Afternoon Must-Read: William Barnett, ed.: Rational Expectations: A Panel Discussion

Robert Lucas: ‘No. I mean, you can’t read Muth’s paper as some recipe for cranking out true theories about everything under the sun…. My paper on expectations and the neutrality of money was an attempt to get a positive theory about what observations we call a Phillips curve. Basically it didn’t work…. I thought my model was going to explain price stickiness, and it didn’t. So we’re still working on it…. I don’t think we have a satisfactory solution… but I don’t think that’s a cloud over Muth’s work. If Jack [Muth] thinks it is, I don’t agree with him. Mike [Lovell] cites some data that Jack [Muth] couldn’t make sense out of using rational expectations…. There’re a lot of bad models out there. I authored my share, and I don’t see how that affects a lot of things we’ve been talking about earlier on about the value of Muth’s contribution…. You know, people had no trouble having financial meltdowns in their economies before all this stuff we’ve been talking about came on board. We didn’t help, though; there’s no question about that. We may have focused attention on the wrong things; I don’t know…’

Kevin Hoover: In 1986, Mike [Lovell], you… examined the empirical success of… rational expectations… adaptive expectations, structural expectations, and implicit expectations…. Rational expectations does not dominate…. You even cite a paper by Muth, which comes down more or less in favor of implicit expectations….

Michael Lovell: I wish Jack Muth could be here… but… he died just as Hurricane Wilma was zeroing in on his home…. I sent Jack my paper with some trepidation…. He wrote back… in October 1984….

I came up with some conclusions similar to some of yours on the basis of forecasts of business activity compiled by the Bureau of Business Research at Pitt….

Rational expectations model did not pass the empirical test. He went on to say:

It is a little surprising that serious alternatives to rational expectations have never really been proposed. My original paper was largely a reaction against very naıve expectations hypotheses juxtaposed with highly rational decision-making behavior and seems to have been rather widely misinterpreted. Two directions seem to be worth exploring:

1. Explaining why smoothing rules work and their limitations.
2. Incorporating well known cognitive biases into expectations theory (Kahneman and Tversky).

It was really incredible that so little has been done along these lines.

Muth also said that his results showed that expectations were not in accordance with the facts about forecasts of demand and production. He then advanced an alternative to rational expectations. That alternative he called an ‘errors-in-the- variables’ model. That is to say, it allowed the expectation error to be correlated with both the realization and the prediction. Muth found that his errors-in-variables model worked better than rational expectations or Mills’ implicit expectations, but it did not entirely pass the tests…. Muth thought that we should not only have rational expectations, but if we’re going to have rational behavioral equations, then consistency requires that our model include rational expectations. But he was also interested in the results of people who do behavioral economics, which at that time was a very undeveloped area.

Hoover: Does anyone else want to comment?…

Robert Shiller: What comes to my mind is that rational expectations models have to assume away the problem of regime change, and that makes them hard to apply….

Kevin Hoover: Bob, did you want to comment on that? You’re looking unhappy, I thought.

Robert Lucas: No. I mean, you can’t read Muth’s paper as some recipe for cranking out true theories about everything under the sun…. My paper on expectations and the neutrality of money was an attempt to get a positive theory about what observations we call a Phillips curve. Basically it didn’t work…. I thought my model was going to explain price stickiness, and it didn’t. So we’re still working on it…. I don’t think we have a satisfactory solution… but I don’t think that’s a cloud over Muth’s work. If Jack [Muth] thinks it is, I don’t agree with him. Mike [Lovell] cites some data that Jack [Muth] couldn’t make sense out of using rational expectations…. There’re a lot of bad models out there. I authored my share, and I don’t see how that affects a lot of things we’ve been talking about earlier on about the value of Muth’s contribution.

Warren Young: Just to wrap up…. Does behavioral economics or psychology in general provide a useful and viable alternative?…

Robert Shiller: Well… the criticism of behavioral economics [is] that it doesn’t provide elegant models…. My opinion is that behavioral economics has to be on the reading list…. Back at the turn of the century—around 1900—when utility-maximizing economic theory was being discovered, it was described as a psychological theory…. I don’t think that there’s a conflict between behavioral economics and classical economics. It’s all something that will evolve responding to each other—psychology and economics.

Robert Lucas: I totally disagree.

Kevin Hoover: The Great Recession and the recent financial crisis have been widely viewed in both popular and professional commentary as a challenge to rational expectations and to efficient markets. I really just want to get your comments on that strain of the popular debate that’s been active over the last couple years…

Robert Lucas: You know, people had no trouble having financial meltdowns in their economies before all this stuff we’ve been talking about came on board. We didn’t help, though; there’s no question about that. We may have focused attention on the wrong things; I don’t know…