2010-10-11

Sumner, Krugman, Rational Expectations, the EMH

This morning, Scott Sumner writes:
Here’s what I find so ironic.  Everyone talks about how the profession became obsessed with ratex and the EMH after 1980, but from my perspective most economists still seem stuck in the adaptive expectations era.  If you really believed in ratex and the EMH, wouldn’t you be really, really interested in market forecasts of the policy goal variable?  I would be.  Yet instead of trying to infer market forecasts, they built elaborate structural models to try to forecast the goal variables.  In the 1980s when I tried to peddle my futures targeting approach, no one seemed interested.  I presented papers at the AEA meetings, the NY Fed, the Philly Fed, and everyone just yawned.  So from my perspective we face exactly the opposite problem; the profession doesn’t take ratex and the EMH seriously enough.  If the Fed really believed in ratex and efficient markets, they would have put the pedal to the metal in the infamous September 16, 2008 meeting.  Instead they yawned, and left rates unchanged at 2%.
I agree with this point of view.  Since this whole "crisis of economics" debacle started unfolding in 2008, I have been struck by the degree to which Krugman and his ilk fail to understand what rational expectations and the EMH are all about.

Which is not to say I agree with either. As modelling tools, they obviously fall far short. As theoretical tools, however, it makes little sense to assume - as Krugman and many other modern economists do - that people are inherently irrational.

Now I'm going to toss my own crazy theory into the mix. Could it be that economists formulate their ideas as a way to confirm what they already believe about the market?

Here’s something Robert Lucas said in 1993:
“What troubles me about neo-Keynesians is not so much that they have a definite clear-cut ideology that I dislike, but that they have too little ideology. They’re too good at rationalizing anything…. These guys have enough talent to put a kind of semi-respectable economic rationale on whatever the hell the politicians come up with. I don’t see a neo-Keynesian agenda on policy issues.”
Say what you want about Lucas and others, I think what the above quote demonstrates is that there is a lot empty rationalization in economics. From Lucas’ side, there is an ideology driving his modelling (at least according to that quote). From the “neo-Keynesian” side, there is a handy ability to justify anything with a model.

For what it’s worth, I think the real shortcoming of economics for the last couple of decades has been a virtual absence of theory and an overabundance of models.