Knowing and Making

Paul Krugman in " Bourbon Economics " (and his commenter Peter von zur Muehlen ) complain that we've had new ideas for decades in macroeconomics, but they don't take hold. By 1988, it was already obvious that equilibrium business cycle theory had failed. Shiller had already circulated his devastating demonstration that asset prices were much too volatile to be explained by fundamentals...nothing happened. Real business cycle theory continued to prosper, developing an increasing stranglehold over the professional journals. Behavioral finance stayed on the margins. The equilibrium guys had learned nothing and forgotten nothing... Our problem, in short, isn’t lack of nifty new ideas; it’s the refusal of too many economists to face up to the fact that some of their preferred theories don’t work I sympathise - as an adherent and practitioner of behavioural finance, I could hardly not. But it's too easy to blame this on the establishment for not listening. And really, ...

Those who defend rational expectations have some explaining to do, in the face of data like this : ...six in ten Americans think most of the money spent to rescue banks will be lost forever. Six in ten think the economy shrunk over the past year. One in two think federal income taxes have gone up in the past two years. Wrong. Wrong. And wrong. In theory, it would still be possible for rich, sophisticated arbitrageurs to bet against the public in all these areas, and thus bring the overall path of markets back in line with the predictions of any given model. But most of the wealth of the economy is (directly or indirectly) under the control of the people who have these wrong impressions; so I think it unlikely that rational expectations can effectively operate. Especially since the errors are not random, but systematic; Derek Thompson in the article above has five explanations for why this might be. David Laibson gave a fascinating talk on this topic at the Geary Institute on Tuesda...