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12 September 2017 Financial Analysts Journal Book Review

Rethinking Expectations

The Way Forward for Macroeconomics (a review)

  1. Mark K. Bhasin, CFA

Rethinking Expectations  provides fresh approaches to macroeconomic analysis, including imperfect knowledge economics (IKE), which models individual behavior and aggregate outcomes and explores the frontier of what formal macroeconomic and finance theory can deliver. These new approaches are needed, given the recent Great Recession and spectacular boom and bust in asset prices.

Rethinking Expectations: The Way Forward for Macroeconomics originated from a 2010 conference organized by Columbia University’s Center on Capitalism and Society. The conference honored the 40th anniversary of the publication of the landmark “Phelps volume” (also known as the “Phelps microfoundations volume”), Microeconomic Foundations of Employment and Inflation Theory (W.W. Norton & Company, 1970). Edited by Edmund S. Phelps, winner of the 2006 Nobel Prize in Economics, that book is commonly credited with pioneering the currently dominant approach to macroeconomic analysis.

In his innovative research, Phelps based macro relationships on explicit “microfoundations.” These foundations’ distinctive feature was to accord market participants’ expectations an autonomous role in economists’ models of aggregate outcomes. The Phelps volume provided radically new accounts of the co-movements of macroeconomic aggregates—notably, inflation and unemployment. The book’s contributors also cast serious doubt on the validity of policy analysis based on then-popular Keynesian macroeconomic models.

In Rethinking Expectations, Roman Frydman, professor of economics at New York University, and Phelps, who directs the Center on Capitalism and Society, contribute a fascinating introductory chapter that summarizes the book’s 13 papers. Frydman and Phelps conclude that the majority of macroeconomic and finance models developed over the last 40 years derailed, rather than built on, Phelps’s microfoundations approach.

The contributors to the Phelps volume recognized the importance of according market participants’ expectations an autonomous role in economists’ models of aggregate outcomes, but economists subsequently began to embrace the rational expectations hypothesis (REH), whereby market participants’ expectations are “essentially the same as the predictions of the relevant economic theory.” In contrast to the contributors to the Phelps volume, REH theorists presume that the role of market participants’ expectations in driving outcomes is not autonomous from the models’ other components. Because REH models, by design, rule out an autonomous role for expectations, they are best viewed as undermining, rather than developing, the microfoundations approach.

Early critics of REH, including Frydman and Phelps, pointed out its epistemological flaws. They argued that REH is inadequate for representing how even minimally reasonable profit-seeking participants forecast the future in real-world markets. For various reasons, however, an overwhelming majority of economists have embraced REH as the way to represent how rational individuals think about the future.

The failed REH explanations of aggregate outcomes gave rise to alternative approaches—most notably, behavioral finance models. Although economists have proposed alternatives that differ in important respects from the one promoted in the Phelps volume, the recent flurry of theoretical efforts has been notable for approaches that bring us back to the Phelps volume’s major theme: non-REH modeling of market participants’ expectations and their active role in driving aggregate outcomes. Columbia’s 2010 conference brought together researchers engaged in developing alternatives to REH.

One of the primary themes of Rethinking Expectations is nonroutine change and its relationship with imperfect knowledge economics. Discussed in the introductory chapter, this topic is explored in greater detail in two later chapters. According to Frydman and Michael D. Goldberg, we can trace the root of REH’s insurmountable epistemological difficulties and widespread empirical problems to a single overarching premise that underpins contemporary macroeconomics and finance theory: Nonroutine change, or change that does not follow mechanical rules and procedures, is unimportant for understanding outcomes.

Most contemporary models must assume away the importance of nonroutine change. These models assume that an economist can fully pre-specify, in terms of some set of causal factors, how individuals make decisions and how the resulting market outcomes unfold at all points in time. This approach presupposes that, in principle, there are no limits to what economists can know about change. However, assuming away nonroutine change does not eliminate its importance for understanding outcomes in capitalist economies—particularly in financial markets, whose participants revise their forecasting strategies at moments and in ways that they cannot fully foresee. Because these nonroutine revisions alter how market outcomes unfold over time, any overarching model of the outcomes eventually becomes inadequate. That is why contemporary macroeconomic and finance models have repeatedly been found to be highly inconsistent with time-series data.

Frydman and Goldberg argue that these models also suffer from epistemological flaws, and they trace the models’ empirical and theoretical difficulties to the core premise that fully predetermined accounts of change are possible. Contemporary economists’ quest for a model that can predict the complete set of future market outcomes in probabilistic terms is not the first such endeavor in the social sciences. Contemporary behavioral finance models rest on the same core premise as their REH-based counterparts. Behavioral finance theorists claim that their portrayal of individual behavior is more “realistic.” However, their assumption that nonroutine change is unimportant for understanding individual decision making suggests that their models, too, lack plausible microfoundations.

As previously mentioned, the contributors to Rethinking Expectations sketch an alternative approach to modeling individual behavior and aggregate outcomes: imperfect knowledge economics (IKE). IKE opens macroeconomics and finance models to nonroutine change and the imperfect knowledge it engenders, which is necessary to render the authors’ microfoundations both plausible and compatible with individual rationality. They argue that recognizing the importance of nonroutine change and imperfect knowledge enables us to, among other things, better understand the process by which financial markets help society allocate its capital. IKE explores the frontier of what formal macroeconomic and finance theory can deliver.

Rethinking Expectations provides fresh approaches to macroeconomic analysis. These new approaches are needed, given the recent Great Recession and spectacular boom and bust in asset prices. REH models implied that such discontinuities could never occur.


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