The way in which economic agents form expectations about the future is one of the most important issues in economics. All economic theory has to take a position on the matter, whether it is discussed explicitly or the treatment is left implicit.

For three decades now the rational expectations hypothesis has dominated, despite a persistent strand of criticism. The more tenacious and optimistic advocates of the REH might take the view that it has something meaningful to say about how people actually make decisions. A more common position is to adopt an instrumentalist as if position. The latter approach is more credible, though nonetheless still problematic.

In a post yesterday at Noahpinion Noah Smith reviews developments in the theorisation of expectations. The stranglehold of the REH is undoubtedly weakening. A range of alternative approaches are now available and being actively explored. Much of this new thinking is inspired by the concern for decision-making biases and heuristics that characterises behavioural economics. Concepts such as recency bias or information cascades are invoked.

These ideas may well bring us closer to an understanding of how expectations are formed in the real world. But they open up the prospect of irrational market movements that is nothing short of alarming for those committed to a vision of markets as a process of orderly and predictable adjustment.

Smith notes that in looking for alternatives to REH not only can we draw on new theoretical resources but we can also look back to earlier approaches. Here Friedman’s approach based upon adaptive expectations is identified as relevant.

I would advocate stepping back even further. Continue Reading →