Rational Expectations: A Rhetorical Tautology

Economics at the onset is behavioural science. That by definition beckons economists to limit the parameterizing to a realistic pasture.

“To assume that individuals systematically and unmistakably anticipate the future implies that the future is systematically and unmistakably known to them at the very moment of action. If this were true, individuals would be automatons”, writes Nikolay Gertchev in a stellar review of Expectations theories.

Without alluding to the obvious, the paper deems the Rational Expectations (RE) School a mere obfuscation rather than enlightenment.

The main idea behind the RE hypothesis is to consistently extend the principle of individual rationality from the problem of the allocation of resources to that of the formation of expectations. The individual is supposed to use all of the available pertinent information when formulating his forecast of prices, interest rates, and even government policies“, observes Gertchev.

Some economists now use the Adaptive Expectation (AE) model in tandem with the RE theory. For example, an anti-inflation campaign by the central bank is more effective if it is seen as having credibility in maintaining its stance. However, the question being asked is inverted. It isn’t one of how individuals and then the aggregate sum of their parts i.e. the economy forms expectations, it is more of how they react to policies. Thence the answer lies in the credibility of the authority dictating it expectations on the agents to take heed of its stance and come to a similar solution as the rest of the economy as predicted by John F. Muth and Robert Lucas.

“Our hypothesis is based on exactly the opposite point of view: that dynamic economic models do not assume enough rationality” (Muth 1961, p. 316).

In other words, individuals’ purposeful behaviour, by virtue of its own nature, is said to be void of systematic expectation errors. If the same errors repeat over time, the individual could not be considered fully rational. Herein lies the fault where Muth assumes the agent to act absolutely and independently, thereby learning from his/her err. However, expectations aren’t absolute unless at a rather micro level; otherwise are superseded as a joint exercise at a macro level and thus are relative. The school assumes that in their stochastically absolute approach to decision-making, the agents will conform to the norm. However, this is primarily due to the presence of the over-bearing herd mentality (Sonnenschein-Mantel-Debreu Theorem). Thus rationally doesn’t enter the realm of decision-making till in later stages and is in fact reactive rather than proactive.

Source: Thōth

In the absence of this credibility, this school of thought falters, as its foundation lies in the assumption of agent’s absolute expectations whose sum is largely similar to what economic theories predict (given that individual behaviour succumbs to aggregate behaviour).

A wage decision when to be determined by the firm and the labour union is also a function of avarice as much ‘rational’ expectations of inflation. Apart from theorising inflation as a reason for locking in higher wages by the labour union, the firm tries to do quite the opposite by trying to understate inflation. The process to achieving a mutually beneficial outcome by both parties requires a finer understanding of this decision-making process, rather than relying on RE. Also in the mix, is the understanding of the agent of the importance and application of available information.

Source: Thōth

Primary then, is comprehending how the importance of information is determined, who and what determine how much the information is worth and where it is determined. In the absence of a market where transactions can be carried out at an arm’s length, herd behaviour sustainably prevails.

A primary criticism of the AE model is the inability to learn from the past and no access to information is common. If agents learnt from their past, bubbles wouldn’t re-manifest themselves in financial markets. Selective memory cohabitates with avarice and the fact of the matter remains that agents aren’t naturally rational. RE is then Utopian jargon of an Ideal world with perfect information and robotic expectations. Even in the presence of perfect information, the RE will fail owing to omnipresent herd behaviour. Economic indicators again are merely reflective of current status quo.

The RE model is thus a guideline to override the actual AE of agents.

References

Gertchev, N. 2007. A Critique of Adaptive and Rational Expectations. Quarterly Journal Austrian Econ 10: 313-329

Lucas, R.E. 1972. Expectations and the Neutrality of Money. Journal of Economic Theory 4: 103-24.

Maarten, J. C. W. 1993. Microfoundations: A Critical Inquiry. Routledge.

Muth, J. F. 1961. Rational Expectations and the Theory of Price Movements. Econometrica 29 (3): 315-35.

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