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Magical thinking, the rational expectations hypothesis, and academic economists

Ideas matter. Roman Frydman and Michael D. Goldberg in the FT:

[T]he debate [about fiscal stimulus, financial reform, and, more broadly, the future of capitalism] is full of terms that mean one thing to the uninitiated and quite another to economists.

Consider “rationality.” Webster’s Dictionary defines it as “reasonableness.” By contrast, for economists, a “rational individual” is not merely reasonable; he or she is 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 a bit of magical thinking, it supposes that each of the many models devised by economists provides the “true” account of how market outcomes, such as asset prices, will unfold over time.

The economics literature is full of different models, each one assuming that it adequately captures how all rational market participants make decisions. Although the free-market Chicago school, neo-Keynesianism, and behavioural finance are quite different in other respects, each assumes the same REH-based standard of rationality.

In other words, REH-based models ignore markets’ very raison d’etre: no one, as Friedrich Hayek pointed out, can have access to the “totality” of knowledge and information dispersed throughout the economy. Similarly, as John Maynard Keynes and Karl Popper showed, we cannot rationally predict the future course of our knowledge. Today’s models of rational decision-making ignore these well-known arguments.

The intellectual gymnastics involved in creating and propagating REH remind me of the torture debate. (Indeed, one can regard the strategic decision-making during the 2007-2008 financial crisisas a form of torture.) As Montag points out, torture is not "effective" at gathering intelligence. However, torture is indeed "effective" at creating disinformation, since torturers can and do get their subjects to say anything at all.** In the same way, the Rational Expectations Hypothesis was not -- and, as we see from Hayek, Keynes, and Popper, could never have been -- "effective" in building a model of reality. REH was, however, extremely effective in enabling Our Betters to loot the our economy, crash it, and then begin the looting all over again, bank-rolled by the taxpayer; the REH- and Nobelist-perpetrated LTCM bailout seems like the blueprint, here. Having paid attention to the men behind the curtain, we now return to our regularly programmed academic discourse:

The unreasonableness of this standard of rationality [haw] helps to explain why macroeconomists of all camps and finance theorists find it hard to account for swings in market outcomes. Even more pernicious, despite these difficulties, their models supposedly provide a “scientific” basis for judging the proper roles of the market and the state in a modern economy.

But incoherent premises lead to absurd conclusions - for example, that unfettered financial markets set asset prices nearly perfectly at their “true” fundamental value. If so, the state should drastically curtail its supervision of the financial system. Unfortunately, many officials came to believe this claim, known as the “efficient markets hypothesis,” resulting in the widespread deregulation of the late 1990s and early 2000s. That made the crisis more likely, if not inevitable.

Once again, we need to ask ourselves "efficient" at what? The Efficient Markets hypothesis, since it provided a handy justification for dismantling regulation -- and with the imprimatur of Nobelists, who functioned, in this instance, as a sort of ratings agency for ideas -- was extremely efficient at allowing the banksters to, as above, loot the economy, crash it, and then begin looting it all over again.

Public opinion has swung to the other extreme [which would matter if we weren't living in the banana republic these academics labored so hard, and billed such substantial sums, to create], as complacency about the need for financial regulation has been replaced by calls for greater oversight by the state to control the unstable behaviour of financial markets.

Behavioural economists [e.g.] have uncovered much evidence that market participants do not act like conventional economists would predict “rational individuals” to act. But, instead of jettisoning the bogus standard of rationality underlying those predictions, behavioral economists have clung to it. They interpret their empirical findings to mean that many market participants are irrational, prone to emotion, or ignore economic fundamentals for other reasons. Once these individuals dominate the “rational” participants, they push asset prices away from their “true” fundamental values.

The behavioural view suggests that swings in asset prices serve no useful social function. If the state could somehow eliminate them through a large 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. ...

For the most part, asset prices undergo swings because participants must cope with ever-imperfect knowledge about the fundamentals that drive prices in the first place. So long as these swings remain within reasonable bounds, the state should limit its involvement to ensuring transparency and eliminating market failures.

Yes, well. FWIW -- obviously, I'm no academic, let alone an academic economist -- these two guys sound like old school economists: They've got this weird idea that economists should be studying the economy, which can't be a science (sample size of one), instead of building models of the economy and calling that science (when it fact they're performing an especially vile form of social engineering that finished up laying waste to the hopes and dreams of tens of millions of people in the collapse, as well as killing some fraction of them).

That said, let's use their policy prescription as a yardstick: "Ensure transparency and eliminate market failures." Can anyone say with a straight face that the administration has done either? There's no more transparency now than there was under Bush, and the administration has rewarded the "Too Bigger To Fail" banks by making them even more dominant, creating the conditions for a second and even worse crash down the road.

In other words, on financial reform, the administration hasn't even come close to following the policy recommendations of two sober, middle-of-the-road academic economists. Another squandered opportunity -- and one with even worse consequences down the road than the health care clusterfuck.

NOTE * Beware of any guy whose former girlfriend was a model. Or, indeed, any professor.

NOTE ** It would be irresponsible not to speculate that most of this information is shared only with insiders. National security, doncha know. One envisions transcripts, even the odd video, if particularly edifying or arousing, circulating among our betters. A secret circle of elect voyeurs would, no doubt, go far to explain the distinctive gang culture of Versailles.

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