Like many economists he has decided to call "The Efficient Markets Hypothesis", "Rational Expectations."

TO BE NOTED: From Angry Bear:

"Shrill

Robert Waldmann

I usually try to be semi polite. I especially don't usually deliberately write rude things about smart economists. However, here goes. Evidently Tyler Cowen* wrote

In a strict rational expectations model, we might expect some people to overtrust others and one view of rational expectations is that investors’ errors will cancel one another out in each market period. Another view of rational expectations is that investors’ errors will cancel one another out over longer stretches of time but that the aggregate weight of the forecasts in any particular period can be quite biased owing to common entrepreneurial misunderstandings of observed recent history. In the latter case, entrepreneurial errors magnify one another rather than cancel one another out. That is one simple way to account for a widespread financial crisis without doing violence to the rational expectations assumption or denying the mathematical elegance of the law of large numbers.

After the jump an argument which might be of some interest (added as an update) and a rant.

* Update: spelling error corrected.



Update: I just noticed something odd about the paragraph by Cowen. Like many economists he has decided to call "The Efficient Markets Hypothesis", "Rational Expectations." So before his redefinition (which I think must be absolutely condemned as I do below) he wrote "one view of rational expectations is that investors’ errors will cancel one another out in each market period." If by "errors" he means avoidable errors, then that would be the efficient markets hypothesis. However, it would not amount to rational expectations.

When the rational expectations assumption is used, it is used to mean "the things we care about have the same values they would have if everyone were rational." In particular, inferences about welfare which some people actually take seriously, are derived from models including the rational expectations hypothesis.

Then somehow, when it is tested it changes to a quite different hypothesis. "aggregate variables which we can measure have the same values they would have if everyone were rational." So, in finance, it becomes a statement about asset prices. However, for the use of the assumption in contributions to the policy debate to be defensible, one would need a model in which welfare is what it would be if everyone were rational. I am fairly confident that you can't do this unless you assume people are risk neutral, that is make an assumption which is overwhelmingly rejected by the data.

If aggregates act as if people are rational and they make irrational mistakes which cancel out then they will bear more risk than they would if they were rational. Welfare will be lower. The amount of irrational risk bearing can be influenced by policy. The optimal policy is laissez faire *if* people are rational. If they are not rational yet aggregates behave as if they were rational, then the optimal policy will not be laissez faire.

Before moving on to discuss Cowen's effort to dodge data by redefining terms,
I note that it does *not* become a statement about asset prices and trading volume for the simple reason that no one can write down a model with the rational expectations hypothesis which isn't overwhelmingly rejected by the data. I believe that there are simply no models of trading volume including the rational expectations assumption in the literature. For more than 20 years agents who trade with no motive described in the model have been present in (as far as I know) all models of market microstructure. Now it may be hinted that there might be some rational reason for noise traders to trade as they do. However, no one (as far as I know and I am ignorant) has presented such a model, because the volume of trading that could be rationalized is a tiny tiny tiny fraction of observed trading volume.

My original rant is below. 5 minutes after posting, I stand by it, but I think the objection above is actually of some potential interest, while the shrillness below is, of course, something that has been said and written many many times.



Cowen has chosen to redefine the rational expectations hypothesis. He has also defined it so that it is meaningless, unfalsifiable, and not a hypothesis.

His intellectual accomplishment can be reproduced in other fields. If I redefine "The Ptolomaic model" to mean "The hypothesis that the earth orbits the sun" then I can save it from its recent difficulties.

I think he could have made his point more clearly if he decided to redefine "the rational expectations hypothesis" to be the hypothesis that 2+2=4. Oh and while he's at it he could define "the law of large numbers" to mean large numbers are larger than small numbers."

His use of the phrase "law of large numbers" shows that he is absolutely unwilling to consider the actual statement of any actual theorem. Oh and that he doesn't know the difference between mathematics and science.

I think a refutation of Cowen's argument which is just as valid as his argument is "I am Tyler Cowen and I retract abjure and reject my argument". Technically, I am not Tyeler Cowen, but if he can redefine the rational expectations hypothesis as he pleases then why can't I redefine "Tyler Cowen" to mean "Robert Waldmann."

Posted by Robert"

In real life, he explains, households and businesses are highly uncertain

TO BE NOTED: From Business Week:

"Macroeconomics: Adjusting the Big Picture

Three experts weigh in on how to better handle, and even avoid, the next global financial crisis

By Peter Coy

Is macroeconomics worthless? Far from it. Here are three economists trying to draw lessons from the global economic crisis so the world does a better job of keeping growth on track next time.

Hyun Song Shin, 49, Princeton University
Big Idea: The Federal Reserve should pop credit bubbles early by raising interest rates.
The financial crisis arose, in large part, because companies and households borrowed too much. Shin faults macroeconomists for developing models that didn't allow for the possibility of risks such as a bubble in lending or a deterioration of credit standards. "Over the past 10 years our mainstream colleagues in macroeconomics have somewhat neglected finance," he says.

The economists at the Federal Reserve, too, weren't looking at the right problems, says Shin: "These things crept up behind the backs of the central bankers. It was a blind spot."

Shin says the Fed should nudge rates up when credit is expanding rapidly. He's looking for data that give hints of trouble, such as heavy secured borrowing by financial firms. Creating better models of the economy is "not easy, but I think it's too defeatist to say it's impossible," says Shin.

Roger E.A. Farmer, 54, University of California at Los Angeles
Big Idea: The Fed should make large-scale purchases of equities to restore investor confidence and get the economy back on track.
Farmer thinks Fed stock purchases would be more effective than the Obama Administration's deficit spending. He frets that if the government puts more money in the public's pockets via increased spending or tax cuts, people won't spend it as long as they feel poor because of stock market losses.

The answer, in Farmer's view, is for the Fed to set a target for how high it wants the stock market to be by a certain date, then commit to buying enough shares (through broad-based index funds) to hit that target. Higher stock prices will make people feel wealthier and spend more, creating prosperity. Symmetrically, he would have the Fed sell to hold down prices in boom times.

Similar ideas have been tried before in Hong Kong, Taiwan, and Japan. They've had mixed results but are credited with helping to rescue Hong Kong from the Asian financial crisis in 1998. "I get a lot of interest from other economists," he says, "but it takes a long while for new ideas to spread."

Thomas Sargent, 65, New York University and Hoover Institution
Big Idea: The economy is volatile, in part, because households and businesses hold "fragile beliefs" that shift quickly.
In the 1970s, Sargent was one of the thinkers behind "rational expectations," which says that ordinary people can correctly anticipate the range and likelihood of possible future outcomes.

Sargent now says that theory was an oversimplification. In real life, he explains, households and businesses are highly uncertain. Developments such as an unexpected government action or a major company going bust can cause people to drastically revise their beliefs about what might happen next.

The good news: Beliefs may shift back again through unexpected positive events. Sargent is not willing to say how that might happen, but he notes that in the early 1980s the Federal Reserve was able to lower the public's expectations about long-term inflation. That, in turn, caused actual inflation to fall, ending a period of stagflation.

Coy is BusinessWeek's Economics editor."