Wednesday, 23 September 2009

Irrational expectations

Frydman and Goldberg (authors of Imperfect Knowledge Economics, which I still must get around to reading) are in the Economists' Forum with the sexily titled article "An economics of magical thinking". They believe that nobody can predict economic crises and that swings in asset prices are natural. Because all knowledge is intrinsically uncertain, and nobody has access to it all, the market cannot find a "true" price for assets.

So far I agree. But the next part of the argument is suspect:
Behavioural economists have uncovered much evidence that market participants do not act like conventional economists would predict “rational individuals” to act. But, instead of jettisoning the bogus standard of rationality underlying those predictions, behavioral economists have clung to it...

The behavioural view suggests that swings in asset prices serve no useful social function. If the state could somehow eliminate them through a large intervention, or ban irrational players by imposing strong regulatory measures, the “rational” players could reassert their control and markets would return to their normal state of setting prices at their “true” values.

This is implausible, because an exact model of rational decision-making is beyond the capacity of economists - or anyone else - to formulate.
Yet again Nudge seems to have made people think that behavioural economics is all about state intervention. Far from it. But even if we accept the argument above, see where they take it next:
...sometimes price swings become excessive, as recent experience painfully shows. Even accepting that officials must cope with ever-imperfect knowledge, they can implement measures - such as guidance ranges for asset prices and changes in capital and margin requirements that depend on whether these prices are too high or too low - to dampen excessive swings.
So behavioural economists are not allowed to guide the state to limit asset price swings...but officials must implement measures to dampen excessive swings?

Where is the sense in this argument?

The article also confusingly conflates three separate concepts: individual rationality, the efficient markets hypothesis and rational expectations. These are quite distinct, and invalidating one does not throw out the others.

Oddly enough, the whole article, though it thinks it is a critique of rational expectations, is actually a good argument for it. A more coherent argument comes from Arnold Kling:
Gilles Saint-Paul writes:
"...any macroeconomic theory that, in the midst of the housing bubble, would have predicted a financial crisis two years ahead with certainty would have triggered, by virtue of speculation, an immediate stock market crash and a spiral of de-leveraging and de-intermediation which would have depressed investment and consumption. In other words, the crisis would have happened immediately, not in two years, thus invalidating the theory."

David K. Levine writes:
"Do you believe that it could be widely believed that the stock market will drop by 10% next week? If I believed that I'd sell like mad, and I expect that you would as well. Of course as we all sold and the price dropped, everyone else would ask around and when they started to believe the stock market will drop by 10% next week - why it would drop by 10% right now."

[and Arnold says]
...if policymakers saw a crisis coming, then they would take steps to stop it, so that it would not happen. Thus, any crisis that does occur has to be one that was not forecast.
Indeed, a simple logical argument arises from these observations.

If market expectations in general (that is, the expectations of the median investor) are different from current prices, prices will immediately move to match what people think they are going to be. Thus, the only way a market can be stable is if it is exactly the same as what people expect it to be - or, equivalently, people's expectations are an exact prediction of the real outcome of the market.

And hey presto! Rational expectations theory.

And much as I hate to admit it, there might just be some truth to the idea of rational expectations. The market is a powerful mechanism for transmitting information - as long as it's liquid, moves immediately to a clearing price, short and long positions are available, and traders are not capital-constrained.

Equivalently, provided a given market has mechanisms enabling it to stabilise (at least in the short-run), rational expectations can hold - and should keep prices at a sensible level, relative to other things in the economy; if they do not, then turbulence, overshooting or full-scale bubbles can emerge.

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