Edmund Phelps trashes rational expectations

I'm not generally one to enjoy reading interviews with macroeconomists, but this one is an exception. Published yesterday in Bloomberg, it features an interview by Caroline Baum of Edmund Phelps, Nobel Prize winner for his work on the relationship between inflation and unemployment. This focus of the interview is on Phelp's views of the rational expectations revolution. He is not a big fan:

Q (Baum): So how did adaptive expectations morph into rational expectations?

A (Phelps): The "scientists" from Chicago and MIT came along to say, we have a well-established theory of how prices and wages work. Before, we used a rule of thumb to explain or predict expectations: Such a rule is picked out of the air. They said, let's be scientific. In their mind, the scientific way is to suppose price and wage setters form their expectations with every bit as much understanding of markets as the expert economist seeking to model, or predict, their behavior. The rational expectations approach is to suppose that the people in the market form their expectations in the very same way that the economist studying their behavior forms her expectations: on the basis of her theoretical model.

Q: And what's the consequence of this putsch?

A: Craziness for one thing. You’re not supposed to ask what to do if one economist has one model of the market and another economist a different model. The people in the market cannot follow both economists at the same time. One, if not both, of the economists must be wrong. Another thing: It’s an important feature of capitalist economies that they permit speculation by people who have idiosyncratic views and an important feature of a modern capitalist economy that innovators conceive their new products and methods with little knowledge of whether the new things will be adopted -- thus innovations. Speculators and innovators have to roll their own expectations. They can’t ring up the local professor to learn how. The professors should be ringing up the speculators and aspiring innovators. In short, expectations are causal variables in the sense that they are the drivers. They are not effects to be explained in terms of some trumped-up causes.

Q: So rather than live with variability, write a formula in stone!

A: What led to rational expectations was a fear of the uncertainty and, worse, the lack of understanding of how modern economies work. The rational expectationists wanted to bottle all that up and replace it with deterministic models of prices, wages, even share prices, so that the math looked like the math in rocket science. The rocket’s course can be modeled while a living modern economy’s course cannot be modeled to such an extreme. It yields up a formula for expectations that looks scientific because it has all our incomplete and not altogether correct understanding of how economies work inside of it, but it cannot have the incorrect and incomplete understanding of economies that the speculators and would-be innovators have.

I think this is exactly the issue: "fear of uncertainty". No science can be effective if it aims to banish uncertainty by theoretical fiat. And this is what really makes rational expectations economics stand out as crazy when compared to other areas of science and engineering. It's a short interview, well worth a quick read.

Highly ironic also that, nearly half a century after Lucas and others began pushing this stuff, the trend is now back toward "adaptive expectations." Is rational expectations anything other than an expensive 50 year diversion into useless nonsense?

A Random Walk

I am trying to be cheerful. Honestly, and then write a nice feel good article. An article about our goldilocks economy, make believe rainbow of never ending growth where unicorns eat the corn out of your hand. But I am finding it difficult to be cheerful.

But it should not be so. I see the futures jumping six handles pre-market and it seems the selling of the last few days might come to a close. Then we might start the never ending upward movement. After all, is that not the objective of our Govt.

But instead of the rainbow or unicorns, I see a great depression coming. It is like watching a train wreck in slow motion. Should we call it depression or great balance sheet contraction? When the bubble goes bust and bust it will, when all the sushi hit the fan, what we shall be left with? What will happen to the millions upon millions of middle class investors and retirees may be many pension funds who have taken on the risk to increase the yield for their members and other hard working lots.

There are so many Black Sawn events on the horizon that we might be tempted to think that swans are black after all. The financial downturn of 2008-2009 was just a snap shot of what is supposed to come. And when the next default hits us, which may be as early as August end 2011, the Governments of the world will have much less ammunition left to do anything. None of the problems which caused the crisis of 2008/2009 has been solved. They have simply been pushed down the road for another day. The too-big-to fail Banks have gone bigger, the assets in their books have further gone down the value, even with the “mark to fantasy” rules because home prices keep falling and the end of the fall is nowhere in site. After couple of Trillions of dollars, all we have to show for are 50,000 jobs in McDonald flipping burgers. Those who are fortunate to have jobs, have seen their wages being stagnant or being asked to do more work for the same while food inflation and gas price increase is taking out their discretionary spending ability.

The situation in Europe is so bad that there are no words to define the situation.  The EU leaders are engaged in the game of brinkmanship and are waiting for a miracle of happen. One day we hear that Greece is being bailed out, next day it is not. The fact is, there is no way out. EU is just buying time for their Banks, same as in USA. No country in the world can pay loan which is 160% of their GDP and when they are in recession, as is the situation with Greece.  More debt cannot be a solution for the debt problem.   The situation is same with Ireland, Portugal and the 800 pound gorilla named Spain. The risk of contagion is real and imminent.  We might see a Banking collapse in Europe by end of summer and things go downhill thereafter.

But hey, if they have been able to kick the can down so far, they might be able to do it for a while longer. The markets are rigged and they ( Big Banks & Central Banks) will continue their best effort to do so, until one day it snaps and the common investors are left holding the empty can.

So while the going is good, do not get fooled by the fairy tale but prepare for the coming depression and bubble collapse. It may not be tomorrow. In fact we might see a good poop up in July/August when they convince everyone that the music will never stop and draw in all the cash that are sitting on the sideline. But come September, at least I shall be on the other side of the fence. You have been warned.