Noah Smith — Harrison & Kreps 1978: The power of irrational expectations

So what does that say about macro? Since the late 70s, nearly all of the models used by macroeconomists have been "rational expectations" models. "Rational expectations" is the idea that people don't make systematic mistakes when predicting the future. If you think that sounds a bit silly, you're not alone, but I kid you not when I say that rational expectations absolutely dominates modern macro.

But if expectations aren't rational in financial markets, why should they be rational in the economy as a whole? The answer is that they shouldn't. This is why Thomas Sargent, who won the Nobel Prize this year and who helped develop the theory of rational expectations, calls himself a "Harrison-Kreps Keynesian." Keynes, though he is usually associated with the idea of fiscal stimulus, was a professional stock speculator, and perceived clearly the irrationality of the markets in which he participated; Sargent is merely recognizing that financial market irrationality, which was formalized by Harrison and Kreps, is a huge hint that rational expectations is not going to get the job done in macro either. 

Read the whole post at Noahpinion

Harrison & Kreps 1978: The power of irrational expectations

by Noah Smith

(h/t Keven Fathi via email)

Some good comments too.

Smith points out that Keynes was a trader. Unlike many academic economists he was familiar with how financial markets actually operate based on trader psychology. He understood "uncertainty" based on personal experience with skin in the game. He also was aware of the many factors that affect traders in addition to those studied by academics when they consider markets. This shaped his views on macro that make the Keynesian approach to macro different from the approach based on rational expectations modeling.

I would suggest to traders and those interested in the cognitive-affective aspects of trading, along with the biases involves, that they take a look at Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Biases by Michael M. Pompian ((Wiley Finance, 2006).