in common parlance is a synonym for 'reasonableness,' many economists take a rational individual to be "someone who behaves in accordance with a mathematical model of individual decision-making that economists have agreed to call rational."

The centrepiece 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 effect, REH-based models make markets unnecessary because they use equations rather than adaptive learning to predict outcomes. Yet Hayek has shown how markets can contain in dispersed form more information than is accessible to anyone, and Popper has illustrated the impossibility of predicting future knowledge. REH models gloss over these objections as they use their assumptions to 'price' new derivative products and 'predict' outcomes.

Real markets are uncertain. It is not that people are irrational, just that their rationality does not lend itself to mathematical modelling.

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.

In fact, say Frydman and Goldberg, asset prices are subject to swings because "participants must cope with ever-imperfect knowledge about the fundamentals that drive prices in the first place."

One of the few good things to come out of the financial crisis is a re-examination of the fundamentals of Austrian Economics. One of them is that value is entirely subjective, residing in the mind of the individual, not in the object contemplated, and that it changes over time and is different between individuals. This is light years away from the REH-based models that have dominated academic economics, and treated it as practically a subset of mathematics. For some years now most academic economists have talked only to each other, describing in ever more detail a fantasy world that never touches reality. If the crisis undermines the heresy of Rational Expectations, at least some good will have come from it.

Dr Madsen Pirie has recently published "101 Great Philosophers."