Saturday, October 15, 2011

Rational Expectations vs. Heliocentrism

More philosophy-of-science blogging...

It's not often that I take strong exception to a Matt Yglesias point, but today is one of those days. Discussing John Kay's epic rant against modern macro, Matt compares the Rational Expectations Revolution to the Copernican Revolution in astronomy:
The basic impulse to say that the theory has to make sense and be grounded in a compelling account of how the world works makes major contributions here. It’s why Copernicus ditching geo-centrism for heliocentrism, and it’s how Newton develops the theory of gravity. But the instinct to say that no, the important thing is for the theory to produce actual results is also important. If we’d stuck with Copernicus’s “theoretically compelling” idea about perfect circles, we’d never have noticed that this was actually a totally arbitrary modeling assumption with no basis whatsoever...What’s more, while in retrospect we see Copernicus as the ancestor of our modern way of thinking, the fact of the matter is that if you were trying to launch a rocket ship somewhere in the early 16th Century you’d be much better off chugging along with the epicycles rather than siding with the guy who knew that the earth orbited the sun. 
My view, with both all due respect and all due derision, is that the Robert Lucas types are like the early Copernicans here. There’s something admirable in their insistence that it ought to all work out to an easily modeled system grounded in compelling theoretically considerations. The New Keynesian model is a mess, like late-Ptolemaic astronomy, thrown together to account for observed reality. But you don’t fly to a moon with an elegant model that delivers mistaken predictions about where the moon’s going to be. And what we actually need is a Kepler to give us an elegant model that actually predicts the phenomena, and then a Newton who can explain what that model means.
While I agree with Matt's take on how good science works (alternating steps of theoretical deduction and experimental induction), and with his take on the Copernican Revolution, I think he's being way too generous with the analogy to Rational Expectations. For two reasons:

1. Unlike heliocentrism, we don't know yet that Rational Expectations is right. It is certainly not the case that Rational Expectations is the only "easily modeled system grounded in compelling theoretical considerations." There are plenty of alternatives! The obvious candidate here is a model where people learn over time. If you don't think that's a compelling alternative, just ask recent Nobel winner Thomas Sargent; even though he helped invent Rational Expectations, when found that the RE models didn't fit the data, he started working on learning-based models instead. So until the data give us a good idea of which overarching theoretical framework (if any) describes the world, we should treat RE as only one candidate among many. It may not even turn out to have been a good guess.

2. The Rational Expectations people didn't just insist that macroeconomists use self-consistent, perfectly microfounded Theories of Everything. In fact, they didn't stop at insisting that people use Rational Expectations! They went so far as to insist that theories of business cycles should be driven by so-called "real shocks" - changes in technology, changes in government policy, or changes in people's willingness to work. These were at the heart of Ed Prescott's "Real Business Cycle" theory, which became the heart of the "freshwater" school of macro. Although New Keynesian models also use the Rational Expectations framework, freshwater types went out of their way to denigrate these demand-based models. The current insistence by political conservatives that our economic malaise is due to workers' laziness, or "policy uncertainty," or uncontrollable changes in technological progress, is given intellectual heft by the freshwater school's insistence that these are the only things that should matter. It's kind of like if Copernicans had called Kepler a "bad guy" for daring to suggest elliptical heliocentric orbits instead of circular ones. 

I try not to be too hard on the Rational Expectations Revolution. It was motivated not only by theoretical elegance or ideology, but by observation of the real world - specifically, the failure of stimulative monetary policy in the 1970s. And it may well have erased a false sense of certainty among econometricians that was leading to policy mistakes (I plan to write a post about this soon). That is all to the good. But the revolution has not yet led to a theory of business cycles that fits the data well. And it very well may never do so - especially, I predict, if its adherents keep insisting on including only "real shocks" in their models. Until RE gives us something constructive, I think that comparisons with Copernicus are premature.

Update: Gregory Chow makes my first point...with real math and data!


  1. Anonymous6:58 AM

    It's worse. The so called 'sound' or 'non-trivial' micro-economic foundation of ´rational expectations` is not only not micro at all, but it´s also not sound, and in highly trivial. It´s fairy tale economics± "and they maximized happily forever after". Or, in the argot of economics: "Also assume that "There is a fixed number of infinitely lived households that obtain utility from consumption and from holding real money balances, and disutility from working. For simplicity, we ignore population growth and normalize the number of households to 1. The representative household's objective (!?!, as it´s not estimated but assumed, M.K.) function is", and then comes the formula which implies that the prince and the princess took a mortgage to buy a castle and never wanted work or to pay any taxes or to have children anymore.

    But what the heck is this 'representative household' maximizing? Unlike the orbit or size of the planets of Copernicus and Keppler and Newton it's not defined - at least not by economists. And how are ´households´defined? Statisticians include jails, and soccer clubs, and dormitories and whatever. Did any of your prfoessors even try to tell you this? Did they even bother about this? And what's the metric used to estimate 'utility'? which dimensions does it have? What kind of scale do we use? What's its name (The "Bohm Bawerk"? The "Bentham"?)? How do we measure it? What's our equivalent of the telescope? Even the concept of utility is never discussed, "People do what they do", to quote the noble price lecture of Samuelson, and we assume that this maximises utility (Samuelson was smart and recognized the problem of this kind of 'science, but his proposal of 'revealed preference' to pin down utility empirically has come to nothing). And Arrow proved, with his paradox, that the whole concept of 'social utility' is inconsistent. By the way - our very brain seems to be modular and is therefore prone to the same paradox...

    "Utility" is the phlogiston of economics. Let's move on. Let's teach out students how the sector households is defined and estimated, how we estimate consumer confidence and consumer expenditure, how these variables influence each other, how households are prone to fuelling housing bubbles when given the chance to obtain unrestricted cheap credit - but let's leave "utility" behind us. Start with reading a book on Consumer Behavior, written by those guys who actually observe people to investigate what people really do, instead of assuming to know what they do. Real science.

    P.S. - when you read these consumer behavior books you will find that they don't mention utility at all, "as it does not sell nylons". People who investigate consumer behavior to advise companies have no use for the concept. These people should get the Noble!

    Merijn Knibbe

  2. Anonymous7:06 AM

    Indeed: read the wikipedia entry about 'quantifying utility'. There is nothing, nothing in it about how to measure it... (and I read Varian and Lucas and Becker too...).The obvious failure of neo classical economics to estimate and quantify it's basic concept, utility, clearly discredits the whole neo-classical endeavour as a scientific program.

  3. Anonymous10:51 AM

    I beg to differ on the subject of the referential import of "utility."

    I know of two efforts to measure utility: one by the happiness research people and the other by the brain scan mavens. I don't claim to necessarily know them all.

    I agree that utility is, at the current state of the art, hard to measure. I think, though, that it is in principle measurable. To be sure, not necessarily by economists...


  4. Anonymous5:12 PM

    A copernican revolution is an analogy that befits the work of people like Cullen Roche and Steve Keen. Macro that is based on real accounting of the monetary system, and that understands dynamics.

    BT London.

  5. No. You are each thinking about "utility" all wrong. Utility is imaginary. There is no real metric for utility. It need not be correlated with happiness, it doesn't necessarily represent well being, and economists don't assume that everyone has a utility function that they are constantly maximizing in the back of their heads. A utility function is a mathematical construct invented so that we can represent people's choices. We don't start with a utility function and then get choices, we start by observing people's choices, and if those choices are sufficiently well behaved (complete, transitive, and continuous) we can represent them by a utility function in which the person always chooses the option that corresponds to the highest utility.

    If we have unlimited data on individual's choices, and their choice pattern is convex, we can actually precisely trace out a corresponding utility function. In practice, we usually pick an extremely general mathematical function for the utility function, and then estimate the parameters from what data we have available. This method allows us to make predictions on what choices people will make under different contexts, such as a new tax etc. Utility is as imaginary as the imaginary number i, but like i, it is also very useful as a mathematical tool.