Commentary on rational expectations since the 2011 Nobel Prize in economics was awarded to Tom Sargent and Chris Sims continues to pour in. Last week, in addition to a post of my own, John Kay posted a hostile assessment of rational expectations on his website, prompting a half-hearted defense of sorts from Matt Yglesias likening the rational expectations revolution to the Copernican Revolution, a comparison of which Noah Smith, launching a renewed attack on rational expectations and its claims to have transformed economics into a hard science, heartily disapproves. In today’s Financial Times, John Kay returns to the attack with an ironic jab at the Nobel committee for avoiding any mention of rational expectations in its citation of Sargent and Sims, and some well-aimed barbs at the pretensions of rational expectations to a sort of infallible knowledge.
I agree with these criticisms of rational expectations, though as I suggested, the rational-expectations hypothesis can be, and often is, a useful one. Rational expectations only becomes dangerous when transformed from an empirical hypothesis and a way of testing the coherence of a model into a methodological principle and an axiom purporting to embody a necessary attribute of the world, on the order of Newton’s laws of motion. Thus, through a program of methodological imperialism, rational expectations has been imposed on much of mainstream economics as the only acceptable modeling strategy.
The spirit of this methodological imperialism is captured remarkably well by the abstract to the entry on “calibration” contributed by Edward Prescott and Graham Candler to the New Palgrave Dictionary of Economics, second edition.
The methodologies used in aerospace engineering and macroeconomics to make quantitative predictions are remarkably similar now that macroeconomics has developed into a hard science. Theory provides engineers with the equations, with many constants that are not well measured. Theory provides macroeconomists with the structure of preference and technology and many parameters that are not well measured. The procedures that are used to select the parameters of the agreed upon structures are what have come to be called ‘calibration’ in macroeconomics.
I would like to comment on another aspect of the methodological imperialism of rational expectations which is its reductionism. (The reductionism of rational expectations has, to my knowledge, been noted only by Allesandro Vercelli in a paper “Keynes, Schumpeter and Beyond: A Non Reductionist Perspective” in A Second Edition of the General Theory, edited by G. C. Harcourt.) In philosophy, reductionism refers generally to the idea that all higher level (i.e., more particular theories) are (can be? will be?) ultimately derived from and translatable into (can be reduced to”) lower-level, deeper, theories. Thus, the laws of chemistry, geology, astronomy, meteorology, biology (?) can ultimately be “reduced to” the laws of physics.
One field in particular in which the idea of reductionism is very much alive and discussed is in the nexus between brain science and the philosophy of mind — the old mind-body problem. Many philosophers and brain scientists argue that all mental states are “reducible to” physical states. The problem with reductionism in brain science and the philosophy of mind is that, unlike chemistry and physics, where the reduction is to some (unknown to me) extent already worked out, there is not even a glimmer of understanding of the physics that would allow one to derive mental states from physical states. Thus, reductionism in brain science and the philosophy of mind is a purely metaphysical notion that has no basis in known science. (Admittedly, I am speaking largely out of relative ignorance of the relevant philosophy and total ignorance of the relevant science, but my impression is that there are philosophers and scientists who would agree with my assertions about the current state of brain and physical science.) Moreover, even if we had all the science worked out, it is still not clear that mental states would in fact be reducible to physical states because there is not necessarily any way of bridging the chasm between mental and physical.
Rational expectations as a methodological principle requires that agents in every model base their decisions on the expected values of the stochastic variables, ruling out divergent expectations among agents, thereby promoting the adoption of representative agent models. Macroeconomic models not derived from explicit utility or wealth-maximizing assumptions and rational expectations are inadmissible. This sharply limits the possibility for deriving anything like what Keynes referred to as involuntary unemployment.
Thus, involuntary unemployment is to rational expectations theorists what consciousness is to mental reductionists. Even though we all have direct experience of consciousness, mental reductionists deny that there is any such thing as consciousness (which obviously is a far stronger claim than that consciousness is a figment of our imagination). Similarly, rational expectationists deny that there is such a thing as involuntary unemployment even though we seem to have plausible evidence that there are people who would be willing to work at the prevailing wage but are unable to find work. One can imagine that such evidence for involuntary unemployment might be discounted, but generally to do so, one would have to be able to provide a plausible reinterpretation of the evidence combined with compelling independent evidence that supported an alternative theoretical conclusion. But where is the compelling alternative evidence of the rational expectationists? And what is the plausible reinterpretation of the plausible evidence that there is involuntary unemployment? Rather than confront these issues squarely, rational expectationists simply insist that they are following the dictates of rigorous science. But their conception of rigorous science confuses an axiomatic method designed to deduce logical inferences from a set of assumptions and definitions with an attempt to compare the implications of alternative hypotheses with the evidence. The latter it seems to me is closer to true science than the former, unless your conception of true science is very close to that of Ludwig von Mises.
Uneasy Money 
Philosophy of mind isn’t my department (quite literally: that’s handled by the Philosophy Department, while my department handles the history and philosophy of science) but it’s worth noting that, at its best, reductionism occurs when scientists (say in physics) needs to use a concept (say chemical valence) that belongs to a different field. If they can provide a reductionist account in the existing terms within the scientists’ own field, they will. If not, they won’t perform stupid contortions or cry about it; they’ll just import the concept wholesale (as with Newton’s importation of action at a distance from occult metaphysics).
That seems to me to be a very different programme from saying that a concept/theory/model MUST be reduced to physical terms or a model incorporating rational expectations, come hell or heavy water. If there are good macroeconomic models that can’t be reformulated well with ratex, then we’re just going to have to live with them.
PS: In defence of von Mises, he would have had very little time for ratex reductionism, albeit PARTLY for the wrong reasons. In fact, I think he’d have had very little time for ratex at all, despite being a deductive rationalist with far more faith in individual human reason than, for example, von Hayek.
LikeLike
“…unless your conception of true science is very close to that of Ludwig von Mises….”
Methinks you answer your own question…
LikeLike
“Thus, involuntary unemployment is to rational expectations theorists what consciousness is to mental reductionists.”
At least one school in the philosophy of mind holds that the trouble with reductionism is not that we lack an adequate scientific theory of consciousness, but that the criteria we use in attributing mental states, e.g., “he thinks the train’s coming at 2 pm,” are such facts his waiting at the train station around 2 pm, overhearing him saying this, etc.
Now suppose scientists discovered a brain pattern that generally correlated with people thinking the train (or something) is coming at 2 pm. Not so fast. How do the scientists know when to take their brain scans? They must rely on the criteria we ordinarily use to determine whether someone’s waiting for the train. Otherwise, they’re not talking about the same thing we’re talking about when we talk about someone waiting for the 2 pm train.
“Involuntary unemployment” is a little trickier simply because it’s a theory-ladden concept. But if an economist says, “X is voluntarily unemployed because she refuses to accept a job paying $0.01/hour,” then one might well conclude that this only true on idiosyncratic definitions of “voluntary” and “involuntary.”
LikeLike
While this is slightly off-topic, I wanted to give you a little update on something we discussed a few weeks ago, i.e. a growing divide in thought regarding use of money. Recently Sumner has gotten some chiding from another blog that is opposed to his ideas, When I weighed in and suggested that some people might like to abandon money altogether, one of those individuals came back with what basically amounted to “don’t be ridiculous”. The next day, news broke that Louisiana voted to disallow cash in Goodwill stores, thrift stores, flea markets and the like. I know that’s a limited circumstance of base money but it really was unbelievable.
LikeLike
Should the law hold, that would create some significant distortions in the use of cash in Louisiana. Apparently the cash money base does not change much all that often. But why would Louisiana want to create an underground economy for second hand goods?
LikeLike
This is probably some right-wingers’ idea to make the life of poor people harder. In Michigan, we’ve seen ideas like people on welfare being banned from possessing something like anything over $20 in cash, being required to purchase clothes with government money only at used clothing stores, etc.
Right-wingers, in the end, are evil.
LikeLike
There must have been a coalition of left and right for such a thing to happen. All too often, the economic rights of the individual become a punching bag for some on the left, and the idea of the individual simply serves as a straw man for some on the right.,
LikeLike
Yes, there was a coalition. Even numbers from both sides, if I recall correctly. And it was done for the purpose of allowing police to track certain types of stolen goods such as copper by forcing a paper trail, and the primary target wasn’t things like Goodwill or garage sales. I think those were unintended consequences. I read about this story on a forum, but can’t recall more details than that.
LikeLike
W. Peden, I think I agree with everything you said. The conflict between rational expectations and Austrian business cycle theory has been widely noted, so I didn’t mean to suggest that Mises was an early exponent of rational expectations. But the very dogmatic conception of a kind of axiomatic method as the only valid method of economic reasoning seems to me to be a characteristic shared by Lucas and Mises. Hayek, of course, was in every respect much less dogmatic than Mises.
Donald, Well, I was trying to at least suggest the answer. I’m glad you think I was successful.
Greg, I think you are right.
Becky, Thanks for the update. Do you have a link for the Louisiana story? Was the vote by the legislature or was it a referendum?
Barry, I agree that it sounds pretty awful. But I would reserve judgment on what these people actually thought they would accomplish by this measure. The further comments by Becky and Dustin suggest that there may be more to the story than meets the eye.
LikeLike
This is the only source I have: Jeffrey Tucker at Mises Economics Blog, who linked to Eyewitness News 10 KCFY.
http://blog.mises.org/18776/wreck-the-money-
(Wreck the Money and Then Abolish it)
LikeLike