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Friday, March 16, 2007

Rational Expectations, Robert Lucas, and Randa the Psychic

Caroline Baum of Bloomberg says the idea of rational expectations "sounds nice in theory," but she isn't so sure people actually hold them:

Nobel Laureate Bob Lucas, Meet Randa the Psychic, by Caroline Baum, Bloomberg: In 1995, the Swedish Academy of Sciences awarded the Nobel Prize in economics to Robert Lucas... Lucas's specific contribution was developing and applying the hypothesis of rational expectations, the idea that people make economic decisions based on previous experience and expectations about the future. ...

This rational expectations stuff sounds nice in theory. In practice, it seems more suited to an elite club -- folks who watch and analyze the Fed or trade stocks and bonds for a living -- than the public at large.

I decided to test my hunch that expectations aren't always rational or even informed by hard knowledge. My simple survey consisted of four questions designed to determine the public's inflation expectations and the Fed's credibility. I posed four questions to 40 randomly selected people near Bloomberg's world headquarters at Lexington Avenue and 59th Street in New York:

1) What is the current rate of inflation or, in response to a blank stare, how fast are prices rising?

2) What is your expectation for economy-wide prices over the next 12 months?

3) Do you know what the Federal Reserve is?

4) Do you know how the Fed affects inflation?

I don't pretend that my survey was in any way scientific... It was eye-opening, to say the least. When one considers the territory (a high-rent district) and sample selection (I avoided people who looked as if they were more interested in picking my pocket while I was picking their brain), the results were even more discouraging than I imagined.

The most popular answer to the first question on the rate of price increases was ''no clue.'' Some were embarrassed at their lack of knowledge... The quantitative answers on question 1 ranged from a low of ''.03 to .04 percent'' to 20 percent. ...

It's not so much that people outside the financial industry are poorly informed. The question is, how can we ascribe rational expectations theory to the behavior when information is lacking?

Lucas and his cohorts put ''a lot of emphasis on the benefits of information but very little on the costs of getting it,'' said Allan Meltzer... ''There is no cost of acquiring information in their model.'' That said, it doesn't make the role of inflation expectations ''less important,'' Meltzer said. ''It just makes it noisy.''

Participants in my survey may not know how fast prices are rising, but most of them knew what the Fed is and how it affects inflation. At least they answered in the affirmative.

Some folks qualified their responses when asked ''What is the Federal Reserve?'' ''The federal government?,'' one driver for a moving company asked. Others got closer: ''A bank,'' ''Money comes through the Fed and goes out to the branches,'' ''Alan Greenspan used to cover it,'' ''Money for defense,'' ''5.25 percent.''...

Given the uninformed answers to questions one, two and three, I was impressed that a few folks had a partial grasp of the Fed's role in inflation, my fourth question. Some of the answers -- ''They control the flow of money,'' and ''they set the interest rate on Treasury bills'' -- were encouraging if not entirely accurate. Others -- ''They regulate it'' -- were not.

A man who described his occupation as a ''part-time distributor of fliers in the New York area ... was hawking ''Psychic Prediction by Christine,'' who seemed like a good candidate for my survey. Christine was with clients, so I called the psychic hotline and got 10 minutes of clairvoyance from an ''adviser'' named Randa.

Randa said she saw ''a bit more inflation from late July to mid-September,'' leveling off until next winter's ''Great Inflation.'' She saw (she said she pictured the graph) ''upward motion'' in the stock market during the summer time, and then a ''very dramatic fall, like the one that just occurred, in late September, the first week in October -- something having to do with the economy.''

The economy's ''rate of growth is slowing,'' she said, and ''there needs to be an adjustment in the forms of employment: Health care will be ''big'' versus manufacturing. Housing should be ''on better footing'' by next year, but with all the ''alternative financing, buyers need to be more savvy.''

What more could you want? Randa sounded like an informed economic agent, someone who would make decisions based on past experience and expectations about the future, just as Lucas said.

Then again, psychics by definition can see the future. It's the man in the street I'm worried about.

Defining rational expectations as "the idea that people make economic decisions based on previous experience and expectations about the future" isn't quite right. But first, let's be sure to mention John Muth, the first to propose the theory of rational expectations. Tom Sargent has the details:

Rational Expectations, by Thomas J. Sargent: The theory of rational expectations was first proposed by John F. Muth of Indiana University in the early sixties. He used the term to describe the many economic situations in which the outcome depends partly upon what people expect to happen. The price of an agricultural commodity, for example, depends on how many acres farmers plant, which in turn depends on the price that farmers expect to realize when they ... sell their crops. As another example, the value of a currency and its rate of depreciation depend partly on what people expect that rate of depreciation to be. That is because people rush to desert a currency that they expect to lose value, thereby contributing to its loss in value. Similarly, the price of a stock or bond depends partly on what prospective buyers and sellers believe it will be in the future.

The use of expectations in economic theory is not new. Many earlier economists, including A. C. Pigou, John Maynard Keynes, and John R. Hicks, assigned a central role in the determination of the business cycle to people's expectations about the future. Keynes referred to this as "waves of optimism and pessimism" that helped determine the level of economic activity. But proponents of the rational expectations theory are more thorough in their analysis of—and assign a more important role to—expectations.

He goes on:

The influences between expectations and outcomes flow both ways. In forming their expectations, people try to forecast what will actually occur. They have strong incentives to use forecasting rules that work well because higher "profits" accrue to someone who acts on the basis of better forecasts, whether that someone be a trader in the stock market or someone considering the purchase of a new car. And when people have to forecast a particular price over and over again, they tend to adjust their forecasting rules to eliminate avoidable errors. Thus, there is continual feedback from past outcomes to current expectations. Translation: in recurrent situations the way the future unfolds from the past tends to be stable, and people adjust their forecasts to conform to this stable pattern.

The concept of rational expectations asserts that outcomes do not differ systematically (i.e., regularly or predictably) from what people expected them to be. The concept is motivated by the same thinking that led Abraham Lincoln to assert, "You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time." From the viewpoint of the rational expectations doctrine, Lincoln's statement gets things right. It does not deny that people often make forecasting errors, but it does suggest that errors will not persistently occur on one side or the other.

Economists who believe in rational expectations base their belief on the standard economic assumption that people behave in ways that maximize their utility (their enjoyment of life) or profits. Economists have used the concept of rational expectations to understand a variety of situations in which speculation about the future is a crucial factor in determining current action. Rational expectations is a building block for the "random walk" or "efficient markets" theory of securities prices, the theory of the dynamics of hyperinflations, the "permanent income" and "life-cycle" theories of consumption, the theory of "tax smoothing," and the design of economic stabilization policies.

Sargent's statement that "when people have to forecast a particular price over and over again, they tend to adjust their forecasting rules to eliminate avoidable errors" is one reason why asking strangers on the street questions tells us little about rational expectations. Take the same people interviewed above and tell them they will be interviewed weekly on a particular topic, that they will be identified by name in the article (so it is costly to be wrong), and see if their answers improve.

One more point. Information in these types of models isn't costless. In fact some information cannot be obtained at any cost (for example when data about the current time period cannot be observed by agents when their expectations are formed). But even if information is costly it doesn't undermine the theory, it just means that only those with an incentive to collect the information, i.e. benefits that exceed the costs, will do so, and that those who collect information will choose to collect an optimal amount.

This means the theory predicts that we shouldn't expect the average person on the street to be able to answer a random financial question if the answer is costly to obtain, and if knowing the answer is of no real benefit (except in the highly unlikely event that a columnist writing a story taps you on the shoulder). Thus, the statement about rational expectations above that "In practice, it seems more suited to an elite club -- folks who watch and analyze the Fed or trade stocks and bonds for a living -- than the public at large" is just what we would expect.

And I can't resist commenting on this statement, "The question is, how can we ascribe rational expectations theory to the behavior when information is lacking?" since Lucas' model was about just that, how agents behave when they have incomplete information, in particular, when they cannot distinguish specific, idiosyncratic shocks affecting individual prices from economy-wide shocks that affect all prices. The models are known as "information confusion" models. Lack of information does not rule out rational expectations, all that is assumed is that people will process the information that they have so as to avoid leaving money on the table.

For more, the article by Tom Sargent continues with applications of rational expectations models to the efficient markets theory of stock prices, the permanent income theory of consumption, tax-smoothing models, expectational error models of the business cycle, and the design of macroeconomic policies.

    Posted by on Friday, March 16, 2007 at 12:15 AM in Economics, Macroeconomics | Permalink  TrackBack (0)  Comments (11)


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