The Utility and Disutility of Rational Expectations: Wednesday Focus
OK. We are going to get deep into the history-of-thought, the intellectual-autobiographical, and the methodology-of-economics weeds here, so perhaps this should be called not “Wednesday Focus” but rather “Wednesday Unfocus”. Go and talk among yourselves rather than reading this if you wish…
I find that Simon Wren-Lewis wants to stick his head in the lion’s mouth by defending “rational expectations” as a working hypothesis:
Simon Wren-Lewis: Defending rational expectations:
Whenever I post anything which suggests that the idea of rational expectations was a useful innovation… Lars Syll writes something to the effect that I am… “so wrong, so wrong”. Now why does this bother me? Well… this kind of eloquent prose can appeal…. There is plenty to legitimately criticise about mainstream economics (and its textbooks), so it is a shame Professor Syll wastes his talents on one of its major achievements, which is rational expectations. On this he is, well, so wrong….
It is… a debate about… feasible alternatives…. Most of the time macroeconomists want to focus on something else, and so… either we assume that agents are very naive… or we assume rational expectations. My suspicion is that heterodox economists, when they do practical macroeconomics, adopt the assumption that expectations are naive…. Perhaps you think the alternative is equally unbelievable. Rational expectations… implies that agents know the model that the modeller has constructed….
The reason why mainstream economics replaced adaptive expectations with rational expectations in the 1970s was because the new approach was consistent with what economists did elsewhere…. I suspect the problem some people have is that they associate rational expectations with the New Classical critique of Keynesian economics…. This confuses who fought wars with the weapons they used…. For the foreseeable future, rational expectations will remain the starting point for macro analysis, because it is better than the only practical alternative…
I will merely point out that it is very very important to know when the assumption of rational expectations is a technical modeling shortcut to allow you to get the closed form answer–one that is perhaps less wrong and likely to be less damaging than the assumption of static or adaptive expectations–and when the assumption leads you to strong conclusions that you should not allow yourself to be led to. And I will merely point out that the art of telling these two cases apart is not well-taught in any graduate economics program. And I will merely point out that Robert Lucas and company never sold and do not see rational expectations as a technical modeling shortcut rather as a game-changing substantive insight. And… And I should turn this over to my ex-roommate:
Robert Waldmann: Robert’s Stochastic Thoughts:
In (almost all of ?) [rational expectations-based] contemporary macro, it is assumed that there is a unique steady-state [with] saddle dynamics around it…. [That] provides a key insight to policymakers (in scare quotes): “In the long run, macro policy doesn’t affect real variables. So the very serious statesman who focuses on the long run should target inflation and ignore unemployment and output.” The problem is that this policy-relevant conclusion is an arbitrary assumption. The “fearful plumbing” [of the model] is all [in the] analysis of the short run… complicated… a lot of controversy… [and] since it is fearful plumbing it makes policy makers queezy…. [Yet] the impact… on actual policy[making] is all due to the assumption [of rational expectations convergence to an invariant steady-state] and not the fancy math, clever modeling innovation, or, well, anything which wasn’t shoved aside…
And let me recall a celebrated paper from the summer of 2008 that shows, in an admittedly extreme version, what Robert (and, I think, Lars Syll) are worried about and what Simon Wren-Lewis dismisses:
V. V. Chari, Lawrence J. Christiano, and Patrick J. Kehoe: Facts and Myths about the Financial Crisis of 2008:
The United States is indisputably undergoing a financial crisis and is perhaps headed for a deep recession. Here we examine three claims… argue that all three claims are myths… present three underappreciated facts…. Conventional analyses of the financial crisis [that] focus on interest rate spreads… lead to mistaken inferences about the real costs of borrowing…. Even if current increase in spreads indicate increases in the riskiness… this increase does not necessarily indicate the need for massive government intervention. We call for policymakers to articulate the precise nature of the market failure they see, to present hard evidence that differentiates their view of the data from other views which would not require such intervention, and to share with the public the logic and evidence that burnishes the case that the particular intervention they are advocating will fix this market failure.
And let me grab from the archives a little of my intellectual history, to somewhat account for the fact that I am hiding in my foxhole and making Simon Wren-Lewis take the flak for a modeling strategy I often adopt myself all by himself:
Brad DeLong: The Economist’s Take on the State of Macroeconomics Once More…:
Paul Krugman thinks that the Economist doesn’t give the Pragmatists enough credit for the analyses of financial crises that they did in the late 1990s and early and mid 2000s:
Views on shape of macroeconomics differ: [T]he common claim that economists ignored the financial side and the risks of crisis seems not quite fair–at least from where I sit. In international macro, one of my two home fields, we’ve worried about and tried to analyze crises a lot. Especially after the Asian crisis of 1997-98, financial crises were very much on everyone’s mind. There was a substantial empirical literature from economists like Carmen Reinhart and Graciela Kaminsky (with Ken Rogoff joining in latterly); there was modeling from Guillermo Calvo, Jose Andres (grrr) Velasco, Nouriel Roubini, Paolo Pesenti, and others, including yours truly….
I saw the housing bubble and expected the bust; but I hadn’t appreciated in advance either the vulnerability of the shadow banking system or the leverage of American consumers. Once the crisis was underway, however, I had a more or less ready-made intellectual framework to accommodate these revelations: at a meta level, this was very much the same kind of crisis as Indonesia 1998 or Argentina 2002…. [T]he prevailing trend now is to assert that there are more risks in the economy than were dreamed of in our philosophy; I don’t think that’s fair.
At least where I sat, the prevailing view was that the U.S. housing bubble was (a) not very big and (b) could be easily managed by the Federal Reserve, because (c) a panic and a domestic surge in demand for high-quality assets could be easily met by the Federal Reserve’s printing money. The prevailing view was that the truly dangerous financial crisis would be one produced by the unwinding of “global imbalances”–a collapse in the dollar and a panicked flight not toward but away from dollar-denominated cash–that could not be handled by the Federal Reserve because in such a crisis the assets that it would create would be assets that nobody wanted to hold.
So I think–surprise, surprise–that Paul Krugman is right here: Pragmatists weren’t ignoring the risks of crisis, but they were watching out for the wrong crisis because we had no clue how bad the state of risk management in America’s investment banks had become and we overestimated the power of the Federal Reserve. Our analyses were wrong, but not because we were cluelessly off the page.
But Paul has a more serious bone to pick with the Economist:
The Economist reaches, I think, for a false symmetry [between Pragmatists and Purists], and glosses over too easily the sheer ignorance that has become obvious in the debates over fiscal policy…
Here too I think Paul Krugman is right (I really should just abbreviate the phrase “HtItPKir”).
When I first ran into the “Purists” back when I was in graduate school, they were gathered under the banner of the so-called “policy ineffectiveness result”: maintaining that neither systematic fiscal nor systematic monetary policies could have any effect on production or employment, and that the only thing that either the fiscal or the monetary authority could do was to add pointless and welfare-reducing variance to production and employment by randomly and destructively injecting surprise disturbances into the economy.
The underlying argument went something like this:
- There is no sense talking about anything like “involuntary unemployment”: markets clear, and at all times people work as much as they want to work and firms produce as much as they want to produce.
- Workers work more relative to trend when they think their real wages are high, and firms produce more relative to trend when they think real prices for their products are high.
- Workers work less relative to trend when they think their real wages are low, and firms produce less relative to trend when they think real prices for their products are low.
- Workers and firms have rational expectations, so if they expect government fiscal or monetary policies to expand (or contract) nominal demand they will expect nominal wages or prices to rise (or fall) accordingly.
- Thus if a predicted government-driven expansion (or contraction) raises (or lowers) nominal demand and thus their nominal wages or prices, they will understand that their real wages or prices have remained unchanged–and hence will not work more or less, and will not produce more or less.
- Only if nominal wages or prices rise (or fall) in an unexpected fashion will workers or firms get confused, and work and produce more (or less) than the trend.
- But with rational expectations the only cases in which government policy produces unexpected rises or falls in wages and prices is if the government policy is random.
- In which case its effects are random.
- And so government policies–not just fiscal but monetary policies too–cannot be stabilizing but only destabilizing.
- Hence the best of all policies sets a predictable and constant rule for monetary and fiscal policy and does not deviate from it no matter what.
The “Purist” position left it unclear what exactly the rule should be: Should the monetary rule be a gold standard, a price-level target, an inflation-rate target, a nominal GDP target, a nominal GDP growth rate target, a nominal wage level target, a nominal wage growth rate target, a money-stock level target, or a money-stock growth target? A floating exchange rate? A fixed exchange rate? They did not have a view: any one should work just about as well as any other. Should the fiscal rule be a budget balanced all the time? A budget balanced on average over the cycle? A budget with a constant deficit that produced a stable debt-to GDP ratio? A budget that swung into surplus in booms and deficit in recession that produced a debt-too-GDP ratio that was stable over the cycle?
The Purists did not have a view: any one should work just about as well as any other. The key was to be predictable, and not to deviate from the plan no matter what. The absolute condemnation of discretionary, seat-of-the-pants policy interventions that were not part of a previously well-known and well-specified rule–absolute condemnation of both discretionary fiscal and discretionary monetary policy tuned to the state of the business cycle–was the bedrock principle of the “Purists.”
Critics of the Purists asked why–if fiscal and monetary policies could not have systematic stabilizing effects–we had business cycles, and why we had smaller business cycles than had been the case back before World War II. The Purists answered:
- We had smaller business cycles because central banks and governments had learned their lessons and did less destructive discretionary policy to randomly disturb and surprise the economy.
- We still had some cycles because policy was still somewhat discretionary, no completely rule-bound, and hence not properly predictable.
- We had some cycles because of cyclical fluctuations in productivity–that booms were booms because productivity was then high and people ought to be working harder and longer, and recessions were recessions because productivity was then low and people ought to be working shorter and lighter–the real business cycle wing’s “great vacation” theory of high business-cycle unemployment.
We Pragmatists did not find these answers very convincing, or think that they were going to lead to a constructive research program.
So when the financial crisis began in the summer of 2007, we Pragmatists largely ignored the Purists, for they seemed to have nothing to say. The financial crisis was not accompanied by any sharp fall in productivity that reduced real wages, so the theories of the Purists’ “real business cycle” wing had no purchase on what was going on.
Moreover, the financial crisis was not associated with any sudden collapse in nominal demand–government-caused or otherwise–that pushed nominal wages and prices down and made workers and firms conclude that they should be working or producing less, and so the “monetary misperceptions” wing of the Purists had no purchase on what was going on.
And, indeed, for the first year or so the Purists largely remained silent. I would have expected them to rail against all of the extraordinary policy actions that Ben Bernanke’s Federal Reserve was undertaking–these actions were not part of any pre-planned or generally-expected rule of behavior, and the bedrock Purist principle was that government policies that deviated from pre-planned and generally-expected rules of behavior were destabilizing and destructive. But the Purists remained quiet–the only peep I saw was Chari, Christiano, and Kehoe’s (2008), “Facts and Myths About the Financial Crisis of 2008”: an assertion that the Federal Reserve was making a tempest in a teapot, a mountain out of a molehill, criticized the Federal Reserve for making “mistaken inferences,” and argued that:
even if current increase in [interest rate] spreads indicate increases in the riskiness of the underlying projects, by itself, this increase does not necessarily indicate the need for massive government intervention. We call for policymakers to articulate the precise nature of the market failure they see, to present hard evidence that differentiates their view of the data from other views which would not require such [aggressive discretionary] intervention, and to share with the public… logic and evidence… [supporting] the particular intervention they are advocating…
Then, in the late fall of 2008, the Purists surfaced again.
But the Purists did not condemn the aggressively expansionary and highly discretionary monetary policy emergency moves that Ben Bernanke and his colleagues were putting into effect–they endorsed them. Somehow, discretionary monetary policy had become good. Yet there was no symmetry: the Purists did not endorse the aggressively expansionary discretionary fiscal policy moves that the incoming Obama administration was planning (and that the incoming McCain administration would have been planning had the election dice rolled differently)–they condemned them.
Why the Purists endorsed discretionary monetary and condemned discretionary fiscal policy moves never became clear. It wasn’t the standard policy-ineffectiveness Purist position: that would have led to a condemnation of discretionary monetary policy as well. It was–well, it wasn’t clear what it was. As Paul Krugman wrote last January, and htItPKir:
Economists, ideology, and stimulus: This has not been one of the profession’s finest hours…. What’s been disturbing… is the parade of first-rate economists making totally non-serious arguments…. John Taylor arguing for permanent tax cuts as a response to temporary shocks…. John Cochrane going all Andrew-Mellon-liquidationist on us…. Eugene Fama reinventing the long-discredited Treasury View…. Gary Becker apparently unaware that monetary policy has hit the zero lower bound.
And you’ve got Greg Mankiw–well, I don’t know what Greg actually believes, he just seems to be approvingly linking to anyone opposed to stimulus, regardless of the quality of their argument…. [They] have… drop[ped] their usual quality-control standards when it comes to economic analysis. Has there been any comparable outbreak of mass bad economics from good liberal economists? I can’t think of one, although maybe that’s my own politics showing. In any case, what’s happening now is pretty disturbing…
It is in summarizing this episode, I think, that the Economist does its readers bad service, writing only that:
Economics: What went wrong with economics: [T]he financial crisis has blown apart the fragile consensus between purists and Keynesians that monetary policy was the best way to smooth the business cycle…. [S]hort-term interest rates are near zero… in a banking crisis monetary policy works less well. With their compromise [monetary policy] tool useless, both sides have retreated to their roots, ignoring the other camp’s ideas. Keynesians, such as Mr Krugman, have become uncritical supporters of fiscal stimulus. Purists are vocal opponents. To outsiders, the cacophony underlines the profession’s uselessness…
I would say that the Purists are ignoring not just the ideas of John Maynard Keynes but of Chicago-School patriarchs like Jacob Viner and Milton Friedman as well. And I would say that us Pragmatists are not ignoring the Purists’ ideas–I would say that I don’t know what ideas the Purists have. For the life of me I don’t. The basic quantity theory of money:
M * V(i) = PY
tells us that nominal demand PY depends on:
- the nominal money stock M, and
- the velocity of money V, which
- is an increasing function of the short-term nominal interest rate on government securities i.
Monetary policy changes M, and so changes PY (but may, in circumstances like those of today, induce offsetting changes in i and V that neutralize its expansionary effect). Fiscal policy–government deficits–change the quantity supplied of government bonds. By supply-and-demand things that change the quantity of something change its price, and the price of government bonds is this interest rate i. This logic works unless desired bond holdings are exactly proportional across the population to future taxes, and unless the utility people derive from government purchases is exactly the same as what they would derive from their pro rata tax burden amount of private consumption spending. Thus fiscal policy changes the velocity of money V, and so changes PY with no offsetting changes in M to neutralize its effect.
3165 words…