The Problem with “Rational Expectations” is that it’s Usually Irrational

The internet is still abuzz with the distinction between Fama and Shiller.  E.g. from Mark Thoma:

Fama is a staunch defender of efficient markets and rationality, while Shiller argues, “The theory makes little sense, except in fairly trivial ways.” Shiller emphasizes “the enormous role played in markets by human error, as documented in a now-established literature called behavioral finance.”

These discussions, however, failure to state the basic problem with models that assume rational expectations: theorists long ago demonstrated that only in aberrant circumstances (i.e. when market participants are small relative to the market) is rational expectations rational. John Geanokoplos entry in the New Palgrave on Arrow Debreu Equilibrium makes this clear:

[The definition of a rational expectations equilibrium] is itself suspect; in particular, it may not be implementable. Even if rational expectations equilibrium were accepted as a viable notion of equilibrium, it could not come to grips with the most fundamental problems of asymmetric information. For like Arrow-Debreu equilibrium, in [rational expectations equilibrium] all trade is conducted anonymously through the market at given prices. Implicit in this definition is the assumption of large numbers of traders on both sides of every market

The short version of this quote is this: Rational expectations is not incentive compatible with the behavior of self-interested individuals in the typical market where at least one side of the market is likely to have either a small number of traders or a few traders who are large relative to the size of the market. When rational traders should take the effects of their actions on the price itself into account when making their decisions, the rational expectations approach will fail to be rational.

Thoma concludes:

Rational expectations are important for two reasons. First, they serve as a “perfect case” benchmark. In order to understand departures from rationality such as those embraced by Shiller, we need to know how the economy will function if agents fully understand everything about the economy, and can process the information optimally.

Assuming rational expectations is like assuming a perfect vacuum in physics – it provides a baseline that can be augmented with real-world features. Second, there are cases – simple games and financial markets for example – where the assumption of rational expectations may be approximately satisfied. But it’s a mistake, I think, to assume that rational expectations apply in all other settings or to the economy as a whole.

I agree with Thoma’s first point. As a benchmark rational expectations is invaluable. It’s so difficult to discuss what’s going on in the economy that idealized models are very useful reference points.

I disagree with Thoma’s second point. Why on earth would financial markets, where there are almost always market participants who are large either in terms of their inventories or in terms of the information they have about the market, be composed of people who don’t take into account the effects of their actions on prices. In fact, is there anyone who actually thinks that the large banks that dominate our financial market trade as “price-takers”? As long as rational behavior on a market includes significant effort to affect the movement of the price, then deviations from the rational expectations model will be as important to understanding the behavior of prices on these market as the benchmark model itself.

To avoid the possibility that the foregoing discussion generates confusion, Fama deserves his Nobel.  But as this year’s award clearly shows he doesn’t deserve it because he got the theory of financial markets right. Nobody can do that.  He deserves it because the efficient markets hypothesis is an extremely important benchmark and he showed us its importance.

Note: Toned down the text a little.

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