Tuesday, June 9, 2009

The goal of an RE model is to establish the universality (or lack thereof) of a specified problem.

From Marginal Revolution:

Why it's worth defending rational expectations theory

RSuleiman, a commentator over at Ezra Klein, writes:

Having just finished reading the paper, it seems very much of a piece with Professor Cowen's other post-crash writings, and yes, it does seem to be designed as a defense of the rational markets hypothesis.

He is referring to my piece on the crash. Suleiman's is a common response but it is neglecting why rational expectations (RE) models are so powerful and also, at least among economists, so popular. Economists try to fit various phenomena into RE models to show that the mechanisms underlying those phenomena are general and not relying on some very specific set of assumptions about expectations. The goal is not to convince everyone that expectations, or markets, are indeed rational. They're not, at least not always.

The goal of an RE model is to establish the universality (or lack thereof) of a specified problem.

There are people who misuse rational expectations techniques, but don't let those mistakes mislead you. Krugman and Stiglitz also have used RE a lot as a modeling device, although they are (properly) willing to abandon it as a descriptive assumption in many cases. A market failure argument with RE is often more powerful than a market failure argument without RE.

Posted by Tyler Cowen on June 9, 2009"


Although I often disagree with you, I generally find your views useful and clear. In fact, even when I generally disagree with you, as in this paper, I understand your point and am, in a certain basic sense, sympathetic to it. I feel the same way about Richard Posner. Even as I disagree with him, I tend to feel some common ground.

In the last few years, some people sold their houses and most of their stocks, and ended up largely in, say, CDs. They did this because they saw that we were in a housing bubble, and stocks had risen quite a bit after the tech bubble burst. Also, the Bush Administration had run up such a huge debt in a short amount of time, that, if a crisis hit, the government's responses would be hindered. What did these people know?

I don't think that some of these people knew anything for sure, but they had a motley list of rules, nostrums, and life experiences ( very important ), that translated into a careful, prudential, manner of dealing with money. When I read Taleb's works, I basically find that he simply produces such a list in the end. Possibly these people are followers of Benjamin Graham, for example. In any case, these people had a manner of dealing with money that helped them weather this crisis. Prudentially, beforehand, they had bought houses and some stocks and mutual funds. This doesn't mean that they became rich, just better off than they would have been.

In real life, such people, seeing the riskiest buyers buying houses at the top of the market,could make no sense of this event. It's not that the buyers were poor. Presumably, in a different market, these people could afford a house. But, in this market, they couldn't.

If you're such a conservative person with money, you might find the explanations being given by people for their actions more like excuses. That doesn't mean that you have to be unsympathetic, but you are more likely to want to know what the assumptions and presuppositions of these people were, at all levels. In many cases it will come down to trust. However, depending upon the relationship, trust can mean fiduciary responsibility and professional ethics. All this needs to be investigated. There's no a priori way to determine the exact causes of this crisis.

In that sense, saying that people trust other people, follow advice, get greedy, get scared ( want to buy a house as an investment for retirement), isn't much of a theory. It's helpful to remind ourselves of these truisms, but that's all that they are. In that sense, I actually like Black's methods and ideas:

"At bottom, the financial
crisis has been a story of how poorly suited we are
at handling unexpected systemic risks, especially
those that stem from the so-called real economy."

To me, it's more a question of how and why people made decisions that they suspected were dubious.

"Again, this
conclusion follows from Black’s insistence that a
business cycle is essentially a set of sectoral shifts,
and those shifts do not always occur easily."

People's views about many issues will change because of this crisis. The shift will not be easy because many people don't yet know where they want to go, or, when they do, how to get there.

"But we
do not yet know how to get investors out of T-bills
and back into riskier assets."

On the contrary, we have some decent ideas, and we're trying them. The stimulus, which could include tax cuts, infrastructure spending, automatic stabilizers, has some merit. What we don't know, and, from my point of view, never will know, is exactly which of these moves will be responsible for getting us out of this mess. That's why we're trying them. And, because human beings are involved, it's quite possible that the mix that will work this time, didn't work the last time, and won't work the next time.

Posted by: Don the libertarian Democrat

No comments: