Saturday, November 21, 2015

Roman Frydman on the New Rational Expectations Hypothesis

While reading a post at the Coordination Problem blog, I came across this interview of Roman Frydman (NYU economist) by Lynn Parramore at the Institute for New Economic Thinking. The interview was very interesting and I thought I'd share some of my favorite bits. The whole thing is worth reading.

LP: It seems obvious that both fundamentals and psychology matter. Why haven’t economists developed an approach to modeling stock-price movements that incorporates both?

RF: It took a while to realize that the reason is relatively straightforward. Economists have relied on models that assume away unforeseeable change. As different as they are, rational expectations and behavioral-finance models represent the market with what mathematicians call a probability distribution – a rule that specifies in advance the chances of absolutely everything that will ever happen.

In a world in which nothing unforeseen ever happened, rational individuals could compute precisely whatever they had to know about the future to make profit-maximizing decisions. Presuming that they do not fully rely on such computations and resort to psychology would mean that they forego profit opportunities.

LP: So being irrational means forecasting differently from the economist’s probabilistic model?

RF: Strangely, yes. In the hypothetical world of economists’ models, irrationality means inconsistency with an economist’s exact probabilistic hypothesis about how the world might unfold over time. This is very different from the dictionary definition of rationality, which is that people think for themselves, have their own objectives, and make decisions that advance those objectives. In a standard economic model, the economist assumes what the right way to think about the world is – and that the right way is to assume that unforeseeable change will not happen. I remember vividly how uneasy I felt when I first heard this Orwellian twist.

LP: You like to toss students a brainteaser: “If markets were perfect, we wouldn’t need them.” What does that mean, and what does it say about the need for a new understanding of the role of markets?

RF: For Fama and Lucas and their followers, if an economist gives you a rule that describes how outcomes will actually unfold, then there’s only one rational way to think about the future. But markets exist to enable society to take advantage of many different rational evaluations of the future. If there is only one rational forecast, the main reason for having markets disappears!

In the real world, there’s never just one correct interpretation or way to interpret. That’s why Friedrich Hayek argued – rightly – that central planning is impossible: it’s a pretense of exact knowledge. The planning committee sits down and figures out how the world will unfold and then allocates resources accordingly. What happens? In communist Hungary, people couldn’t find size 10 shoes.

LP: Does your new theory help economics become more scientific?

RF: Yes. Economists have long worried about being able to test their predictions empirically. If they couldn’t test them, they were philosophers, not scientists, as Soros put it.

As it turns out — and this is an important part of what I’m working on with pioneering colleagues at the University of Copenhagen — you may well be able to test the predictions of an NREH model. But you have to give up one thing: exact knowledge. You can get qualitative predictions: for example, you can say that when a company’s earnings rise, its stock price tends to rise as well. But you can’t get quantitative predictions: you can’t say exactly how much.

LP: Seems like a big thing to give up. How will economists and economic forecasters stay in business?

RF: It’s a big cost. It changes the status of economists. They are no longer fortune-tellers.

But, we gain something big, too. If we don’t become wedded to quantitative predictions, and we admit that both psychology and fundamentals matter, we can find out a lot about the world. We begin to understand that it is not a world of near-equilibrium; financial markets fluctuate. And we understand that these fluctuations are not necessarily a result of market inefficiency. They may be part of the way that markets try to assess what the actual values are. We begin to appreciate what markets really do.

And, when we understand better what markets do, it has an effect on government regulations, because we understand that markets sometimes go too high or too low. This awareness of the provisional nature of our knowledge has a very practical effect, actually, in the financial industry. We can adjust models as needed. In a broader sense, we gain the openness of the world and give play to creativity. We say that no one has the final answer. We get away from either/or thinking and imagine the multiplicity of possibilities.

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