No offense, but introducing far-flung make-believe analogies generates more heat than light.
Who is discussing business cycles?
If we assume that market interaction generates the most accurate prices, then could expectations be anything other than rational? If so, please explain (rather than simply praise Hayek and insist he would not endorse rational expectations). I wasn’t attempting to hijack Hayek; rather, I was attempting to inquire how Hayek could still be right without rational expectations.
The reason I’ve become a bit impatient is that this precise argument has been addressed in previous posts, both explicity and implicitly.
Expectations can be perfectly rational with respect to prices (in fact, this is trivial) but not with respect to the underlying data. If prices become unhinged from the underlying data, then you’ll have a divergence.
Thus, you can think of expectations as being judged on the basis of 2 criteria:
1.) If they’re rational w.r.t prices
2.) if they’re rational w.r.t to the underlying data
1 is basically a tautology. 2 only holds if prices accurately represent the underlying data.
In the context of the example I gave earlier, it is trivial to say that the average of the values by the guessers will approach what the slips guide them to approach (assuming they want to be accurate). Just as it is trivial to say that producers will produce what prices guide them to produce. But if what those slips guide them too is not the true value, then their guesses are not rational w.r.t the true underlying value.
How do you know whether a price accurately reflects the value of the underlying asset or not? You are assuming that you can objectively know whether or not a price is ‘right’ or ‘wrong’.
justin, if you read my example carefully you’ll notice that I make the ASSUMPTION that the slips diverge from the true value. This would be knowledge on behalf of the experiment conductor, but not on behalf of the guessers. I made that assumption to illustrate a point. And if you read further in my example, you’ll notice that it discusses how the guessers DON’T KNOW WHETHER THE SLIPS ARE ACCURATE OR NOT.
So yes; we can never know whether prices are accurate or not; this is one of my main points!!!
I realize that you may be dis-inclined to read the thing, but having to work with concrete examples sheds light on what’s really going on behind concepts. Just repeatedly regurgitating the arguments of others leads me to think you haven’t meticulously thought through what those arguments mean in various contexts.
If you’ve read Muth’s paper than you’d know that he’s always working within some model that is already in Eq-m. And he’s assuming that 1.) that model is an accurate representation of some phenomena and 2.) that a given person has access to that model. He never makes an effort to justify why such strong assumptions would hold in a real-world economy.
And then you have followers who blithely justify Muth’s assumptions on the basis of profit and loss (e.g. Knoop). But they do so without thinking deeply about whether profit and loss necessarily conveys the true underlying data. This is not a given.
Your example is a bit of a strawman. Rational expectations imply that people act to maximize the present value of their expected utility. Do you think that people do not act to maximize their expected utility?
justin, your comment is irrelevant to the discussion. Whether or not we model individuals as maximizing the present value of their expected utility has no bearing on the argument that’s being made. Your thinking on a different plane.
IF you had been reading the thread carefully you’d also note that I specifically take care to point out that I assume individuals attempt to do what’s in their own best interest (e.g. trying to be as accurate as possible or to generate as much profit as possible).
I didn’t say all of politics is vulnerable to Caplan’s critique, did I?
On the other hand, it can be rational (in terms of cost-benefit analysis) to deny something even when it’s staring you in the face. The costs that other people aren’t considering are the psychological costs of admitting to yourself that you are and have been wrong about it.
Yes, it does. That’s what rational expectations is built on. Your example of rational expecatations and actual rational expectations are two different things.
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.
http://www.econlib.org/library/Enc/RationalExpectations.html
I really don’t have time for amateur drivel. One component (or one assumption) of RE is the assumption of maximizing behavior. I fully assume this in my example.
RE is mathematically built on much more than simply “people maximize their utility”. It says that their expectations are on average the same as the true value. The whole point of this debate is to ask whether that sort of assumption is applicable to a dynamic economy in which the individuals 1.)do not have a model of the economy and 2.) do not have complete information. And the whole point of my example is to illustrate that we may only assume RE when prices accurately convey the underlying data. If this breaks down (prices diverge from the underlying data) than incomplete information, limited compuational ability, etc. DO HAVE IMPLICATIONS FOR THE VALIDITY OF RE. And this is despite the fact that we still may assume individuals behave so as to maximize their utility.
Can you provide examples of this being the case?
I read your analogy (repeatedly, actually), but I was unsure of what point you were making; thank you for clarifying. However, I’m not sure anyone is suggesting that profit and loss are the only signals being used to form expectations.
To reiterate a question (not a challenge of any sort), does Hayek’s support of the price mechanism imply that prices do accurately convey “true values”? Doesn’t your criticism lead to distrust of the price mechanism?
In John Muth’s own words, “[T]he hypothesis asserts that the economy generally does not waste information.” Doesn’t a rejection of rational expectations indicate that a free market would “waste information”?
P.S. Thanks for the debate. You’re obviously an intelligent person, and I enjoy your counterarguments–they’re helping me think through these issues more.
It generates the most accurate prices insofar as prices are not continuously and arbitrarily manipulated by external authorities. Such manipulations, in turn, influence the expectations of rational economic actors (especially entrepreneurs when monetary expansion takes the form of producer credits). Due to the complexity and the inherent interconnectedness of economic phenomena, the expectations will change and manifest themselves in different ways. Inflation does not, in itself, lead to malinvestment (bubbles); it requires human action (manipulated expectations).
This is why I said, in a previous post, that the Austrian theory of cycles and expectations go hand-in-hand. This is also why I reject rational expectations; it ignores too many relevant variables (which is why only its initial premises are almost reasonable while its conclusions are blatantly incorrect). Essentially, Rational Expectations was a slightly more accurate and an extremely expedient way to incorporate expectations into mathematical models. That’s my take, at least.
There are certainly other means by which individuals form expectations, but profit and loss is the only rational means (even if it becomes disconnected) by which they can judge those expectations; all other factors are more or less guess work.
Most certainly not (to both questions). Support of the price mechanism only implies that it is the best means by which resources can be allocated; not that it is invincible to manipulation. In fact, I would say my criticism strengthens the argument for the price mechanism. Part of the argument is that producers/entrepreneurs do not have access to the underlying data; this is why it’s possible for allocations to diverge from such data if the price mechanism becomes disconnected. Given that individuals do not have access to the underlying data, there needs to be a selection mechanism that directs production in a “reasonable” way. Such a selection mechanism is the price mechanism in an economy. It is true that the price mechanism is subject to manipulation under special conditions (below), but the absence of a selection mechanism leads to complete chaos; there is no rational alternative. In other words, even if the price mechanism diverges from the underlying data, it is still the only rational means by which individuals can judge the success of their predictions. There would be no alternative means to resort too for large scale complex production.
In one sense I would say Muth’s statement is correct, but not in the way most would interpret it. And what I mean by that is that (as discussed above) producers produce what prices guide them to produce. This is a sort of trivial form of RE’s. And in this form there is no wasting of information, or unexploited profit opportunities. As noted above, individuals only have limited access to the true underlying data. It is not that that information is available but unexploited, it’s that much of it is fundamentally incommunicable. Thus, it is perfectly consistent to say that RE is false in the sense that people do not necessarily make predictions consistent with the underlying data, while still maintaining the assumption that no information is being wasted. Once again, this is because that information is not available to them; rather it is communicated by the price mechanism. And in so far as decisions approach consistency with the price mechanism, information will not be wasted. This is concomitant to the fact that that mechanism may for periods of time guide them astray. It is when this occurs that the common interpretation of RE fails (the stronger form).
So no, a rejection of RE doesn’t imply that information has been wasted. Muth’s statement above is weaker than what most would interpret RE to imply. That is, most seem to interpret RE to not only imply that information is not wasted, but more importantly that, in some manner, individuals are in the aggregate able to acquire all necessary information (not individually) and therefore form their expectations in line with the fundamentals (on the average). Of course, this is what I’ve been trying explain is the inappropriate interpretation.
You asked for some examples. In general, I would say that any complex adaptive system in which information is communicated indirectly by means of some signal is subject to manipulation.
Some short hypothetical examples (some of which I haven’t thought about deeply but seem to apply):
1.) In the case of drugs entering the body, certain neurotransmitters are released that “mimic” the shape of other fundamental neurotransmitters. This redirects the firing of neurons in particular ways, ways which in general would only be justified by heightened levels of the actual neurotransmitters fitting in to the post-synaptic neuron. This leads to the firing of patterns of neurons that is in general inconsistent with activity in the rest of the brain. In consequence, the true lack real neuro-transmitters eventually asserts itself. This push and pull process is in the individual the manifestation of the high and then consequent depression.
2.) You already know of my wonderful ant example!
3.) Another area of phenomena of which I know little about but I imagine there to be examples is in immunology. There is constant indirect communication of information between cells in the body, and I imagine that in certain situations signals can produce cell activity that is inconsistent with activity else where in the body. I really know nothing about this area, but I imagine that there are certain diseases that operate in this manner (perhaps diseases like lupus in which the body seems to attack itself).
4.) One example of which I’m not sure about is when a person experiences a mirage. If, for example, there is a certain set of stimuli that culminate to create the sensory perception that an apple tree is some distance ahead of you (like in a desert) and you go to that mirage in hope of finding the tree, only to find nothing, you will have in some sense been misdirected. And all of this is possible because people, and animals in general, are not able to perceive the sort of ‘objective’ physical relationships that exist between phenomena but are rather only able to operate on the basis of the world created by the sequential firing of their neurons and the range of sensitivity of their receptors.
5.) Of course, the example of which I’m sure you’re tired of hearing is the ABCT. In general, producers/entrepreneurs judge the success of their expectations on the basis of profit and loss, i.e., the magnitude of distance between the monetary costs which they incur compared to the monetary reward. It is true that this is not the only basis on which they form expectations but it is the only rational means for evaluating those expectations. Hence, they will constantly update their decisions for future production on the basis of how profitable they have been in the past. If additional monetary units are produced and entered into a specific market, for example the bank market, this will generate activity that would only be consistent with greater savings on behalf of individuals (in other words the real underlying change of preferences with regard to the time allocation of their consumption habits). But in reality there has been no such change in the underlying data (the preferences of individuals). Now you have often countered with the argument that general knowledge of the fact that individuals have not really changed their preference orderings would negate the effect of additional units of money entering through the bank market. But such general knowledge, as I have tried to address over and over (and specifically in my example), does not result in the negation of the misdirecting effects. Individuals do not have access to underlying data (even in a dispersed from) and hence cannot adjust their production decisions accordingly.
The whole existence of a large complex structure like an economy hinges critically on there being some medium which communicates information across time and space in a perceptible manner. Without this medium the whole system breaks down; the data that needs to be communicated is simply not perceivable. So that’s why dis-locations in the medium from the source misdirect individuals; they cannot perceive the data in a usable way. And even if this dislocation occurs, the medium (e.g. price mechanism), is still the only rational means for communicating information. It is what the phenomenal results of the system depend on. Not using the mechanism is synonymous to rejecting the opportunities (greater and more various output levels) provided by the complex system itself.
This is a forum full of amateurs. And apparently you did have time, as you then carried on to post a reply.
Statements like that do nothing to enhance your reputation or argument.
haha this is like the 5th time i’ve seen esuric quote mishkin’s textbook since august so i don’t think anyone needs to guess which class he is taking this semester. good luck! anyways, i think that you will want to rethink your critique of rational expectations in a week or two when they start to cover the term structure of interest rates.
here are are some problems i have with esurc’s defense of abct against rational expectations (ratex)
problem #1. people will have to make forecasts no matter what. i really don’t understand esuric’s point about needing prices to serve as signals for directing production. not because i disagree with it, but i doubt any proponent of rational expectations would disagree! plus it seems irrelevant to relating ratex to interest rates. as i understand it, even austrians would agree that part of deciding whether to buy a long-term bond is going to depend on what you expect shourt-term rates to be in the future. for example, say you have a 2 year bond with a 4% interest rate. part of how you decide whether to buy that bond is what you expect the return on 2 1-year bonds purchased sequentially will be. for eample, support this year you can purchase a 1 year bond with a 4% interest rate and next year you can purchase a 1 year bond with a 6% interest rates. then the average rate of return for these 2 bonds is 5%. that means you would actually do better to buy 2 1-year bonds than the single 2-year bond (ignoring liquidity preference, inflation risk, etc). so no matter how you slice it, expectations are always going to play a role in determining long-term interest rates. the only question is how those expectations are made (note i could be missing esuric’s point here, like i said it wasn’t exactly clear).
problem #2. Even if esuric’s criticism were true, they still don’t save ABCT. so esuric brings up several points about why investors might get their forecasts wrong. lets say he’s right, is that alone good news for ABCT? no. even if he was right, his argument only supports the notion that investors can be wrong about future interest and/or inflation rates, but they could be wrong in either direction. for example, if the fed starts printing money investors could over estimate future inflation and therefore invest less contrary to abct.
now maybe you want to say “but esuric’s argument still supports the notion that fed intervention makes things harder for investors so they will make more errors, right?” that doesn’t strike me as obvious. first, it seems esuric’s argument could just as well be used to justify inflation targeting (it reduces the guess work in forming inflation expectations). second, it isnt clear that inflation or interest rates would be easier to forecast in the absense of the fed. after all it isn’t like the price level is going to stop moving just because the fed gets out of the game (so long as money supply and demand can change so can the price level). if investors can’t predict this now, why would we expect them to start if we got rid of the fed?
problem #3. would esuric really want to follow him arguments to their logical conclusion? so lets assume investors actually are really bad at forming expectations about future interest rates and inflation. like i was saying earlier, i don’t see any reason to suspect from his argument that investors will suddenly be able to make better forecasts in the absense of the fed. so what does that mean? that investors are not very good at making long-term investments? i just want to see if that is what esuric really meant.
side note: since esuric has citing mishkin quite often, i thought he might be interested with this paper: http://www.nber.org/papers/w0517.pdf
It is not obvious that if prices are still to be regarded as signals that convey at least some meaningful economic information, then if some of those prices are tampered with, then there are likely to be more errors? It’s not obvious? This should be obvious to anybody who understands the concept of informational signals in general.
It’s not about some hypothetical price level. It never is.
It’s about relative prices being distorted. It’s price differentials that convey the relevant economic information. Not some aggregate hypothetical price level. It’s about some particular prices affected immediately, while others only later, and still others even later.
As for a world absent the Fed, or more accurately, central banking:
So it’s not the price level that’s important as I’ve just said. But as for changes in the money supply and demand for it,absent Fed, two points need to be stressed:
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Changes in the money supply are likely to be very small, theoretically insignificant, where monetary contraction is practically impossible.
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Changes in demand to hold money can indeed occur, however, this would not cause any systematic problem for two main reasons:
a. Variations in such demand (Or your velocity) is likely to be small, particularly absent the recurring banking crisis now that central banking has been eliminated.
b. Such changes are voluntary in nature. They should not be considered as tampering or distortion for they convey real changes in preferences of individuals. It is nonsensical, and this also applies to what the Monetary Equilibrium folks claim, that such changes are equivalent to government tampering of the money supply. The first is a real change in preference, while the latter is a temporary change that does not match consumer preference. It is unsustainable.
Since you decide to bring up my education, you should know that I’ve already graduated summa cum laude with a BS in business economics. Also, why do you assume that I read the textbook before the semester started? Weird.
So, just to be clear, you find my critique of RE somewhat agreeable, but you don’t believe that this is good news for the ABCT (you didn’t really address my critique of RE at all). Is this correct?
**“Problem 1”**doesn’t even begin to address my argument and is entirely immaterial.
Problem 2: My argument does not solely deal with inflation rates (by inflation rates, I assume you’re referring to general price inflation of consumer goods measured by various inherently flawed indices) and/or market interest rates. It has to do with inter-temporal equilibrium/disequilibrium, and relative price distortions that effect the prices of every single good, and every single factor of production, but not to the same degree or even in the same direction. And yes, I assume that suppressing short-term interest rates, which are tied to longer term interest rates, and arbitrarily elevating the short-term profitability of various economic employments (again, not all economic employments), will lead to over-investment in specific sectors (malinvestment). Furthermore, such investments will not be offset by a corresponding diminution of investment in other sectors (economy operating off of the PPF).
Economic actors will continue to use prices as information signals because, well, there’s nothing else! Next, inflation and interest rate targeting may reduce uncertainty about government intrusion, but this entirely misses the point. The fact that the government manipulates the supply of money in a uniform way cannot yield inter-temporal equilibrium (the main issue at hand). In other words, government intrusion may be stable, but it persists, and all other economic variables remain in continuous flux. Investors may try to adjust market interest rates but they can never “figure out” the natural rate of interest, which is entirely independent of expectations and which is never stable.
Problem 3: First, there is no possible way to predict the way that monetary expansion will manifest itself; again, inflation is a microeconomic phenomenon (saying this to you for the 6th time now). The effects of monetary expansion extend far beyond money and capital markets; it affects the prices of every single economic good. The economic system must be looked at as a whole; all markets are interconnected. Next, if you don’t see how markets may be negatively influenced by arbitrary manipulations in the supply of money (1/2 of all economic phenomena), by a centrally planned authority, then I don’t know what to tell you. Either way, my argument is that rational economic calculation is entirely contingent upon an accurate price mechanism that actually expresses underlying preferences and relative scarcities.
Also, please directly quote the passages you are referring to (for the sake of clarity).
I’m not interested in Mishkin; the man’s a lunatic. Half of his textbook is devoted to explaining the magical powers of inflation. I cite him because he’s seen as an authority, and the Neoclassicals on this forum seem to appreciate that kind of stuff.
I’m getting from Student that Rational Expectations is true, and consequently the fed or any other government agency can not negatively or positively influence the economy through monetary changes. Does this mean that all believersin Rational Expectations think of the Fed as a dead weight loss, which is a fiscal burden whose monetary tinkering is completely anemic,ineffective and that this could not be otherwise ? If Rational Expectations is the mainstream attitude where is the mainstream contempt for the Fed ?