Neorational Keynesonomics

This article by Brian Kantor is probably best understood as a defense of the rational expectations hypothesis by demonstration 1) of its (apparently) common-sense consequences and 2) the empirics that bear it out.  It is divided into a history of the hypothesis’s development and relevant precedents, an account of its movement from hypothesis into a utile theory, and a discussion of its various actual and potential applications.  Kantor’s position is clearly stated in the conclusion: Rational expectations is here to stay and has changed macroeconomics for the better.

The impetus for a rational expectations theory appears to derive, as it seems do most new developments in the economics of the 60s and 70s, from a recognition of the failure of policies informed by the long-run Phillips curve.  Rampant inflation in the 60’s followed by stagflation in the 70s demanded a “new” approach, which, the likes of Kantor thought, demanded a partial return to classical ideas and a critical appraisal of Keynes and the economic policies derived from his General Theory.  In particular, it was suspected that policy changes were broadly anticipated by market participants and that, therefore, prices mostly - if not entirely - reflected these anticipations.  If I am reading Kantor correctly, he seems to be suggesting that a strong version of the idea that economic actors might actually be able to develop expectations of the future based on current trends and events and past experiences was nigh revolutionary.  In other words, it was not broadly suspected that such information was widely accepted and integrated into economic actors’ supply and demand schedules.  It was as if economists considered it implausible that their ilk might be employed by the private sector and use standing theory to make forecasts about the future.  Besides, if economists held the monopoly on knowledge of future market movements, then wouldn’t it stand to reason that all economists would invest and become quite wealthy?

The general outline of the rational expectations hypothesis is that there are three factors which market participants observe and for which they adjust.  There is the information from the previous period about market movements and responses (especially in relation to policy changes and reactions), anticipation of the market movements of the current and future periods (which are functions of that history as well as current real and nominal factors), and a stochastic disturbance term with a mean at zero.  After the time period is up, actors observe outcomes and adjust accordingly.  The stochastic terms are assumed to not be serially correlated; that is, as Kantor observes by way of the Austrian economist Lachmann, consistent systematic error on the part of particular actors is weeded out by competition applying the available information. 

Throughout the seventies (this paper was published in December 1979), the rational expectations hypothesis was born out by empirical study.  Kantor particularly focuses on studies of the equities markets, since they produced ample if not definitive evidence against Keynes’s notion that changes in investment were, it seemed, entirely explicable by the idea that it was driven by speculation and “animal spirits.”  The efficient markets hypothesis - the idea that prices reflect all the available information about past, present, and future market conditions - garnered a great deal of support from these studies, and would definitely seem to go against Keynes’s implicit preference for a strong role of a more ‘rational’ central authority.  However, critics have suggested that this is all well and good when discussing investment, but other markets - such as those for labor - are less apt to be explicable from a rational expectations perspective.  The answer here for Kantor and others is that both sides of the labor market are liable to make decisions based on the information available, but they may no doubt have some difficult distinguishing whether shocks to the economy are temporary or permanent, positive or negative.  Evidence suggests that this uncertainty leads to a regular deviation about some trend (in terms of employment or economic activity).  The lags in bringing new information into decisions, or delays in the acquisition of relevant information, may be as Robert Lucas suggests, an important source of economic fluctuations which we know as the business cycle.

What does this say for stabilization policy?  Well for one it suggests that it was entirely misguided insofar as it had been conducted up to that point. Unless policy makers can somehow find a way to surprise the market every time they attempt to guide it, it would be very difficult to ’shock’ it in the way that they might hope.  It may be difficult to keep one step ahead of the market at every turn. 

Instead, Kantor suggests that efforts and resources expended in smoothing the business cycle may best be spent in improving the function of existing institutions and in bringing new, helpful institutions into existence.  On this, at least, Kantor remains substantially vague, and I think this is to his credit.  There are, it seems to me, two roads here.  On the one hand, it may provide support for those who believe government has as a tendency to get in the way of and disrupt otherwise well-functioning markets.  To wit, one might suggest that deregulation, lower taxes, etc. etc. are the key.  This will give added incentive for entrepreneurs to find means to improve flows of productive factors and information between markets.  On the other hand, for those more inclined for government-supported solutions, there is the road of policy taking an active role in creating institutions that serve this same purpose.  Nonetheless, we must grant the other side that, even in this, the private sector just might be able to do it better and more efficiently.  The debate is unavoidable, and it continues. 

Good article, fairly intelligible.  I have avoided, despite the voices of my better angels, discussion of some of the philosophical implications here. Suffice it to say that while there is ample evidence and good old-fashioned intuition that rational expectations is the ‘right’ way to go, we may want to question (as I did in my previous and equally long-winded entry) just how far we want to take it without wondering what sort of queer and possibly inefficient or disastrous paths our ‘rational’ expectations, taken in the aggregate over a long period of time, might lead us down.

This entry was posted on Saturday, February 9th, 2008 at 11:26 pm and is filed under e488-expectations. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.