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:
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:
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.
[1] In other words, a 4% market interest rate may be “too high” and a 15% market rate of interest may be “too low.”
[2] John Muth, “Rational Expectations and the Theory of Price Movements,” Econometrica 29 (1961): 315-335.
[3] Mishkin, Frederick S., Money, Banking & Financial Markets, 9th edition. (2009): 157-158
"If we wish to preserve a free society, it is essential that we recognize that the desirability of a particular object is not sufficient justification for the use of coercion."
Student:this comment doesn't address my comment. just because the fed keeps printing money to "prevent corrections", doesn't mean people will systematically continue to make the same mistakes over and over again. maybe you can make the connection a bit more explicit for me.
sieben,
i have a hard time squaring your skepticism with a comment you made in an earlier thread.
Inflation/deflation should have no impact whatsoever on debts. Anyone with a brain simply writes inflation into contracts that ocurr over a long amount of time. http://mises.org/Community/forums/p/20146/370097.aspx#370097
this is almost exactly what i am saying.
Ambition is a dream with a V8 engine - Elvis Presley
The model of inflation I am describing in the previous thread is the Humean, or "fairy" model of inflation, where all holders of money have their monies increased by a fixed amount in concert. IRL, the kind of inflation we have now is asymmetric. The price distortions come out of this asymmetry, not simply an increase in the money supply. If it weren't for PR, the fed could operate without any inflation at all, and simply appropriate or debase the nominal value of everyone's assets.
this comment doesn't address my comment. just because the fed keeps printing money to "prevent corrections", doesn't mean people will systematically continue to make the same mistakes over and over again. maybe you can make the connection a bit more explicit for me.
It is not the same mistake over and over again. It would be the same mistake if, for example, monetary expansion beyond the demand for cash holdings continuously lead to the same housing bubble over and over again. The point is that they periodically make different mistakes, and that prices, and not entrepreneurial intuition, guide production. This is the Austrian position; here's Hayek:
you don't seem to notice the difference between long-term interest rates and "interest rates in the long-run" (this why imagining a world of a single interest-rate can be dangerous when you're trying to distinguish between long-term and short-term investments). long-term interest rates are simply the rate of return recieved for loaning money for extended periods of time (depending on who you ask the exact definition of long-term may vary but we are talking at least 3 years)…….. now, if i believed in ratex, i would seriously doubt the ABCT as an explaination for most business cycles because i would contend that investors (lenders) would see the government printing money today and understand that in a few years that will mean higher inflation which will erode their real returns and perhaps make their investments profitable.
I’m sorry for the confusion. The first time I read your comment I thought you were referring to interest rates in the long-run. I understand the term structure of market interest rates, but all of this is unessential and completely ignores the crux of my argument (plus there are many different theories that attempt to explain the term structure of interest, including Austrian explanations). Investors may in fact be aware of economic theory, and they may expect inflation in the long-run, and this may very well elevate the yields on long-term market interest rates. But expectations of future inflation, risk, the supply/demand for money (etc) do not, in anyway, affect the natural rate of interest; they only affect market interest rates.
Economic stability is contingent upon inter-temporal equilibrium (when the market rate = the natural rate) and monetary equilibrium (when the demand for money = the supply of money). Now, your argument would only makes sense if individuals somehow knew what the interest rate “should be”(the natural rate of interest), and if they then adjusted market interest rates accordingly.
What you’re essentially saying is that if the government, for whatever reason, decided to set the price of a particular economic good way below the market-clearing level, then individuals would not only be aware of this, but they would also know where the price of that commodity should be, and they would adjust their purchases accordingly in order to prevent a massive shortage. But this would have to be true for every single economic good, because money constitutes one-half of all exchanges. An entrepreneur would need to know that the elevated demand for his product was the result of monetary expansion, and he/she would have to, rather than elevating his/her prices, keep them stable in order to suppress higher short-term profits and capital accumulation within that industry (a bubble). This is why I continuously repeat that inflation is a microeconomic phenomenon that depends on how individuals spend the newly created sums, and that the effects of monetary expansion extend far beyond the money/capital markets. There is no actual uniform rate of inflation (this is your major problem, Student, you do not understand inflation).
Individuals simply do not posses this kind of knowledge on their own which is why market prices are absolutely vital (undisturbed prices contain the relevant information). This is the reductio I was trying to make (what you call an “unsubstantiated assertion”).
And finally, Austrian’s tend to stress the importance of interest rates and the lonabale funds market because this is where the newly created sums are first introduced into the economic system. The financial intermediaries, in turn, funnel the inflation to investors, which elevates the demand for capital goods, and therefore their prices, but without a corresponding diminution in the demand for consumer goods. If the king, on the other hand, printed a lot of money and gave it directly to consumers then the inflation would yield the opposite effect. The ABCT is both extremely broad and complicated so I understand the confusion.
i am not sure what you are getting at here. i keep getting the vibe you want to tie this back to the economic calculation debate, based on statements like this one here:
Individuals simply do not posses this kind of knowledge on their own which is why market prices are absolutely vital (undisturbed prices contain the relevant information).
but that only tells me you are not clearly understanding what "rational expectations" means. like i keep saying, people that believe in rational expectations would likely be on your side in the economic calculation debate. but that isn't what ratex is about. rational expectations is about about how people form **expectations** and people will always have to form these expectations even if the fed didn't exist. there is really no amount of signaling that will avoid this fact. let me lay it out this way.
#1. Investors will ALWAYS have to guess about future price inflation/deflation. first, even if the fed didn't exist the price level would fluctuate so long as money demand and money supply can fluctuate. this implies that investors are ALWAYS going to have guess what future inflation/deflation rates are when making long-term investments.
#2. Investors today will ALWAYS have to guess what the short-term interest rate will be tomorrow when making long-term investment decisions today. earlier you agreed that the expectations investors hold about nominal short-term rates tomorrow will influence long-term interest rates today (i have an explicit example for why this would be the case in what i called problem #1). Now, since these future short-term rates will depend on saving and investment in the future (which is unknown in the present). this means that investors will ALWAYS have to guess what the "natural rate" of interest should be.
these two points are essential, so if you disagree please explain why.
if you do not disagree these two points, then you have not mentioned any problems that wouldn't exist if the federal reserve didn't exist. so the point of the above paragraph is lost on me. there is simply no signal that will eliminate the guesswork involved in #1 and #2.
What you’re essentially saying is that if the government, for whatever reason, decided to set the price of a particular economic good way below the market-clearing level, then individuals would not only be aware of this, but they would also know where the price of that commodity should be, and they would adjust their purchases accordingly in order to prevent a massive shortage.
that is not what i am saying at all. your analogy assumes the government has the ability to set the price of a particular commodity. if you truly believe in rational expectations, then the government should not have the ability to set the "price" in question (long-term interest rates) at all. this seems to be a sticking point so let me repeat. "if you believe long-term lenders have rational expectations about the future, then you would argue that they would always respond to monetary expansions by demanding higher rates of returns from their borrowers to preserve their real returns after accounting for inflation."
And finally, Austrian’s tend to stress the importance of interest rates and the lonabale funds market because this is where the newly created sums are first introduced into the economic system. The financial intermediaries, in turn, funnel the inflation to investors, which elevates the demand for capital goods, and therefore their prices, but without a corresponding diminution in the demand for consumer goods.
okay, let's follow that reasoning. lets say you're a financial intermediary like a bank and you're now sitting on top of a new pile of freshly printed cash. naturally you want to loan this money out so you can draw a return on it. now, if you were smart, you would know that as this new cash works it way through the economy prices are going to go up. so you have to ask yourself, do you want to lend this to money to a guy for a 30 year mortgage at current interest rates? no way! you already know your returns will be eaten away with inflation. instead, you would either demand higher interest rates on your loans (to keep your return the same) or you will want to put that new money to, say, 1-year small business loans or maybe cash advances. anything that will get you returns soon so you can enjoy real profits before prices begin to rise.
that is what rational expectations would tell us anyways. yet nothing you have said has really disrupted that story. even if we assume that banks like this one makes frequent mistakes, we have no reason to suspect the mistakes will be anything but random. iow: we have no reason to suspect the bank will always loan the money to long-term investment projects that will become unprofitable when interest rates start to rise. and that is kinda essential to the ABCT story.
Okay, first, before I directly deal with your arguments, let me reveal the assertion that I was essentially responding to in my OP (Caplan’s critique of the ABCT):
The objection is simple: Given that interest rates are artificially and unsustainably low, why would any businessman make his profitability calculations based on the assumption that the low interest rates will prevail indefinitely? No, what would happen is that entrepreneurs would realize that interest rates are only temporarily low, and take this into account. http://econlog.econlib.org/archives/2008/01/whats_wrong_wit_6.html
This statement only makes sense if individuals somehow intuitively knew what the natural rate of interest is. A 4% market rate of interest can be too high and a 20% market rate of interest can be too low. It all depends on its position relative to the natural rate. His argument is very different from the one you're making (monetary expansion does not affect long-term interest rates).
but that only tells me you are not clearly understanding what "rational expectations" means. like i keep saying, people that believe in rational expectations would likely be on your side in the economic calculation debate. but that isn't what ratex is about.
Expectations and economic calculation go hand in hand. Entrepreneurs are merely speculators that analyze current market conditions and try to predict future market conditions. The fact of the matter is that the formulation of accurate expectations is entirely contingent upon identifying and incorporating all relevant information. But this information is, in large part, expressed by the price mechanism.
#1. Investors will ALWAYS have to guess about future price inflation/deflation. first, even if the fed didn't exist the price level would fluctuate so long as money demand and money supply can fluctuate. this implies that investors are ALWAYS going to have guess what future inflation/deflation rates are when making long-term investments. #2. Investors today will ALWAYS have to guess what the short-term interest rate will be tomorrow when making long-term investment decisions today. earlier you agreed that the expectations investors hold about nominal short-term rates tomorrow will influence long-term interest rates today (i have an explicit example for why this would be the case in what i called problem #1). Now, since these future short-term rates will depend on saving and investment in the future (which is unknown in the present). this means that investors will ALWAYS have to guess what the "natural rate" of interest should be
#2. Investors today will ALWAYS have to guess what the short-term interest rate will be tomorrow when making long-term investment decisions today. earlier you agreed that the expectations investors hold about nominal short-term rates tomorrow will influence long-term interest rates today (i have an explicit example for why this would be the case in what i called problem #1). Now, since these future short-term rates will depend on saving and investment in the future (which is unknown in the present). this means that investors will ALWAYS have to guess what the "natural rate" of interest should be
I don’t understand the point you’re trying to make here, mainly because I obviously agree with you. I’m merely stating the fact that government intrusion makes formulating accurate expectations an extremely difficult, if not impossible endeavor, because it must necessarily disturb natural market processes. The market tries to match expectations with reality (see Lachmann) through the price mechanism and the profit/loss constraint. But let me respond to an issue you raised that is somewhat relevant:
The supply and demand for money will indeed fluctuate in a free-banking environment (where the FED, or the arbitrary cartelization of banks, does not exist). In such a competitive system (again, where the FED no longer exists), it would be extremely difficult, if not impossible, to increase the supply of money beyond the demand for money. It would be impossible to finance investments without real savings (differed consumption). This is the point of inflation and why it is praised by the inflationist’s (again, because it allows firms to invest without first gaining access to real savings; the savings/consumption relationship becomes temporarily decoupled).
And for the nth time, there is no uniform rate of inflation. Predicting how the inflation will manifest itself, that is, how it will alter relative prices, is impossible.
The banks will continue lending and increasing the supply of short-term loans (1 year) to small businesses until the rate of return falls within this market. Once this market becomes oversaturated, the 30 year bond market will become more lucrative (relatively), and financial intermediaries will begin increasing the supply of loans within this market. That money will not simply lie idle (unless we’re talking about abnormal economic conditions). Total lending will have increased without a corresponding increase in real savings and a corresponding diminution in consumption. This is all that’s required for the ABCT.
Additionally, the newly created sums, once lent, will permeate amongst the economic system altering relative prices and the short-term profitability of various investments. This, in turn, will draw capital away from other industries towards those industries (Cantillion effects). So, even if we assume that long-term interest rates are not affected by alterations in the supply of money at all(which I don’t), the ABCT still holds (because of the alterations in relative prices which guide production patterns).
You're right that Caplan's argument is different from the one i was making, so that helps me better understand your original post. though i would say that the argument is still incomplete if one wants to fully show that rational expectations is irrelevant for ABCT. if i am understanding caplan correctly, i would say he is only talking about expectations of borrowers given that rates can be lowered. and i am talking about the perspective of lenders and questioning whether rates can be lowered to begin with. but rational expectations underly both our arguments.
The fact of the matter is that the formulation of accurate expectations is entirely contingent upon identifying and incorporating all relevant information. But this information is, in large part, expressed by the price mechanism.
I am not sure what you mean. what information are you thinking of here? can you be more specific?
don’t understand the point you’re trying to make here, mainly because I obviously agree with you. I’m merely stating the fact that government intrusion makes formulating accurate expectations an extremely difficult, if not impossible endeavor, because it must necessarily disturb natural market processes.
but as i noted before, you have not provided good reason for us to expect this task to be more difficult with the fed. your argument has only amounted to the fact that real individuals would find it hard to form expectations when inflation and future rates are uncertain and that this can lead to mistaken investments. but a mainstream economist could use that exact same argument to justify inflation targeting (it takes out much of the guess work in forming inflation expectations). as i keep saying, you will need to add something here for this argument to save ABCT.
as a side note, in your discussion on free banking you simply assert that free banking will make inflation impossible, but even if that were true what about deflation? maybe not a problem for lenders, but certainly a potential problem for borrowers (and lenders too i guess if borrowers default as a result). how is that supposed to be easier to forecast than inflation?
so unless you can explain to me that prices will be absolutely stable under free banking, investors will always have to do some forecasting of the price level and nothing you have said has justified how that task would be easier without the fed.
The banks will continue lending and increasing the supply of short-term loans (1 year) to small businesses until the rate of return falls within this market. Once this market becomes oversaturated, the 30 year bond market will become more lucrative (relatively), and financial intermediaries will begin increasing the supply of loans within this market. That money will not simply lie idle (unless we’re talking about abnormal economic conditions).
how "saturated" does the short-term market have to be to make unprofitable long-term investments attractive?
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PS* this really will have to be my last post for a while. :( traveling again tomorrow and studying for an exam friday. so if i don't respond for a while im not ignoring you, just trying to keep my mind on my money and my money on my mind.
Once again, Student, you're simply dissatisfied with the Austrian position, and your last comment did not introduce any new arguments at all.
On a side note: I simply can't figure out why some free market economists, such as yourself, have a hard time understanding why a free market in banking must be more efficient than our current system (monetary central planning).
esuric,
it looks like this will be quick as the convo is drawing to a close, so i can take a quick sec to drop in...
first, let me clarify that i am dissatisfied with **your** position which doesn't fundamentally strike me as austrian at all. no mainstream economist will disagree with that a failure to anticipate price inflation will lead to making investments. and few would argue that volatile inflation makes it harder to make investments (this is one reason why inflation is associated with reduced economic growth). but there is nothing uniquely austrian about these points (you keep using language about "microeconomcis of inflation" but never follow through with concrete arguments). that is why i keep stressing that your arguments could just as easily be used to justify inflation targetting.
and certainly nothing you have said directly defends ABCT against the rational expectations critique. okay, you're arguing the fed makes it harder to make investment decisions. now what? why would investors always be fooled to underestimate price inflation such that they lend money to long-term ventures that will become unprofitable when interest rates start to rise? in a previous post you said something about how once the short term market becomes "saturated" banks will naturally start putting their money into bad long-term investments. but that makes no sense to me. first, how much is "saturated" (do interest rates have to be near zero on all short-term forms of lending??? if not, when is it "saturated"??) and what about other investments like inflation-adjusted government securities? why would i naturally move my money to long-term investments where i realize inflation risk is higher now that the fed is printing more money when i can put my money in safer assets like these?
you just are not connecting the dots. :-/
Student:it looks like this will be quick as the convo is drawing to a close, so i can take a quick sec to drop in...
Who didn't see this coming...
liberty student,
procrastination is my one weakness...after women and booze...and television.....a good steak...the rolling stones....
anyways
when i have a test coming (like this week) i try to say i wont post often in hopes that it will precomit me to not posting (stengthing my extended will: http://www.newyorker.com/arts/critics/books/2010/10/11/101011crbo_books_surowiecki). sometimes it works, sometimes it doesn't. at this point you're right it probably it isn't working but i'm trying. :P
glad you've taken an interest in my posting habits though. it means a lot to me.
ps* just to clarify, i am not ending the convo. though esuric seems to be by not supporting his assertions with solid arguments. this all sounds familiar doesn't it?