Simon Wren-Lewis — Defending rational expectations

This post by Professor Wren-Lewis seems to indicate that mainstream proponents of REH don't understand the heterodox critics of REH.

Economic models are not replicas to scale. They are simplifications, that is to say, approximations and estimates rather than general descriptions as in physics.

Based on the laws of planetary motion, the position of a planet can be predicted with great accuracy at any point in time. This is due to the nature of the system being modeled.

Social systems are not like physical systems. They are complex adaptive systems that involve reflexivity and emergence. They are determined as much by cultural and institutional factors as individual inputs. Social systems resemble biological systems more than physical systems. They are non-ergodic, whereas physical systems are ergodic. This means that while relative certainty applies in physical systems, uncertainty rules in social systems.

Statements about models describe the model, not reality. There are criteria for assessing the quality of a model, such as formal consistency and rigor, but the model is determined by the assumptions. Assumptions can be empirically based, arrived at through induction based on data, or they can be postulated. Other than in very simple models, assumptions that are empirically derived are more likely to yield a model that is representational.

Proposition cannot establish their own truth, and models cannot guarantee that they are representational of facts. This involves judgement that links the conceptual to the real. Judgments can be true or false. This is established empirically.

Mainstream economists claim that REH is useful in macroeconomics and ask what alternative is better. Heterodox economists say that there is nothing inherently wrong with assuming REH as a heuristic provided that one recognize and take into account its limitations and refrain from interpreting the model as providing knowledge of the future or giving forward guidance where it is incapable of delivering. Heterodox economists accuse mainstream economists of over-promising results to the point of misrepresenting, which can have disastrous results in the economy and society, since macroeconomics is considered a policy science, hence, useful if not indispensable in policy formulation and assessment.

Much more can be said specifically, but this is the kernel of the issue. I think that the ball is in the mainstreamer's court on this one, especially after the crisis, where mainstream modeling failed miserably, yet some heterodox approaches warned about the gathering storm and explained why. Mainstream economists complain that heterodox economists did not use an econometric model so they were just lucky. But do macroeconomic models have to be econometric? Why so? (Keynes on Tinbergen: ""Newton, Boyle and Locke all played with alchemy. So let him continue.")

As an outsider looking in on economics, but as one familiar with the history of thought and philosophy of science, it appears to me that the mainstream and heterodox camps are having difficulty communicating with each other since they are operating in terms of different frames of reference and different criteria. The challenge is get enough to being on the same page as to be able to talk across the table. But when the mainstream holds that methodological questions are now settled, that seems unlikely to happen.

mainly macro
Defending rational expectations
Simon Wren-Lewis | Professor of Economics, Oxford University

One of the big problems, as every traders knows from experience, that acting based on "rational expectations" does not preclude acting stupidly. For example, people using the conventional model of monetary economics rationally expected that when the Fed greatly increased the monetary base through QE that rampant inflation would ensue. Some of the supposedly most astute financial advisors recommended taking such positions, e.g., shorting US Treasury securities. Top money managers took such position. On the other hand, heterodox economists using a different approach to monetary economics warned that this trade was misguided. It was. Those that took it got creamed. Their expectations were perfectly rational. They just had the wrong model.