Noah Smith — The power and the terror of Irrational Expectations

In most theories of non-rational expectations, like Bayesian learning or rational inattention, expectations evolve in a smooth, stable way. And so these models, as Chris Sims writes, look reassuringly like rational-expectations models. But there is no guarantee that real-world expectations must behave according to a stable, tractable model. I see no a priori reason to reject the possibility that expectations react in highly unstable, nonlinear ways. Like tectonic plates that build up pressure and then slip suddenly and unpredictably, expectations may be subject to some kind of "cascades". This can happen in some simple examples, like in the theory of "information cascades" (In that theory, people are actually rational, but incomplete markets prevent their information from reaching the market, and beliefs can shift abruptly as a result). In the real world, with its tangle of incomplete markets, bounded rationality, and structural change, expectations may be subject to all kinds of instabilities.

Anyone that has traded much knows how this goes. Expectations can and do run wild. As Baron Rothschild is famous for observing back in 1871, "Buy when blood is running in the streets." But it takes a strong stomach — aided by very deep pockets or the faith that moves mountains — not to get sucked in by runaway irrational expectations that seem perfectly rational.

Naohpinion
The power and the terror of Irrational Expectations
Noah Smith | Assistant Professor of Finance, Stony Brook University