Critique of Rational Expectations

Economics Economics Questions
41

esuric,

you’re right that my post doesn’t directly address your rational expectations critique in the sense I did not try to try to prove it was false. instead, i tried to show that your argument was inadequate for reaching the conclusions you stated (that ratex is false and therefore irrelevant for ABCT). this actually seemed like the best route for discussion because your argument essentially comes down to “i just don’t believe people are able to do all the things rational expectations says they can do”. your post didn’t even try to support that assertion with evidence. you basically just said “isn’t it obvious???”. how can i argue with logic like that? so i decided to take an easier route.

but your latest post seems to go all over the map and never directly defends your original assertion that ABCT can be preserved against an expectations critique. so i am having a hard time following it. let me just say that to preserve ABCT, you will have to show not only that people make mistakes in forming expectations, they will have to make systematic mistakes, such that they monetary expectations will typically lead to over-investment in particular sectors.

anyways, i think the reason your post may be hard for me to understand is because you apparently aren’t talking about rational expectations as defined in your stated source. here you say…

my argument is that rational economic calculation is entirely contingent upon an accurate price mechanism that actually expresses underlying preferences and relative scarcities.

and i respond: “then your argument has nothing to do with rational expectations.” as i noted in problem #1, i doubt you can find any proponent of rational expectations that would disagree with the coordinating role that prices play in a market economy. and that is because rational expectations is about, well, how people form expectations about the future.

maybe it will be more fruitful to narrow down the discussion. i am particuarly interested in seeing your response on problem #2 so allow me to re-post that problem in a few seconds with a direct quote from the passage I was addressing as you requested.

PS* I don’t think I have ever called a prominent austrian economist a lunatic. i am glad you’re extending your polite debating style to people you’ve never met.

42

esuric, in your initial post you said…

Let’s quickly reexamine the first implication of rational expectations, since there are many assumption already built into it:

  1. Each individual is fully aware of the time preferences of all other individuals and knows what the natural rate of interest is. In other words, they are able to see what the normal return on investment would be in a purely theoretical barter economy.
  2. They fully understand the effects of a suppressed market rate of interest below the natural rate of interest and choose not to capitalize (for lack of a better term) on potential short-term profits because they can see into the future.
  3. Essentially, individuals have some intuitive connection to some illusory general equilibrium; that is, they know where the interest rate “should be” even if the market does not express it.

The absurdity of such a position is obvious. Thus, rational expectations, within the realm of economics, are entirely contingent upon a price mechanism that is not continuously manipulated by external authorities. And since prices are in fact continuously altered, we must therefore dismiss rational expectations as a valid critique of the ABCT.

To make sure we are both on the same page, allow me to spell out the rational expectations critique of ABCT. The critique basically says that investors will see the federal reserve printing money today and that they will be smart enough to demand a higher nominal rate of return on long-term investments to perfectly account for future inflation. This means long-term nominal interest rates will rise (not fall, contrary to ABCT) and that over investments in specific sectors will not be made because people are not fooled by price inflation.

The quote above seems to suggest that we have reason to suspect that people will not be able to do this very well and that investors will make lots of mistakes in forming expectation. So lets say that esuric is 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.

  1. it seems esuric’s argument could just as well be used to justify inflation targeting (it reduces the guess work in forming inflation expectations).

  2. 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 anything, it seems very possible to me that prices might be much more volatile because now all fluctuations in money demand will likely be met by changes in the price level.

over all, esuric’s argument just doesn’t accomplish what he hopes.

43

No this is the argument made by the RE crowd. The burden of proof is on them to explain why the intrusions of an institution, like the FED, which centrally plans one-half of the economic system, does not lead to the results I’ve already mentioned and which you’re familiar with. Their argument, in a nut shell, is that it doesn’t matter because expectations = equilibrium results.

It’s called a reductio ad absurdum and is in no way fallacious or an example of poor reasoning. I’m sorry that you’ve never heard of it, but it’s used quite often (most refutations of objective theories of value take this form). I’ve also implied that RE is either a non sequitur or an example of circular reasoning (someone else actually brought this up); I’m sorry that you did not comprehend my argument.

  1. The ABCT says that arbitrarily manipulating the supply of money must necessarily yield relative price distortions, which, in turn, will misdirect resources towards ultimately untenable productions.
  2. RE says that this is not so because expectations equal optimal or equilibrium results.
  3. Expectations will be optimal because individuals identify and employ all relevant variables (costly not to do so).
  4. The total “supply” of relevant information exceeds human mental capacity and is, for the most part, expressed or contained within the price mechanism.
  5. Rational expectations are contingent upon a fully functional and undisturbed price mechanism.

This is not the RE critique of the ABCT; this is the monetarist critique of the Keynesian framework (the expected-inflation effect, Mishkin, pp. 115). RE asserts that investors are immune to arbitrary alterations in nominal interest rates because they know where the interest rate “should be” and they will factor it into their calculations.

I’ve already addressed this in my previous post, which you’ve completely ignored. But let me quickly respond to the highlighted part. If you’re saying that it is at least conceivable that artificially lowered interest rates and high inflation may not yield additional investment, then I certainly agree. But this does not question or compromise the validity of the ABCT in anyway whatever. In fact, Mises says that such a condition characterizes the final stage of an economic collapse, namely when the authorities systematically and perpetually expand the supply of money, beyond the demand for cash holdings, in order to prevent the necessary correction. Simply put, the condition you mention is the exception and not the rule. I’m assuming that there’s an inverse relationship between total investment and market interest rates during normal economic conditions. Do I have to explain why?

And again, the economic system must be looked at as a whole. The effects of monetary expansion extend far beyond the capital and money markets.

I think he’ll live, but it’s nice to know that you’re so concerned about his feelings. You’re a very good person Student!

44

i found the reason you don’t seem to be following my argument…

The ABCT does not say that monetary expansion will lower interest rates in the long-run; in fact, it says quite the opposite. Next, this is not the RE critique of the ABCT;

you don’t seem to notice the difference between long-term interest rates and “interest rates in the long-run” (this why imagining a world of a single interest-rate can be dangerous when you’re trying to distinguish between long-term and short-term investments). long-term interest rates are simply the rate of return recieved for loaning money for extended periods of time (depending on who you ask the exact definition of long-term may vary but we are talking at least 3 years). for example, mortgage rates are considered “long-term interest rates”

and ABCT most certainly does say that monetary expansion will lower long-term interest rates. it has to. because long-term investment decisions are made in part on long-term interest rates. keeping with the mortgage example, the argument goes that expansionary monetary policy might lower long-term interest rates like 30 year mortgages which might lead to a housing bubble like the one we saw 5 years ago (at least thats the story mark thorton tells: http://mises.org/journals/scholar/thornton13.pdf)

now, if i believed in ratex, i would seriously doubt the ABCT as an explaination for most business cycles because i would contend that investors (lenders) would see the government printing money today and understand that in a few years that will mean higher inflation which will erode their real returns and perhaps make their investments profitable. so they will demand higher interest rates to accomodate that inflation risk.

this would imply that the federal reserve has no ability to systematically influence long-term investment decisions at all. and i’m sorry, but yes that is a central part of the ABCT. and i don’t see how you have adequately addressed that.

If this is not how you see that RE applies to ABCT, maybe you can provide a quote from a non-Austrian economist critiquing AE using RE. I can see how RE could be used in a variety of ways. so it would be interesting to see what you actually have in mind. because based on your argument thus far i can only say the way you use the notion of RE is a lot different than the way that “lunatic” Mishkin uses it (despite having quoted him in your opening post).

ps* i never realized that they called it “reductio ad absurdum” when you make bold assertions without evidence because “they’re obvious!!”. are you sure that is what it means?

45

I’ve already addressed this in my previous post, which you’ve completely ignored. But let me quickly respond to the highlighted part. If you’re saying that it is at least conceivable that artificially lowered interest rates and high inflation may not yield additional investment, then I certainly agree. But this does not question or compromise the validity of the ABCT in anyway whatever. In fact, Mises says that such a condition characterizes the final stage of an economic collapse, namely when the authorities systematically and perpetually expand the supply of money, beyond the demand for cash holdings, in order to prevent the necessary correction. Simply put, the condition you mention is the exception and not the rule. I’m assuming that there’s an inverse relationship between total investment and market interest rates during normal economic conditions. Do I have to explain why?

this comment doesn’t address my comment. just because the fed keeps printing money to “prevent corrections”, doesn’t mean people will systematically continue to make the same mistakes over and over again. maybe you can make the connection a bit more explicit for me.

46

This presupposes that we can even identify mistakes, which we can’t if the price system is messed up. People will repeat their actions if they get no negative feedback. You will never guess how many situps I can do with any rationality because you don’t have the information.

The Austrian claim that low interest rates cause people to make “mistakes” is perhaps a little awkward. All we know is that people are making choices in a vacuum of information. Whether they actually make mistakes or correct decisions is totally unknowable, which is the whole point.

47

sieben,

i have a hard time squaring your skepticism with a comment you made in an earlier thread.

Inflation/deflation should have no impact whatsoever on debts. Anyone with a brain simply writes inflation into contracts that ocurr over a long amount of time.
https://forum.freecapitalists.org/t/a-discussion-with-my-professor-over-deflation/15390/5

this is almost exactly what i am saying.

48

The model of inflation I am describing in the previous thread is the Humean, or “fairy” model of inflation, where all holders of money have their monies increased by a fixed amount in concert.

IRL, the kind of inflation we have now is asymmetric. The price distortions come out of this asymmetry, not simply an increase in the money supply. If it weren’t for PR, the fed could operate without any inflation at all, and simply appropriate or debase the nominal value of everyone’s assets.

49

It is not the same mistake over and over again. It would be the same mistake if, for example, monetary expansion beyond the demand for cash holdings continuously lead to the same housing bubble over and over again. The point is that they periodically make different mistakes, and that prices, and not entrepreneurial intuition, guide production. This is the Austrian position; here’s Hayek:

I’m sorry for the confusion. The first time I read your comment I thought you were referring to interest rates in the long-run. I understand the term structure of market interest rates, but all of this is unessential and completely ignores the crux of my argument (plus there are many different theories that attempt to explain the term structure of interest, including Austrian explanations). Investors may in fact be aware of economic theory, and they may expect inflation in the long-run, and this may very well elevate the yields on long-term market interest rates. But expectations of future inflation, risk, the supply/demand for money (etc) do not, in anyway, affect the natural rate of interest; they only affect market interest rates.

Economic stability is contingent upon inter-temporal equilibrium (when the market rate = the natural rate) and monetary equilibrium (when the demand for money = the supply of money). Now, your argument would only makes sense if individuals somehow knew what the interest rate “should be”(the natural rate of interest), and if they then adjusted market interest rates accordingly.

What you’re essentially saying is that if the government, for whatever reason, decided to set the price of a particular economic good way below the market-clearing level, then individuals would not only be aware of this, but they would also know where the price of that commodity should be, and they would adjust their purchases accordingly in order to prevent a massive shortage. But this would have to be true for every single economic good, because money constitutes one-half of all exchanges. An entrepreneur would need to know that the elevated demand for his product was the result of monetary expansion, and he/she would have to, rather than elevating his/her prices, keep them stable in order to suppress higher short-term profits and capital accumulation within that industry (a bubble). This is why I continuously repeat that inflation is a microeconomic phenomenon that depends on how individuals spend the newly created sums, and that the effects of monetary expansion extend far beyond the money/capital markets. There is no actual uniform rate of inflation (this is your major problem, Student, you do not understand inflation).

Individuals simply do not posses this kind of knowledge on their own which is why market prices are absolutely vital (undisturbed prices contain the relevant information). This is the reductio I was trying to make (what you call an “unsubstantiated assertion”).

And finally, Austrian’s tend to stress the importance of interest rates and the lonabale funds market because this is where the newly created sums are first introduced into the economic system. The financial intermediaries, in turn, funnel the inflation to investors, which elevates the demand for capital goods, and therefore their prices, but without a corresponding diminution in the demand for consumer goods. If the king, on the other hand, printed a lot of money and gave it directly to consumers then the inflation would yield the opposite effect. The ABCT is both extremely broad and complicated so I understand the confusion.

50

Economic stability is contingent upon inter-temporal equilibrium (when the market rate = the natural rate) and monetary equilibrium (when the demand for money = the supply of money). Now, your argument would only makes sense if individuals somehow knew what the interest rate “should be”(the natural rate of interest), and if they then adjusted market interest rates accordingly.

i am not sure what you are getting at here. i keep getting the vibe you want to tie this back to the economic calculation debate, based on statements like this one here:

Individuals simply do not posses this kind of knowledge on their own which is why market prices are absolutely vital (undisturbed prices contain the relevant information).

but that only tells me you are not clearly understanding what “rational expectations” means. like i keep saying, people that believe in rational expectations would likely be on your side in the economic calculation debate. but that isn’t what ratex is about. rational expectations is about about how people form expectations and people will always have to form these expectations even if the fed didn’t exist. there is really no amount of signaling that will avoid this fact. let me lay it out this way.

#1. Investors will ALWAYS have to guess about future price inflation/deflation. first, even if the fed didn’t exist the price level would fluctuate so long as money demand and money supply can fluctuate. this implies that investors are ALWAYS going to have guess what future inflation/deflation rates are when making long-term investments.

#2. Investors today will ALWAYS have to guess what the short-term interest rate will be tomorrow when making long-term investment decisions today. earlier you agreed that the expectations investors hold about nominal short-term rates tomorrow will influence long-term interest rates today (i have an explicit example for why this would be the case in what i called problem #1). Now, since these future short-term rates will depend on saving and investment in the future (which is unknown in the present). this means that investors will ALWAYS have to guess what the “natural rate” of interest should be.

these two points are essential, so if you disagree please explain why.

if you do not disagree these two points, then you have not mentioned any problems that wouldn’t exist if the federal reserve didn’t exist. so the point of the above paragraph is lost on me. there is simply no signal that will eliminate the guesswork involved in #1 and #2.

What you’re essentially saying is that if the government, for whatever reason, decided to set the price of a particular economic good way below the market-clearing level, then individuals would not only be aware of this, but they would also know where the price of that commodity should be, and they would adjust their purchases accordingly in order to prevent a massive shortage.

that is not what i am saying at all. your analogy assumes the government has the ability to set the price of a particular commodity. if you truly believe in rational expectations, then the government should not have the ability to set the “price” in question (long-term interest rates) at all. this seems to be a sticking point so let me repeat. “if you believe long-term lenders have rational expectations about the future, then you would argue that they would always respond to monetary expansions by demanding higher rates of returns from their borrowers to preserve their real returns after accounting for inflation.”

And finally, Austrian’s tend to stress the importance of interest rates and the lonabale funds market because this is where the newly created sums are first introduced into the economic system. The financial intermediaries, in turn, funnel the inflation to investors, which elevates the demand for capital goods, and therefore their prices, but without a corresponding diminution in the demand for consumer goods.

okay, let’s follow that reasoning. lets say you’re a financial intermediary like a bank and you’re now sitting on top of a new pile of freshly printed cash. naturally you want to loan this money out so you can draw a return on it. now, if you were smart, you would know that as this new cash works it way through the economy prices are going to go up. so you have to ask yourself, do you want to lend this to money to a guy for a 30 year mortgage at current interest rates? no way! you already know your returns will be eaten away with inflation. instead, you would either demand higher interest rates on your loans (to keep your return the same) or you will want to put that new money to, say, 1-year small business loans or maybe cash advances. anything that will get you returns soon so you can enjoy real profits before prices begin to rise.

that is what rational expectations would tell us anyways. yet nothing you have said has really disrupted that story. even if we assume that banks like this one makes frequent mistakes, we have no reason to suspect the mistakes will be anything but random. iow: we have no reason to suspect the bank will always loan the money to long-term investment projects that will become unprofitable when interest rates start to rise. and that is kinda essential to the ABCT story.

51

Okay, first, before I directly deal with your arguments, let me reveal the assertion that I was essentially responding to in my OP (Caplan’s critique of the ABCT):

This statement only makes sense if individuals somehow intuitively knew what the natural rate of interest is. A 4% market rate of interest can be too high and a 20% market rate of interest can be too low. It all depends on its position relative to the natural rate. His argument is very different from the one you’re making (monetary expansion does not affect long-term interest rates).

Expectations and economic calculation go hand in hand. Entrepreneurs are merely speculators that analyze current market conditions and try to predict future market conditions. The fact of the matter is that the formulation of accurate expectations is entirely contingent upon identifying and incorporating all relevant information. But this information is, in large part, expressed by the price mechanism.

I don’t understand the point you’re trying to make here, mainly because I obviously agree with you. I’m merely stating the fact that government intrusion makes formulating accurate expectations an extremely difficult, if not impossible endeavor, because it must necessarily disturb natural market processes. The market tries to match expectations with reality (see Lachmann) through the price mechanism and the profit/loss constraint. But let me respond to an issue you raised that is somewhat relevant:

The supply and demand for money will indeed fluctuate in a free-banking environment (where the FED, or the arbitrary cartelization of banks, does not exist). In such a competitive system (again, where the FED no longer exists), it would be extremely difficult, if not impossible, to increase the supply of money beyond the demand for money. It would be impossible to finance investments without real savings (differed consumption). This is the point of inflation and why it is praised by the inflationist’s (again, because it allows firms to invest without first gaining access to real savings; the savings/consumption relationship becomes temporarily decoupled).

And for the nth time, there is no uniform rate of inflation. Predicting how the inflation will manifest itself, that is, how it will alter relative prices, is impossible.

The banks will continue lending and increasing the supply of short-term loans (1 year) to small businesses until the rate of return falls within this market. Once this market becomes oversaturated, the 30 year bond market will become more lucrative (relatively), and financial intermediaries will begin increasing the supply of loans within this market. That money will not simply lie idle (unless we’re talking about abnormal economic conditions). Total lending will have increased without a corresponding increase in real savings and a corresponding diminution in consumption. This is all that’s required for the ABCT.

Additionally, the newly created sums, once lent, will permeate amongst the economic system altering relative prices and the short-term profitability of various investments. This, in turn, will draw capital away from other industries towards those industries (Cantillion effects). So, even if we assume that long-term interest rates are not affected by alterations in the supply of money at all(which I don’t), the ABCT still holds (because of the alterations in relative prices which guide production patterns).

52

You’re right that Caplan’s argument is different from the one i was making, so that helps me better understand your original post. though i would say that the argument is still incomplete if one wants to fully show that rational expectations is irrelevant for ABCT. if i am understanding caplan correctly, i would say he is only talking about expectations of borrowers given that rates can be lowered. and i am talking about the perspective of lenders and questioning whether rates can be lowered to begin with. but rational expectations underly both our arguments.

The fact of the matter is that the formulation of accurate expectations is entirely contingent upon identifying and incorporating all relevant information. But this information is, in large part, expressed by the price mechanism.

I am not sure what you mean. what information are you thinking of here? can you be more specific?

don’t understand the point you’re trying to make here, mainly because I obviously agree with you. I’m merely stating the fact that government intrusion makes formulating accurate expectations an extremely difficult, if not impossible endeavor, because it must necessarily disturb natural market processes.

but as i noted before, you have not provided good reason for us to expect this task to be more difficult with the fed. your argument has only amounted to the fact that real individuals would find it hard to form expectations when inflation and future rates are uncertain and that this can lead to mistaken investments. but a mainstream economist could use that exact same argument to justify inflation targeting (it takes out much of the guess work in forming inflation expectations). as i keep saying, you will need to add something here for this argument to save ABCT.

as a side note, in your discussion on free banking you simply assert that free banking will make inflation impossible, but even if that were true what about deflation? maybe not a problem for lenders, but certainly a potential problem for borrowers (and lenders too i guess if borrowers default as a result). how is that supposed to be easier to forecast than inflation?

so unless you can explain to me that prices will be absolutely stable under free banking, investors will always have to do some forecasting of the price level and nothing you have said has justified how that task would be easier without the fed.

The banks will continue lending and increasing the supply of short-term loans (1 year) to small businesses until the rate of return falls within this market. Once this market becomes oversaturated, the 30 year bond market will become more lucrative (relatively), and financial intermediaries will begin increasing the supply of loans within this market. That money will not simply lie idle (unless we’re talking about abnormal economic conditions).

how “saturated” does the short-term market have to be to make unprofitable long-term investments attractive?

–

PS* this really will have to be my last post for a while. :frowning: traveling again tomorrow and studying for an exam friday. so if i don’t respond for a while im not ignoring you, just trying to keep my mind on my money and my money on my mind.

53

Once again, Student, you’re simply dissatisfied with the Austrian position, and your last comment did not introduce any new arguments at all.

On a side note: I simply can’t figure out why some free market economists, such as yourself, have a hard time understanding why a free market in banking must be more efficient than our current system (monetary central planning).

54

Student, what is your position on ordinary price controls? What if they made a loaf of bread cost 10 cents? What if they made it cost 5 bucks?

55

esuric,

it looks like this will be quick as the convo is drawing to a close, so i can take a quick sec to drop in…

first, let me clarify that i am dissatisfied with your position which doesn’t fundamentally strike me as austrian at all. no mainstream economist will disagree with that a failure to anticipate price inflation will lead to making investments. and few would argue that volatile inflation makes it harder to make investments (this is one reason why inflation is associated with reduced economic growth). but there is nothing uniquely austrian about these points (you keep using language about “microeconomcis of inflation” but never follow through with concrete arguments). that is why i keep stressing that your arguments could just as easily be used to justify inflation targetting.

and certainly nothing you have said directly defends ABCT against the rational expectations critique. okay, you’re arguing the fed makes it harder to make investment decisions. now what? why would investors always be fooled to underestimate price inflation such that they lend money to long-term ventures that will become unprofitable when interest rates start to rise? in a previous post you said something about how once the short term market becomes “saturated” banks will naturally start putting their money into bad long-term investments. but that makes no sense to me. first, how much is “saturated” (do interest rates have to be near zero on all short-term forms of lending??? if not, when is it “saturated”??) and what about other investments like inflation-adjusted government securities? why would i naturally move my money to long-term investments where i realize inflation risk is higher now that the fed is printing more money when i can put my money in safer assets like these?

you just are not connecting the dots. :-/

56

Who didn’t see this coming…

57

liberty student,

procrastination is my one weakness…after women and booze…and television…a good steak…the rolling stones…

anyways

when i have a test coming (like this week) i try to say i wont post often in hopes that it will precomit me to not posting (stengthing my extended will: http://www.newyorker.com/arts/critics/books/2010/10/11/101011crbo_books_surowiecki). sometimes it works, sometimes it doesn’t. at this point you’re right it probably it isn’t working but i’m trying. :stuck_out_tongue:

glad you’ve taken an interest in my posting habits though. it means a lot to me.

ps* just to clarify, i am not ending the convo. though esuric seems to be by not supporting his assertions with solid arguments. this all sounds familiar doesn’t it?