Critique of Rational Expectations

Esuric posted on Fri, Oct 1 2010 9:36 PM

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This is my critique of Rational Expectations. If you have something to add, or If I’ve made some kind of mistake, please let me know. This thread is extremely lengthy.

The most vocal criticism of the Austrian theory of cycles comes from the rational expectations crowd. They assert that individuals simply do not systematically err in the aggregate, and are therefore immune to arbitrary alterations and manipulations in the price mechanism, especially lowered interest rates. Let’s ignore, for the moment, that this argument entirely ignores the function of the price mechanism, the fact that market interest rates are only “high” and “low” depending on their positions relative to the natural rate[1], and the interrelated microeconomic effects of inflation. Rather, I think it would be more productive if we first actually focused on the theory of rational expectations itself, and its extensions, namely the efficient market hypothesis, both the weak and strong versions.

Rational Expectations:

Prior to the rational expectations “revolution” of the 70s economists regularly employed a one-dimensional theory of expectations solely based on past historical data (adaptive expectations). So, for example, if past inflation rates averaged 5%, expectations of future inflation would be 5% as well. If, on the other hand, inflation rose to a rate of 7%, then inflation expectations would gradually rise to 7%. Clearly, this is problematic. Individuals don’t solely rely on past historical averages when forming their expectations and calculations; they attempt to incorporate as many relevant variables as possible. So, for example, if the Federal Reserve announces that it will triple the supply of high-powered money, and if individuals have some basic understanding of economic theory, then they should expect inflation rates to exceed past historical averages, and they will factor this into their calculations. They will do this because failing to incorporate all relevant variables is very costly (bond holders, for example, will get crushed if they don’t understand inflation).

This is all well and good, and I doubt that many would seriously contest this line of reasoning. But John Muth, the father of rational expectations, went one step further, he asserts: expectations will be identical to optimal forecasts using all available information[2]. There are two major implications from this conclusion:

1. If there is a change in the way a variable moves, the way in which expectations of this variable are formed will change as well: So if the interest rate, for example, is “high,” then individuals will expect it to return to its “normal level.” If it stays “high,” then individuals will expect it to remain “high.”
2. The forecast errors of expectations will, on average, be zero: This was already mentioned, but the formal statement of the theory is X^e = X^of (the expectation of X equals the optimal forecast using all relevant information).

It is important to note that rational expectations does not assert, as many claim, that individuals have perfect information; that is, it admits that some information is simply unavailable, and it actually claims that some individuals may choose to ignore relevant variables because it may require too much effort to identify (too costly). Thus, Rational Expectations admits much of its theoretical deficiencies, and this already casts doubt on its theoretical tenability and usefulness. The truth of this concession is most evident within the political sphere, where individuals (a) are unaware of the true intensions of politicians, and (b) where they simply refuse to educate themselves politically (purposely ignore relevant variables when they make political decisions/vote).

It’s true, though, that the market is unlike the political sphere in many ways. For example, individuals actually have power in the market, and the intensions of market actors are immaterial; only results and performance matter (assuming that the system is free from arbitrary advantages and disturbances). But in the market there is a substantial difference between what individuals attempt to do and what actually happens (the inevitable result of extreme complexity and uncertainty). Individuals may attempt to use all of the relevant information, the same way that the entrepreneur attempts to engage in profitable productions, but distinguishing between relevant information and irrelevant information is an extremely difficult endeavor (much more so than in the political realm), especially when the relevant information is contained within prices (expressed by the price mechanism).

The entrepreneur, for example, needs to understand much more than his own personal preferences and the preferences of one or two actors; he needs to understand the marginal technical rates of substitution amongst various heterogeneous goods with varying degrees of complementarity; he needs to understand the subjective desires of billions of individuals, which are in continuous flux; he needs to understand the ramifications of government intrusion into various markets, ect ect.

The degree of competency required to obtain such information without a functional and accurate price mechanism is beyond the scope of human cognitive abilities. In other words, prices (not intuition) guide production. Hayek explains,

They overlook the fact that, in the exchange economy, production is governed by prices, independently of any knowledge of the whole process of individual producers, so that it is only when the pricing process is itself disturbed that a misdirection of production may occur (Monetary Theory and the Trade Cycle, pp. 41).

Let’s quickly reexamine the first implication of rational expectations, since there are many assumption already built into it:

1. Each individual is fully aware of the time preferences of all other individuals and knows what the natural rate of interest is. In other words, they are able to see what the normal return on investment would be in a purely theoretical barter economy.
2. They fully understand the effects of a suppressed market rate of interest below the natural rate of interest and choose not to capitalize (for lack of a better term) on potential short-term profits because they can see into the future.
3. Essentially, individuals have some intuitive connection to some illusory general equilibrium; that is, they know where the interest rate “should be” even if the market does not express it.

The absurdity of such a position is obvious. Thus, rational expectations, within the realm of economics, are entirely contingent upon a price mechanism that is not continuously manipulated by external authorities. And since prices are in fact continuously altered, we must therefore dismiss rational expectations as a valid critique of the ABCT.

The Efficient Market Hypothesis:

I mention this extension only because I wish to elucidate the point that simple theoretical mistakes have a tendency to turn into unforgivable abominations. The weak version of the EMH merely incorporates RE within the field of finance (current prices in a financial market will be set so that the optimal forecasts of a security’s return using all available information equals the security’s equilibrium return[3]). But it’s the strong version that is truly remarkable: an efficient market prices securities so that they reflect the “true intrinsic” value of the securities. Thus, prices always reflect market fundamentals, so that any investment is just as good as any other investment. And thus we have returned to the classical framework, where value and prices are identical.

Conclusion:

If individuals truly had some mystical connection to some general equilibrium, where their expectations were identical to equilibrium results, then the price mechanism, i.e., the explicit expression of opportunity costs, would be entirely superfluous. We would merely need to find the most intuitive individuals and have them centrally plan our economic system. Recessions and endogenous price rigidities simply could not exist under such circumstances (which is why some proponents of rational expectations deny the existence of bubbles contrary to all empirical and theoretical evidence). But this is merely a utopian fantasy that ignores reality.

Furthermore, Rational Expectations, and its extensions, have been an expedient tool for all those who oppose the free market system and free market economics. Liberal professors continuously refute these straw men while ignoring the indubitable arguments put forth by the likes of Bastiat, Say, Mises, Rothbard, ect.