F. A. Hayek entitled his 1974 Nobel Lecture whose principal theme was to attack the simple notion that the long-observed correlation between aggregate demand and employment was a reliable basis for conducting macroeconomic policy, “The Pretence of Knowledge.” Reiterating an argument that he had made over 40 years earlier about the transitory stimulus provided to profits and production by monetary expansion, Hayek was informally anticipating the argument that Robert Lucas famously repackaged two years later in his famous critique of econometric policy evaluation. Hayek’s argument hinged on a distinction between “phenomena of unorganized complexity” and phenomena of organized complexity.” Statistical relationships or correlations between phenomena of disorganized complexity may be relied upon to persist, but observed statistical correlations displayed by phenomena of organized complexity cannot be relied upon without detailed knowledge of the individual elements that constitute the system. It was the facile assumption that observed statistical correlations in systems of organized complexity can be uncritically relied upon in making policy decisions that Hayek dismissed as merely the pretense of knowledge.
Adopting many of Hayek’s complaints about macroeconomic theory, Lucas founded his New Classical approach to macroeconomics on a methodological principle that all macroeconomic models be grounded in the axioms of neoclassical economic theory as articulated in the canonical Arrow-Debreu-McKenzie models of general equilibrium models. Without such grounding in neoclassical axioms and explicit formal derivations of theorems from those axioms, Lucas maintained that macroeconomics could not be considered truly scientific. Forty years of Keynesian macroeconomics were, in Lucas’s view, largely pre-scientific or pseudo-scientific, because they lacked satisfactory microfoundations.
Lucas’s methodological program for macroeconomics was thus based on two basic principles: reductionism and formalism. First, all macroeconomic models not only had to be consistent with rational individual decisions, they had to be reduced to those choices. Second, all the propositions of macroeconomic models had to be explicitly derived from the formal definitions and axioms of neoclassical theory. Lucas demanded nothing less than the explicit assumption individual rationality in every macroeconomic model and that all decisions by agents in a macroeconomic model be individually rational.
In practice, implementing Lucasian methodological principles required that in any macroeconomic model all agents’ decisions be derived within an explicit optimization problem. However, as Hayek had himself shown in his early studies of business cycles and intertemporal equilibrium, individual optimization in the standard Walrasian framework, within which Lucas wished to embed macroeconomic theory, is possible only if all agents are optimizing simultaneously, all individual decisions being conditional on the decisions of other agents. Individual optimization can only be solved simultaneously for all agents, not individually in isolation.
The difficulty of solving a macroeconomic equilibrium model for the simultaneous optimal decisions of all the agents in the model led Lucas and his associates and followers to a strategic simplification: reducing the entire model to a representative agent. The optimal choices of a single agent would then embody the consumption and production decisions of all agents in the model.
The staggering simplification involved in reducing a purported macroeconomic model to a representative agent is obvious on its face, but the sleight of hand being performed deserves explicit attention. The existence of an equilibrium solution to the neoclassical system of equations was assumed, based on faulty reasoning by Walras, Fisher and Pareto who simply counted equations and unknowns. A rigorous proof of existence was only provided by Abraham Wald in 1936 and subsequently in more general form by Arrow, Debreu and McKenzie, working independently, in the 1950s. But proving the existence of a solution to the system of equations does not establish that an actual neoclassical economy would, in fact, converge on such an equilibrium.
Neoclassical theory was and remains silent about the process whereby equilibrium is, or could be, reached. The Marshallian branch of neoclassical theory, focusing on equilibrium in individual markets rather than the systemic equilibrium, is often thought to provide an account of how equilibrium is arrived at, but the Marshallian partial-equilibrium analysis presumes that all markets and prices except the price in the single market under analysis, are in a state of equilibrium. So the Marshallian approach provides no more explanation of a process by which a set of equilibrium prices for an entire economy is, or could be, reached than the Walrasian approach.
Lucasian methodology has thus led to substituting a single-agent model for an actual macroeconomic model. It does so on the premise that an economic system operates as if it were in a state of general equilibrium. The factual basis for this premise apparently that it is possible, using versions of a suitable model with calibrated coefficients, to account for observed aggregate time series of consumption, investment, national income, and employment. But the time series derived from these models are derived by attributing all observed variations in national income to unexplained shocks in productivity, so that the explanation provided is in fact an ex-post rationalization of the observed variations not an explanation of those variations.
Nor did Lucasian methodology have a theoretical basis in received neoclassical theory. In a famous 1960 paper “Towards a Theory of Price Adjustment,” Kenneth Arrow identified the explanatory gap in neoclassical theory: the absence of a theory of price change in competitive markets in which every agent is a price taker. The existence of an equilibrium does not entail that the equilibrium will be, or is even likely to be, found. The notion that price flexibility is somehow a guarantee that market adjustments reliably lead to an equilibrium outcome is a presumption or a preconception, not the result of rigorous analysis.
However, Lucas used the concept of rational expectations, which originally meant no more than that agents try to use all available information to anticipate future prices, to make the concept of equilibrium, notwithstanding its inherent implausibility, a methodological necessity. A rational-expectations equilibrium was methodologically necessary and ruthlessly enforced on researchers, because it was presumed to be entailed by the neoclassical assumption of rationality. Lucasian methodology transformed rational expectations into the proposition that all agents form identical, and correct, expectations of future prices based on the same available information (common knowledge). Because all agents reach the same, correct expectations of future prices, general equilibrium is continuously achieved, except at intermittent moments when new information arrives and is used by agents to revise their expectations.
In his Nobel Lecture, Hayek decried a pretense of knowledge about correlations between macroeconomic time series that lack a foundation in the deeper structural relationships between those related time series. Without an understanding of the deeper structural relationships between those time series, observed correlations cannot be relied on when formulating economic policies. Lucas’s own famous critique echoed the message of Hayek’s lecture.
The search for microfoundations was always a natural and commendable endeavor. Scientists naturally try to reduce higher-level theories to deeper and more fundamental principles. But the endeavor ought to be conducted as a theoretical and empirical endeavor. If successful, the reduction of the higher-level theory to a deeper theory will provide insight and disclose new empirical implications to both the higher-level and the deeper theories. But reduction by methodological fiat accomplishes neither and discourages the research that might actually achieve a theoretical reduction of a higher-level theory to a deeper one. Similarly, formalism can provide important insights into the structure of theories and disclose gaps or mistakes the reasoning underlying the theories. But most important theories, even in pure mathematics, start out as informal theories that only gradually become axiomatized as logical gaps and ambiguities in the theories are discovered and filled or refined.
The resort to the reductionist and formalist methodological imperatives with which Lucas and his followers have justified their pretentions to scientific prestige and authority, and have used that authority to compel compliance with those imperatives, only belie their pretensions.
Uneasy Money 
David,
You might add that rational expectations began with John Muth in 1961 in microeconomic models and was later picked up and expanded into macroeconomic models by Lucas et, al.
https://en.wikipedia.org/wiki/John_Muth
Also, where does a legal framework fit into rational expectations?
It’s one thing to say all economic agents form rational expectations, but what guides the formation of those expectations in the first place?
Is it rational under certain models for me to expect that anything that I purchase may be stolen either from me or from some other party and sold to me second hand?
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David,
Consider the game – “Trading at gunpoint”
You have apples and I have oranges. We each have a gun with one bullet. We are going to engage in a trade apples for oranges. Each of us puts a bunch of our product in the middle and we vote on whether the transaction happens. With a successful vote, we split the “pot” equally in halves. In this two party transaction it takes the mutual consent of both of us for the transaction to take place.
Me – No, You – No – Transaction does not happen
Me – Yes, You – No – Transaction does not happen
Me – No, You – Yes – Transaction does not happen
Me – Yes, You – Yes – Transaction happens
On average, in one of four (25%) cases, the transaction takes place. Two party transactions are not very efficient.
Because we are each carrying a gun with one bullet, the other part of the trade is that quickest (first) person to shoot the other gets both the apples and the oranges that are brought to the trade.
And so, two party transactions tend to reward villainy.
Now we bring Joe into the mix with his bananas. You have apples and I have oranges. All three of us have a gun with one bullet. We are going to engage in a tri-party trade with apples, oranges, and bananas. In this trade, it takes two out of three parties to vote yes for the transaction to take place.
Me – No, You – No, Joe – No – Transaction does not happen
Me – Yes, You – No, Joe – No – Transaction does not happen
Me – No, You – Yes, Joe – No – Transaction does not happen
Me – No, You – No, Joe – Yes – Transaction does not happen
Me – Yes, You – Yes, Joe – No – Transaction happens
Me – Yes, You – No, Joe – Yes – Transaction happens
Me – No, You – Yes, Joe – Yes – Transaction happens
Me – Yes, You – Yes, Joe – Yes – Transaction happens
In 4 of 8 cases (50%), the transaction happens. In this case (with three party transactions) we have doubled our efficiency.
Now suppose that Joe votes no on the trade, but it proceeds anyway because you and I have voted yes. Joe shoots you with his one bullet, but then I shoot Joe and take both your apples and his bananas.
Man who shoots first in a three party trade loses.
Where is this going?
It is irrational and inefficient for the “representative agent” to engage in two party trades for the reasons outlined above – the individual may not be the “quickest draw in the West” and will on average only engage in a successful trade 25% of the time.
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Substitute Russian, China, and US for me, you, and Joe and the same holds true – man who shoots first loses. Putin is about to find that out.
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1) In his Nobel Lecture, Hayek decried a pretense of knowledge about correlations between macroeconomic time series that lack a foundation in the deeper structural relationships between those related time series. Without an understanding of the deeper structural relationships between those time series, observed correlations cannot be relied on when formulating economic policies.
It has been more than 30 years since I read it, but IIRC, what most impressed me in Friedman’s A Theory of the Consumption Function was the care with which he drew out the implications for different types of data, aggregate time series, vs. micro cross-sections. This type of care had completely disappeared by the 1970s.
2) What, no mention of Paul Romer and his critique of mathiness (many links here
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Frank, Thanks for pointing out that Muth is the source for rational expectations. I think Muth applied rational expectations in a sensible way in a partial equilibrium context. Lucas applied it senselessly in a general equilibrium context.
Certainly the legal and institutional framework is a very important part of the overall environment in which people form expectations about the future.
The representative agent doesn’t trade. There are no trading partners for an isolated individual to trade with.
Paul, Thanks for your comment. I agree that Friedman was a much more careful and astute empirical economist than the New Classical Macroeconomists who superseded him.
I discussed Paul Romer’s criticism of Lucas a couple of times some years ago. Here are links
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David,
You are welcome.
Regarding this:
“The representative agent doesn’t trade. There are no trading partners for an isolated individual to trade with.”
The point was that to jump from the microeconomic isolated individual (representative agent) to macroeconomic rational expectations and efficient markets, the concept of a political economy must be defined.
That was what my game (“Trading at gunpoint”) was all about – it is the smallest most concise political economy that I can conceive of with voting and property rights enforced at gunpoint.
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David,
When you get the time please read this and share your thoughts…
https://www.blogger.com/blog/post/edit/8265413720736398534/2373593465841177063
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I’m sorry, Frank, but I really don’t get the relevance of your game to anything I’ve been talking about.
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I tried following this link, and I see nothing that relates to our discussion.
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It was more for your passing reading interest than about this specific conversation. And it has a lot to do with how the US got itself into it’s present situation.
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David,
I think von Hayek’s paper should be titled “The Pretence of Reasoning”.
Your blog relates only to the second part of von Hayek’s Lecture.
The first part of his lecture is a diatribe against Keynesianism and the notion that the level of employment is a function of aggregate demand, which he admits there is empirical evidence for.
However, von Hayek believes unemployment is caused by mis-set relative prices, but he has no empirical evidence to support this.
Over two or so pages of “reasoning” he attempts to explain why the Keynesian proposition should be rejected, despite there being empirical support, and his accepted, despite there being no empirical support. He is like an octopus attempting to put on a two armed sweater.
I don’t think the first part of his lecture does him any credit. It is a rationalization twisted in any way necessary to validate his thesis.
The second part of his lecture is straight forward enough as are your comments on rational expectations theory.
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David,
From your above:
“Lucas’s methodological program for macroeconomics was thus based on two basic principles: reductionism and formalism. First, all macroeconomic models not only had to be consistent with rational individual decisions, they had to be reduced to those choices. Second, all the propositions of macroeconomic models had to be explicitly derived from the formal definitions and axioms of neoclassical theory. Lucas demanded nothing less than the explicit assumption individual rationality in every macroeconomic model and that all decisions by agents in a macroeconomic model be individually rational.”
Absent a political economy that enforces voting and property rights, what does “individual rationality” even mean?
It may be said that it is individually rational on a microeconomic level for a person to operate with an economic surplus (receipts exceed expenditures). But it is impossible on a macroeconomic level for all individuals to simultaneously run surpluses.
Can rationality even exist in the vacuum of the single representative agent?
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The point is that if you are going to build a macro-economic framework from micro-foundations, you don’t start with some notion of the single “representative agent”.
Instead you start with the smallest political economy – my “Trading at gunpoint” example.
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OK, thanks for clarifying.
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Henry,
HIs Nobel lecture was not one of Hayek’s best efforts, but neverheless, I would still give it higher marks than you do. But to explain why would just lead us back into conversations we have already had previously that I see no reason to revisit now.
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Property rights are only relevant when there are at least two players who can interact with each other whether by exchange or otherwise. Obviously a representative agent is not in that position, so property rights are not part of the analysis. I agree with you that that exposes the absurdity of the representative agent analysis. That is just one of many absurdities.
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It’s just nonsense to start from there, and I’m not going to. But that’s not your fault; it’s someone else’s.
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David,
“But that’s not your fault; it’s someone else’s.”
When you talk to that someone else, tell him / her I said hello.
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Yeah, in due course.
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