Simon Wren-Lewis Makes the Case for Rational Expectations

     It's one of those zombie ideas that just won't die. Yet reading SWL's explanation is helpful in understanding why. SWL is hardly an obnoxious Scott Sumner type, he's a New Keynesian who's heart is basically in the right place and I probably would agree with him on many policy prescriptions. Still, in reading him you see that RE is about a lot more than Sumner. 

    It remains a dominant theoretical belief of the mainstream macro establishment and has been at least since the late 50s. SWL s answer for why seems to be there's nothing better to replace it with:

    "This discussion can easily get populated with straw (super)men, so let's be clear about some things. It is not a debate about rational expectations in the abstract, but about a choice between different ways of modelling expectations, none of which will be ideal. This choice has to involve feasible alternatives, by which I mean theories of expectations that can be practically implemented in usable macroeconomic models. In the past, I have attempted to try and start a dialog with heterodox economists on the level of practical macroeconomics, to get beyond the fine words and phrases. It did not seem to work.  I tried again in that recent post, asking for practical alternatives to rational expectations. Professor Syll referred me to behavioural economics, or Frydman and Goldberg’s ‘Imperfect Knowledge Economics’. But perhaps I did not make it clear what I meant by practical."

     http://mainlymacro.blogspot.co.uk/2013/11/defending-rational-expectations.html

     Prior to the rise of RE in the late 50s economists hued to a belief in adaptive expectations where economic agents presume that he future will look largely like the past. SWL seems to think that this theory is insulting to the very intelligence and dignity of man:

   If I really wanted to focus in detail on how expectations were formed and adjusted, I would look to the large mainstream literature on learning, to which Professor Syll does not refer. (Key figures in developing this literature included Tom Sargent, Albert Marcet, George Evans and Seppo Honkapohja: here is a nice interview involving three of them.) Macroeconomic ideas derived from rational expectations models should always be re-examined within realistic learning environments, as in this paper by Benhabib, Evans and Honkapohja for example. No doubt that literature may benefit from additional insights that behavioural economics and others can bring. However it is worth noting that a key organising device for much of the learning literature is the extent to which learning converges towards rational expectations.

   "However most of the time macroeconomists want to focus on something else, and so we need a simpler framework. In practice that seems to me to involve a binary choice. Either we assume that agents are very naive, and adopt something very simple like adaptive expectations (inflation tomorrow will be based on current and past inflation), or we assume rational expectations. My suspicion is that heterodox economists, when they do practical macroeconomics, adopt the assumption that expectations are naive, if they exist at all (e.g. here). So I want to explain why, most of the time, this is the wrong choice. My argument here is similar but complementary to a recent piece by Mark Thoma on rational expectations."

     I don't really see why believing that the future will resemble the present is so unreasonable. Obviously the future will be different in important ways. The truth is it's impossible to wholly predict the future. Kenynes argued that all we really have are conventions and 'rules of thumb'' in which case it's not unreasonable to assume that there will be many similarities even if this proves wrong. The trouble is there is no omniscient position. Further down in the piece, SWL further defines what he means by 'stupid.'

     "To assume, as mainstream macroeconomists once did, that these expectations just depend on past observations about inflation seems to assume that agents are stupid. These agents ignore everything that economists and the media say about inflation: they ignore monetary policy, and whether the economy is in a boom or recession. Now if getting expectations right did not matter too much to these agents, then maybe such naivety would be understandable. But in this case making expectations errors can mean getting real wages or profits wrong, so it matters."

      I mean an agent may figure different aspects of these things in-it depends on the agent, which gets us into the debate over the representative agent model and homegeity of agents. 

     http://en.wikipedia.org/wiki/Representative_agent

     https://www.aeaweb.org/articles.php?doi=10.1257/mac.1.2.29

     I''m with the heterodox guys here. I think something better than RE is possible. More generally, I think that microeconomics must be put in it's place: the whole idea of microfoundations I think is wrongheaded. What it comes down to is that Keynesian economics can only validate itself in front of a pre-Keynesian peer review. I do think that Nick Rowe took a pretty reasonable attitude to such debates however, 

    "Suppose you lived in a world where the price level followed a random walk. (That's sorta like the Gold Standard world). The naive expectation of 0% inflation would be rational in that world."

    "Suppose you lived in a world where the price level followed a random walk plus 2% drift. (That's roughly a 2% inflation target world). The naive expectation of 2% inflation would be rational in that world."

    "Suppose you lived in a world where the inflation rate followed a random walk. (That's sorta what the world was like in the 1970's and 1980's). The naive expectation that next period's inflation rate would be the same as last period's inflation rate would be rational in that world."

     "And so on."

      "For any naive way of forming expectations, you can find a world in which that naive way of forming expectations would be rational."

      "If the world never changed, you would think that people would figure it out eventually, even if by trial-and-error, or some sort of blind watchmaker Darwinian process. Naive and rational expectations will coincide."

     "It's when the world changes, so the naive expectations that were rational in the old world aren't rational in the new world, that things get tricky."

     "Which is an argument for small-c conservatism, in monetary policy rules and elsewhere. It keeps expectations more rational more of the time than they otherwise would be, so normal people make smaller and fewer mistakes. Because learning that new stuff is true is hard, and learning why new stuff is true is sometimes impossibly hard."

     http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/11/naive-vs-rational-expectations-is-a-partly-false-dichotomy.html

     I do consider myself a small c conservative believe it or not-which is one reason I hate the modern Republican party. The Dems are a good party on the other hand, they're basically the ultimate Whig party.  

     http://diaryofarepublicanhater.blogspot.com/2013/10/we-already-have-sensible-conservative.html

     Nick seems to be disagreeing with SWL that AE simply means economic agents are stupid. Finally, a very good piece over at the blog Decisions, Decisions, Decisions. 

     "There are some rather intemperate characters in this debate though a number of them also have the redeeming feature of intellectual curiosity and flexibility.  What many on the ‘heterodox’ side would really like to see is an engagement on the theoretical  rather than political issues and a reading of the texts in question.  Going for the ball and not the man.  In that regard the willingness of some renowned economic bloggers, such as David Glasner, Marc Thoma and Simon Wren Lewis, to begin debating and understanding the ideas in question is heartening."

      I think Andrew Lainton puts that very well. This is my real gripe with someone like Sumner who simply refuses to engage. He simply acts like anyone who questions the basic theoretical Neoclassical edifice is out of their minds and moves on. I have myself more than once remarked on the class of Glanser in particular, his power of analysis and, what is particularly welcome about him is his deep knowledge of the history of economic ideas. This is a a virtue exceedingly rare in today's NC establishment and it's true of economists I tend to like-Krugman, SWL as well as those like a Sumner. 

     http://diaryofarepublicanhater.blogspot.com/2013/10/scott-sumner-vs-david-glasner-on-fiscal.html

     I don't debate these issues as if I know everything, and in some ways let's face it the academic theorists do know more than many of the laypeople who become interested in heterodox economic ideas. However, this doesn't mean that we simply should cede the store to Sumner's arrogant monetary technocrats without a real discussion. 

     http://diaryofarepublicanhater.blogspot.com/2013/10/central-bank-independence-and-scott.html

    The willingness of some like Glasner, et. al to engage is very welcome and is the only way to learn what Nick talks about-learning whether new stuff is true or not.

    UPDATE: SWL indicates that RE only supplanted AE in the 70s which of course is true. I was thinking that some early developments towards the later victory for RE were already surfacing in the 50s. Still, the ful revolution came in the 70s. Still I would argue that part of what made the revolution so effective is that even the 'Old Keynesian' school shared many of the same microeconomic illusions-the OKers were still also NCers.