Magical Thinking

Roman Frydman and Michael D. Goldberg on the Rational Expectations Hypothesis and its discontents.

the assumptions that underpin these theories are largely inscrutable to those without a Ph.D. in economics. Indeed, the debate is full of terms that mean one thing to the uninitiated and quite another to economists.

Consider “rationality.” Webster’s Dictionary defines it as “reasonableness.” By contrast, for economists, a “rational individual” is not merely reasonable; he or she is someone who behaves in accordance with a mathematical model of individual decision-making that economists have agreed to call “rational.”

The centrepiece of this standard of rationality, the so-called “Rational Expectations Hypothesis”, presumes that economists can model exactly how rational individuals comprehend the future. In a bit of magical thinking, it supposes that each of the many models devised by economists provides the “true” account of how market outcomes, such as asset prices, will unfold over time.

The economics literature is full of different models, each one assuming that it adequately captures how all rational market participants make decisions. Although the free-market Chicago school, neo-Keynesianism, and behavioural finance are quite different in other respects, each assumes the same REH-based standard of rationality.

In other words, REH-based models ignore markets’ very raison d’etre: no one, as Friedrich Hayek pointed out, can have access to the “totality” of knowledge and information dispersed throughout the economy. Similarly, as John Maynard Keynes and Karl Popper showed, we cannot rationally predict the future course of our knowledge. Today’s models of rational decision-making ignore these well-known arguments.