Knowing and Making

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...

Two articles this evening lead me to ask the question: how do we predict GDP growth? Before reading on, why not ask yourself this question: what do you expect next quarter's GDP growth figures to be? How about the next 12 months? And why? I'd be interested to see some of your answers in the comments to this post - please also say which particular GDP figures you're predicting (personally I'm most familiar with the UK and US figures, but would be interested in comments from the eurozone and other regions too)*. I'm not going to test you on the accuracy of your forecasts: I'm more interested in the prediction itself, and your reasoning, than whether it turns out to be right. My prompts for thinking about this are: a paper Roger Farmer sent me this evening, introducing the concept of a belief function  describing what people expect next year's growth and inflation figures to be David Smith's blog excerpt of his Sunday Times column today , in which h...

The UK grew at an unexpectedly strong 1.1% rate in the second quarter, according to the ONS. Unexpected to the consensus of economists, that is - some of us are not so surprised. It has seemed clear - anecdotally, but from a wide range of conversations - that the economy has been fairly strong in the last few months - and with unexpectedly low growth in Q1, a rebound was already likely to show up the Q2 figures. This means that over the last year, the economy has grown by 1.6% - including a quarter of negative growth in 2009 Q3. If this quarter's rate is sustained - which it probably won't be - we will have almost 3% growth from October 2009 to September 2010. Even if it falls back to 0.7%, we will still have achieved a 2.5% growth rate. Despite George Osborne's sheepish attempts to take the credit - you can just tell that he knows better - this is a clear vindication of the last government's policies. Or rather, as Chris Dillow hints , it vindicates the last go...

One of the big divisions in macroeconomics is the idea of rational expectations theory. This is the proposition that people behave as if they have a perfect prediction of the economy's future path, and therefore they collectively fulfil that prediction. This idea is used by some to claim that government borrowing cannot boost the economy because people will reduce spending to pay the future taxes they expect to incur; and by others to propose that price or NGDP level targeting must work, because people will act as if the target will be met and therefore - in a self-fulfilling equilibrium - the target  will  be met! While there must be some truth in the idea, there are three main points where it may fail: Psychologically, people do not act consistently with their rational prediction of the future. People are often over or underconfident even when they make an accurate prediction of future outcomes. Often there is no single stable future path to the economy. Economic growth is...

For a while, I've been storing up lots of links to interesting pages from blogs and other places. I keep meaning to weave many of them into an interesting narrative, but some of them don't quite seem to fit, and yet are still on topics that I'm interested in, namely: expectations (and related, rational expectations theory) sentiment and whether it is real, and can be modelled macroeconomic theory and in particular, under what behavioural or market conditions Keynesian stimulus is efficient Here are some of those links which I'm, realistically, never going to get around to to analysing in detail: Rajiv Sethi on rational expectations and equilibrium paths . A good insight into why the rational expectations model is unlikely to reflect reality. But aren't rational expectations the only way to achieve a stable equilibrium in many models? Yes indeed. The conclusion must be that either those models are incorrect (a cop-out) or that the economy cannot be stable . Th...

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 pl...