Ben Bernanke Must Be Hoping Rational Expectations Doesn’t Hold…

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In the theory of rational expectations, human predictions are not systematically wrong. This means that in a rational expectations model, people’s subjective beliefs about the probability of future events are equal to the actual probabilities of those future events.

Now, I think that rational expectations is one of the worst ideas in economic theory. It’s based on a germ of a good idea — that self-fulfilling prophesies are possible. Almost certainly, they are. But expressed probabilities are really just guesses, just expressions of a perception. Or, as it is put in Bayesian probability theory: “probability is an abstract concept, a quantity that we assign theoretically, for the purpose of representing a state of knowledge, or that we calculate from previously assigned probabilities.”

Sometimes widely-held or universally-held beliefs turn out to be entirely irrational and at-odds with reality (this is especially true in the investment industry, and particularly the stock market where going against the prevailing trend is very often the best strategy). Whether a belief will lead to a reality is something that can only be analysed on a case-by-case basis. Humans are at best semi-rational creatures, and expectations effects are nonlinear, and poorly understood from an empirical standpoint.

Mainstream economic models often assume rational expectations, however. And if rational expectations holds, we could be in for a rough ride in the near future. Because an awful lot of Americans believe that a new financial crisis is coming soon.

According to a recent YouGov/Huffington Post survey:

75 percent of respondents said that it’s either very or somewhat likely that the country could have another financial crisis in the near future. Only 12 percent said it was not very likely, and only 2 percent said it was not at all likely.

From a rational expectations perspective, that’s a pretty ugly number. From a general economic perspective it’s a pretty ugly number too — not because it is expressing a truth  (it might be — although I’d personally say a 75% estimate is rather on the low side), but because it reflects that society doesn’t have much confidence in the recovery, in the markets, or in the banks.

Why? My guess is that the still-high unemployment and underemployment numbers are a key factor here, reinforcing the idea that the economy is still very much in the doldrums. The stock market is soaring, but only a minority of people own stocks directly and unemployed and underemployed people generally can’t afford to invest in the stock market or financial markets. So a recovery based around reinflating the S&P500, Russell 3000 and DJIA indices doesn’t cut it when it comes to instilling confidence in the wider population.

Another factor is the continued and ongoing stories of scandal in the financial world — whether it’s LIBOR rigging, the London Whale, or the raiding of segregated accounts at MF Global. A corrupt and rapacious financial system run by the same people who screwed up in 2008 probably isn’t going to instill much confidence in the wider population, either.

So in the context of high unemployment, and rampant financial corruption, the possibility of a future financial crisis seems like a pretty rational expectation to me.

20 thoughts on “Ben Bernanke Must Be Hoping Rational Expectations Doesn’t Hold…

  1. People don’t seem to deal with the financial situation in the world any better than they do with their own mortality.

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  3. The Catholic church is a system to funnel loose change into fabulous wealth and power. Its ideological theory is no more rational than any other system, but it serves the purpose to steal.

    Whether it is Government corruption giving big business massive infratructure contracts, or Modern Monetary Theory justifying cheap money handed to cronies to take advantage of asset bubbles. The theory is a cover to engage in systematic theft.

    The only rational expectation is in the minds of the Kleptocrats. They are rationalising theft.

    • It’s not MMTers who are guilty of having money donated to “cronies”. The best way of making the rich even richer is QE because it increases asset prices. MMTers in contrast advocate increases in bog standard forms of government spending and/or tax cuts spread across the income scales. E.G. Warren Mosler is a leading MMTer and has long advocated a payroll tax reduction. E.g. see:

      http://www.hardassetsinvestor.com/videos/1868-warren-mosler-payroll-tax-holiday-needed.html

      I’m an MMTer. (See the top of my blog.) I attacked QE here:

      http://ralphanomics.blogspot.co.uk/2012/08/nine-reasons-why-qe-is-farce.html

      • From my professional experience, a banking system that sets rates based on actual risk,is the best method. Not central bank policy. If you can’t find appropriately risk profiled investments for your pool of available capital, attracted by the appropriate interest rate, then the interest rate will have to naturally adjust. Hyman Minsky is the only Economist that understands the business of banking. This method will prevent Minsky moments.

        I feel that the Central bank, changing rates, is too easy to front run, if one is connected to the Central Bank. Instead of people trying to predict policy, they should be focussed on the profitability of the project requiring debt funding.

        I remember when I was in Treasury and we had to set rates based on what the Central bank set, in order to meet the market, not based on what we needed to attract funds to meet our loan approvals that met our requirements.

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    • The Dow Transports index has taken off.

      Consolidation, elimination of excess capacity, increased fares, increased shipping rates, increased fees, fuel surcharges, elimination/reduction in services, reduced labor costs, squeeze on independent trucking, public funded rail improvements, public relations make-over, increased profits and QE,

      • I would agree with the squeeze on independent trucking. The same is happening in Australia. big customers using big truckers, who are utilising the boom in overseas students as workers, so little wage pressure.

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  7. In the final phase of a debt-money system, what else can there be but increasing levels of debt, which is, of course, the etiology of the dys-function in the first place. As long as massive quantities of capital are tied us in mal-investment, producing nothing but heartache [through market intervention], this capital can not be liberated, and nothing will change.

    Imagine what would happen is everything was priced correctly? How much real capital would this liberate for productive investment? This is the essence of the unemployment problem.

    Bankers and the drug they peddle [debt] is massively destructive. Although people do not realize this on the upside of the cycle, they certainly do on the way down. People must keep in the mind that whatever pain is to be felt when the markets do [eventually] re-price, will be followed by great economic liberation and prosperity.

  8. Are we talking about another variation of a cargo cult here when you talk about the self-fulfilling prophesies and expectations?

    • There will always been a great deal of strife in the world, but you can not ignore the fact that, economically, we have reached a stage where great increases in productivity are likely [technology-related]. How this will all shake out is difficult to say, but with the levels of dys-function seen over the past century, one might believe that a return to a more functional economic system [which is in the long-term interests of everybody], is probable.

      If you look at the continuum of historical development, it should seem apparent that man will most likely not decline into some sort of dark ages, as this would support the illusion that this era is somehow, “special.” The only thing special about what’s going on now is that you and I are here, and that’s not too special.

      This system has failed because people do what people do. It will most likely be corrected, because again, people do what they do. Now, this is not to say that we could blow ourselves up or some other event might happen, but one must go with the percentages here, and my money is on the notion that once this runs its course, that better times are ahead [and generally after a great economic purge, there is great prosperity].

      • At impermanence:

        Your Method of thought is astounding and each of your blogged comments holds core truth of society and morality as whole. Your wisdom is needed and I thank you for your contribution to Knowledge.

        Aziz’s subject posts are an ideal plastform to tantilize your brain and give us the truth.

        Thank you Both

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