I was bemused by a comment made during the course of the debate I took part in last night on modern monetary theory. A person made a comment, he said on behalf of central bankers. All I had said was, he suggested, nonsense, because all macroeconomics is based on microeconomics and that, in turn, is based on rational expectations theory and it works, so there was no debate to be had on modern monetary theory because it might suggest otherwise.
The participant seemed quite angry and demanded I respond in detail, which I did not. That is because I do not accept the premises of rational expectations theory, and not do I for one moment think that macro should be built on micro-foundations. If MMT is a good theory it is precisely because it is a genuine macro theory, and one of the rare few that considers money.
Let me address the issue that was raised though. If the Bank of England can use Investopedia to provide definitions on its website, so will I. They say this of rational expectations theory:
What Is Rational Expectations Theory?
The rational expectations theory is a concept and modeling technique that is used widely in macroeconomics. The theory posits that individuals base their decisions on three primary factors: their human rationality, the information available to them, and their past experiences.
The theory suggests that people's current expectations of the economy are, themselves, able to influence what the future state of the economy will become. This precept contrasts with the idea that government policy influences financial and economic decisions.
The analysis of the causes of the financial crisis implies the need for major changes in our approach to capital, liquidity, accounting, and institutional coverage, which are addressed in Chapter 2. But the crisis also raises important questions about the intellectual assumptions on which previous regulatory approaches have largely been built.
At the core of these assumptions has been the theory of efficient and rational markets. Five propositions with implications for regulatory approach have followed:
- Market prices are good indicators of rationally evaluated economic value.
- The development of securitised credit, since based on the creation of new and more liquid markets, has improved both allocative efficiency and financial stability.
- The risk characteristics of financial markets can be inferred from mathematical analysis, delivering robust quantitative measures of trading risk.
- Market discipline can be used as an effective tool in constraining harmful risk taking.
- (v) Financial innovation can be assumed to be beneficial since market competition would winnow out any innovations which did not deliver value added.
Each of these assumptions is now subject to extensive challenge on both theoretical and empirical grounds, with potential implications for the appropriate design of regulation and for the role of regulatory authorities.
And as he added:
In the face of the worst financial crisis for a century, however, the assumptions of efficient market theory have been subject to increasingly effective criticism, drawing on both theoretical and empirical arguments. These criticisms include that:
- Market efficiency does not imply market rationality. There is nothing in empirical tests of market efficiency narrowly defined (i.e. tests of the non-existence of chartist patterns) which illustrates market rationality. The fact that prices move as random walks and cannot be predicted from prior movements in no way denies the possibility of self-reinforcing herd effects and of prices overshooting rational equilibrium levels.12
- Individual rationality does not ensure collective rationality. There are good theoretical and mathematically modellable reasons for believing that, even if individuals are rationally self interested, their actions can, if determined in conditions of imperfect information and/or determined by particular relationships between end investors and their asset manager agents, result in market price movements characterised by self-reinforcing momentum.
- Individual behaviour is not entirely rational. There are moreover insights from behavioural economics, cognitive psychology and neuroscience, which reveal that people often do not make decisions in the rational front of brain way assumed in neoclassical economics, but make decisions which are rooted in the instinctive part of the brain, and which at the collective level are bound to produce herd effects and thus irrational momentum swings.15
- Allocative efficiency benefits have limits. Beyond a certain degree of liquidity and market completion, the additional allocative efficiency benefits of further liquidity and market completion may be relatively slight, and therefore easily outweighed by additional instability risks which increasing liquidity or complexity might itself create. It is for instance arguable that the allocative efficiency benefits of the creation of markets for many complex structured credit securities (e.g. CDO-squareds) would have been at most trivial even if they had not played a role in creating financial instability.
- Empirical evidence illustrates large scale herd effects and market overshoots. Economists such as Robert Shiller have argued persuasively that empirical evidence proves that financial market prices can diverge substantially and for long periods of time from estimated economic values, with the calculated divergences at times so large that policymakers can reasonably conclude that market prices have become irrational.16
Given this theory and evidence, a reasonable judgement is that policymakers have to recognise that all liquid traded markets are capable of acting irrationally, and can be susceptible to self- reinforcing herd and momentum effects.
Precisely. In other words, even if individuals are rational and have reasonable expectations as a result this does not form the basis for regulating financial markets, which are relatively predictable given their limited goals, and much less so macroeconomies.
So, why use such a flawed basis for macroeconomics? I was justified, I think, in my dismissiveness. We need a better basis for macro. I suggest MMT is a major contributor to that. I would also suggest the commentator has not learned the lessons of history. But there is no news there.
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Philip Tetlock, a psychologist at the University of Pennsylvania, interviewed 284 people who made their living “commenting or offering advice on political and economic trends.” He asked them to assess the probabilities that certain events would occur in the not too distant future, both in areas of the world in which they specialized and in regions about which they had less knowledge. In all, Tetlock gathered more than 80,000 predictions. The results were devastating. The experts performed worse than they would have if they had simply assigned equal probabilities to each of the three potential outcomes. In other words, people who spend their time, and earn their living, studying a particular topic produce poorer predictions than dart-throwing who would have distributed their choices evenly over the options. Even in the region they knew best, experts were not significantly better than non-specialists.
Kahneman, Daniel. Thinking, Fast and Slow
Quite a lot of Kahneman’s work is devoted to the frailties of human forecasting.
Agreed
MMT is not a forecasting tool
It describes how an economy works and what it can achieve
Mark Carney is giving the Reith lectures this year. A large part of his presentation in the first one is that many people misunderstand Adam Smith, and place too much faith in unconstrained “free markets” without considering the legal and regulatory regime necessary to make markets work properly to achieve desired aims. Refreshingly candid about how markets respond to price but not value, and then how the prices set by markets (for example, high wages of bankers and low wages of health and care workers mispricing their contribution to society) feed back into the values of society rather than the other way around. https://www.bbc.co.uk/programmes/m000py8t
I think even the IFS has given up on its grand project to build up a theory of macroeconomics from ground level using rules of microeconomics, like economics was a branch of mathematics or physics. And that assumes that microeconomics even works in the first place, outside its toy models with heroic assumptions and major simplifications. Can we identify any rational consumers with perfect information? If not, what rules are we going to impose to ameliorate the irrationality and imperfection?
Interesting that he noted Amazon has enormous value and the Amazon is in no balance sheet
I wish he would read sustainable cost accounting and drop his TCFD, which will never achieve that goal
I hope we can agree that central banks and governments need to make forecasts to manage the economy. MMT would have to do the same, to estimate how much money would need to be spent by full government to ensure full employment, it would have to estimate inflation going forward and then estimate how much taxes would have to rise to remove that inflation.
How would MMT (or the government using MMT) do this without things like rational expectations and efficient market hypothesis?
One hopes MMT would do the obvious thing – and as a consequence:
1) Use appropriate models based on macro and nor macro thinking, which requires fundamentally different mindsets
2) Use a much wider range of experience to inform thinking and so avoid the risk of herd behaviour which now dominates
3) Take time to listen to the outliers who are suppressed in current narratives
In essence, forecast on an informed basis
And yes, that is very different
You’ve given me a lovely sounding but basically meaningless answer.
What exactly does “forecasting on an informed basis” mean? How are you going to inform yourself?
1. What isn’t appropriate about the models currently being used?
2. What does this mean exactly?
3. This might as well read “Listen to Richard Murphy and other MMTers.
None of this supports the idea that rational expectations are totally flawed, especially that any forecasting for MMT would have to use exactly the same type of models and methods.
Go and read Turner I suggest
And think, as I am, about how to do it better
Then come back if you can get over dedication to a system that palpably failed then and still is by requiring adherence to a model of the economy that does not work based on assumptions that are literally unreal
I have no problems with creation al expectations
I do with the theory bearing that name
“I hope we can agree that central banks and governments need to make forecasts to manage the economy. ”
The problem here is that the “need” is totally unrelated to the adequacy of the predictive security of the supposed economic “science” that supposedly informs the modelling (and it is ‘modelling’ not scientific predictions that are produced). Science that does not predict with rigorous accuracy fails the most essential test of science. The “need” is rather a function of public ‘trust’, public ‘faith’ and the ‘authority’ required of central bankers; and that is purely a matter of psychology. Economists have no authority in psychology; they know virtually nothing about it.
Business more modestly produces mere budgets, and the value there is being able to track the deviations, and make adjustments. It is often the deviation between the ‘actual’ and the budget that provides invaluable insights into what is happening to the businessman; but this is typically intuitive, not scientific and no businessman worth his/her salt would invest too much rational faith in the thought. Whether they act on the intuition is little to do with rational expectations.
Fundamentally the question to be answered is about the lens through which the issue is addressed
I think you will agree
Agreed.
I was on the call last night and although you were rightly dismissive you stayed the right side of politeness.
If I recall, I think he proposed that any money creation would be met by a currency devaluation….. and I just wanted to scream JAPAN!! 20 years of QE and the currency is 20% stronger (versus USD).
Thanks
Ah, Cognitive Dissonance – something all orthodox economists and commentators seem to suffer from these days.
The comment made in your debate reflects the standard “Chicago school” neoclassical hard-right rejoinder to any attempt to ground economics (whether macro or micro) in the real world as opposed to abstract theory. The leading rational expectations school of macroeconomics is “real business cycle” theory which basically holds that money and finance are absolutely irrelevant to the business cycle and to fluctuations in output/GDP, with the business cycle instead being driven by technological factors. The weird thing is, that’s pretty much 180 degrees wrong: I do think there’s a role for technology in explaining the long-run slowdown in productivity growth, but I think short-to-medium term economic fluctuations are much more likely to be driven by monetary and finance factors (e.g. the 2008-09 crash). Real shocks from outside the finance sector are also possible (e.g. COVID-19), but “money doesn’t matter” is a very strange way of looking at the macroeconomy which is only really found among hard-right neoclassical extremists these days.
I agree
In a. Era of financialisation the claim makes no sense at all
If people were rational then salespeople would be out of a job.
And the advertising industry!!!!
One of my tutors on the MBA at the University of Derby called himself a ‘pracademic’ on the basis that there was nothing as good as a good theory.
The only way to test a theory to see if it was good is to use it – that’s the pracademic approach – and then decide if it works based on the evidence and an honest appraisal.
Not only do you have ‘rational expectation theory’ but you also still have the ‘efficient market hypothesis’ – which always sounded like a form of apology for the herd mentality to me seen seen in financial economics and was also thoroughly debunked by ‘The Big Short’ and the behavioural economists.
Today, I have reached the age of 55 years old – a life that has been dominated by what I think are bad theories like RET and EMH and public choice theory – and I’ve seen nothing but problems as a result for most people.
It’s time we tried some new theories – MMT being one of them.
‘Rational choice’is like ‘complete markets’, or ‘everyone has access to the same full information’. One of those basis assumptions on which classical economics is based which to non-economists seems blindingly obviously, to bear no relationship to the real world.
None the less people like this cling to these beliefs like the worst religious zealots because to acknowledge the flaws would bring their whole belief system tumbling down.
The problem here is that economics wishes to be a science that relies principally on mathematics, yet in reality the phenomena that drives economies is psychology. Economists do not know how to do psychology. They do not study it. Economics attempts to square the circle by appealing to ‘rational expectations theory’; their escape route from psychology, back into some kind mathematical world driven by geometry and over-simplified equations. The appeal to Abraham Lincoln is a red light signal that this isn’t science (certainly not the science in psychology), but mere anecdotalism. The abject inability of economics to predict (the bedrock of hard science) is the proof of the inadequacy of the methodology.
This whole performance by a central banker is merely a demonstration of how far banking has place itself in the hands of economic theory, and the intellectual mess economics is in.
The book from the Post-Crash Economics team on how economics has been taught and the almost exclusive focus on neo-classical economics explains a lot of why so many economists fail to explain events, let alone predict. That said, there are a few that buck the trend; the likes of Stephanie Kelton, often mentioned here but also Steve Keen, Eric Beinhocker and a few others plus economists from the past like Minsky.
Certainly the apparent lack of understanding of basic psychology is a factor. Re the mathematics, I’d flippantly remark that economists confuse their knowledge and use of statistics, with ‘real’ mathematics! Steve Keen and Eric Beinhocker are good on this with their use of the maths of complexity. Economics has a lot to learn from meteorology and other natural phenomena where they have been dealing with complexity for decades. Most economists ignore and duck complexity by simplifying and making so many assumptions that their models are not just inevitably wrong but useless as well. (To paraphrase the saying about models…)
Agreed
I’m reading Steve Keen’s book Debunking Economics at the moment, and it’s amazing how much of classical economics seems to be based on emotional wish fulfilment and pretty mathematical charts, rather than real world data, of which there is no shortage.
Psychology is not perfect, and there have been dishonest practitioners and problems throughout the years (Zimbardo being a prime example), along with a reproducibility crisis, but it has turned a corner I feel, and the teaching of psychology is extremely strong on empirical results and scientific experimentation. Such that the psychology part of my degree was much more maths and statistics heavy than the computing part.
I hope that economics learns to step out of pretty models and a bit more into scientific method, which it might mean it actually makes the leap to be a true science. Psychology is working on getting there, hopefully they can drag a few classical economists out of the their textbooks and into the real world.
Totally agreed.
From what the speaker on behalf of central bankers was saying, they do seem somewhat obsessed by conventional wisdom. Galbraith would be laughing when not openly crying
Agreed
It is worth reflecting on what Muth actually wrote. Most of the 1961 paper asserts a rational expectations hypothesis – only as a hypothesis; which is presented principally as an abstract discussion, and in the form of a series of equations. It is only at the close, section 5 ‘Rationality and cobweb theorems’ (pp.330-334) that we find any attempt to look at the evidence for its actual effectiveness.
Nothing in Section 5 provides clear or repeatable results, derived from the direct application of the hypothesis to an actual case. Instead Muth frames the problem in this way: “The only real test, however, is whether theories involving rationality explain observed phenomena any better than alternative theories.” Notice here that the real test is not how accurate the hypothesis is as a self-supporting predictive tool; but whether it is better than Muth’s chosen comparative methods. Muth’s principal comparison is with ‘the cobweb “theorem”‘ (his use of the inverted commas here is scarcely confidence inspiring). Muth proposes the ‘coweb theorem’ has been considered to have had some success, but makes the rather lame acknowledgement that: “Few students of agricultural problems or business cycles seem to take the cobweb theorem very seriously, however, but its implications do occasionally appear.” In the only evidence Muth supplies of the comparison between the cobweb theorem and rational expectations, he writes this: “Certain properties of the cobweb models are compared with the rational model in Table 5.1 for shocks having no serial correlation. Such comparisons are a little treacherous because most real markets have significant income effects in demand, alternative costs in supply, and errors in both behavioral equations. To the extent that these effects introduce positive serial correlation in the residuals, the difference between the cobweb and rational models would be diminished” (p.331). Table 5.1 does not provide any data at all, any demonstration of outcomes, but the abstract representation of the formal properties of cobweb models.This is not proof.
Apart from the cobweb theorem (another hypothesis) Muth’s comparisons are with the evidence of Heady and Kaldor (‘Expectations and Errors in Forecasting Agricultural Prices’, Journal of Political Economy, 62: 34-47 (February, 1954)), of which Muth concludes that what Heady and Kaldor show is that, “for the period studied, average expectations were considerably more accurate than simple extrapolation, although there were substantial cross- sectional differences in expectations” (p.332). Modigliani and Weingartner (‘Forecasting Uses of Anticipatory Data on Investment and Sales’, Quarterly Journal of Economics, 72: 23-54 (February, 1958)) drew similar conclusions.
In short, ‘rational expectations’ is introduced, and declared a triumph first by abstracting analysis from direct, observable, data-dependent, critically reviewed and demonstrated empirical tests; and then by setting the bar against a standard of ‘simple extrapolation’ and some fairly limited modelling alternatives in an extremely abstract way; a bar frankly set so low I supect a mouse could leap over it in a single bound.
Very good
Prentii says:
December 3 2020 at 2:21 pm
If people were rational then salespeople would be out of a job.
And Donald Trump would never have had one.
Jeff – I am not sure the Donald has ever had a job…,
I listened into most of the call last night – found it very informative on the whole.
Re. the person on the call last night: he seemed to be saying that Rational Expectations Theory had moved on a bit from homo economicus and was taking into consideration things like “ insights from behavioural economics’” (that Turner mentioned).
Still I can’t believe you can measure expected behaviour (whether rational or not) and hope to aggregate it over a nation and not expect to have a massive margin for error that makes any such calculation meaningless. It could I concede perhaps give you some pointers to trends.
Macro is where is is at. My old university(City University) course slogan was “The whole is more than the sum of the parts”. We generally have no idea how complex systems work by just studying individual parts that make it. Economics is such a complex system, you can delve into the various parts but it will not give a better picture than studying it as a whole.
As to a “rational” economic man ,to paraphrase Keynes(second time today) he claimed that if he did exist he must be suffering from a psychotic disease. To make all life’s judgement’s based on economics would render us inhuman.
Kate Raworth & her team made this brilliant little video on this subject…
“Economic Man vs Humanity: a Puppet Rap Battle”
https://www.youtube.com/watch?v=Sx13E8-zUtA
Good one
Now on the blog
Thanks
If we were rational no one would step up and take the job of parent. It’s a 24/7/365 job where you’ll get bitten, puked on, dribbled on, where your clients are often ungrateful and rather than being paid you actually pay potentially hundreds of thousands of pounds over the course of your life.
It follows then that if we were rational our species would quickly become extinct.
Well, it is just possible neoliberalism is extinct; it just doesn’t know it yet – treading air over the abyss in a ‘Tom and Jerry’ cartoon.
I agree with that
And if that was not proof enough, we do it all over again with grand children!
Simon.
I would add to that, that if we were rational we would not be consuming ourselves into oblivion.
We live in a culture based on consumption of “stuff”. (Two thirds GDP comes from consumer spending).
We are conditioned to behave this way from a very young age. Just watch all the adverts on kids TV for plastic shite that will be in the bin/landfill within a year.
This behaviour is destroying our ability to survive on this planet and yet we all know we are doing it.
The institutions that govern over our actions are complicit in our behaviour. Corporate lobbyists and governments are actively discouraging us from changing our culture/behaviour.
Isn’t not “rational” behaviour, it’s madness.