Rational expectations as dirty words

Each week, Symposium Magazine invites an author to guest-blog. This week’s featured piece is Why Central Bank Transparency May Be Overrated by Brigitte Granville.

You cannot fault the Royal Swedish Academy of Sciences for shying away from controversy after it announced earlier this month the award of this year’s Nobel Memorial Prize in economics to a group including Eugene Fama and Robert Shiller, who are widely thought to have developed diametrically opposite views of how financial markets work – respectively, the efficient market hypothesis and the behavioral finance diagnosis of irrational asset price bubbles.

There has been an avalanche of commentary as proponents of the two schools have taken this opportunity to re-fight their favorite battles. Since financial economics is not my own calling, I would offer only the commonsense gloss that financial market participants must read each other’s psychology alongside the fundamental determinants of fair value — and that this reality goes a long way to reconciling the two positions.

This observation brings me to the real reason why these latest Fama-Shiller discussions attracted my attention. This is the vehemence of the attacks on Fama as an exponent of rational expectations, seen as leading – or even contributing – to the financial crash of 2008. The rational expectations bugbear was similarly on show two years ago when the Nobel Prize was awarded to a group of economists including Thomas Sargent, a macroeconomist I greatly respect, for their contributions to establishing the conditions for macroeconomic stability. Here too, the anti-rational expectations brigade used this opportunity to disparage Sargent and his fellow laureate Christopher Sims.

Such criticism is even more unwarranted in Sargent’s case than Fama’s. In the work on inflation carried out by Sargent and other exponents of the “new classical” school of economics from the 1970s to the 1990s, reasoning on the basis of rational expectations argued that people’s economic behavior and reactions will flow from their actual experience of governments’ resort to, or tolerance of, inflation. The crucial next step in this line of reasoning is that credibility is the key to future expectations – that is, if and when authorities adopt a new policy stance in a shift that is sufficiently radical to make people believe that previous tolerance for inflation will cease, then this credibility alone can permit stabilization without material losses of real output.

So much for the crusade against the rational-expectations style of economic thinking as inimical to welfare!






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