rational expectations might really be wrong. People might make systematic errors, thinking that booms or busts will last forever. If that’s the case, then it will require the economics profession to abandon one of its strongest orthodoxies. But the payoff could be big if the profession devises models that successfully explain phenomena like bubbles and crashes.
Pointer from Mark Thoma.
Smith cites (preliminary?) research by Jesse Bricker, Jacob Krimmel and Claudia Sahm, who
looked at data from the Survey of Consumer Finances, from before and after the housing crash in 2008. They found that more optimistic ZIP codes — that is, places where people had unrealistically high expectations for their own incomes — were more likely to overpay for houses in the bubble run-up before 2008. These overoptimistic people also took on more debt, and they were more likely to increase borrowing in response to rising house prices.
I have not found a write-up of this work. UPDATE: slides here. But my thoughts:
1. “Rational expectations” is one of an entire class of expectations models that I reject. I call this class “identical expectations,” because it assumes that every individual has the same model of the market and the same information, thus arriving at the same set of expectations. I find this both unrealistic and, as Frydman and Goldberg have pointed out, un-Hayekian, because it assumes away any sort of local knowledge.
2. If we are going to attempt a simple model of expectations, then I would suggest one in which there are two types of traders–momentum traders and contrarian traders. Momentum traders live by the maxim “the trend is your friend.” When prices have risen recently, they expect them to continue to rise. Contrarian traders live by the maxim, “if something cannot go on forever, it will stop.” When prices have risen recently to the point where they are above historical norms relative to fundamental measures of value, contrarian traders expect them to fall.
Momentum traders never see bubbles. Contrarian traders see bubbles everywhere.
Economists tend to be contrarian traders. Robert Shiller is the leading exemplar of this. Not all economists share his views, of course, but hardly any economist would confess to being a momentum trader.
Still, I think that there are times and situations where momentum trading dominates. Both Shiller and John Cochrane see momentum trading as something that can persist for a while in housing markets, because of the high costs facing traders who would try to take advantage of even well-founded contrarian views.
Update: Smith recommends a paper by Hong and Stein.
Let’s remember that Minsky had an important point to make on this question. In his view, stability itself is destabilizing precisely because it rewards the riskier forms of finance. As those increase, the system becomes more fragile.
What is viewed as “rational” is constantly changing. Copying the techniques of successful people is usually considered rational. During the housing bubble, many people patiently saving for a traditional 20% down payment found themselves further from that goal each year for a while as home prices soared. Meanwhile, they noticed that those who employed more debt were piling up equity.
It is certainly true that different people will have different ideas of what is rational. What has succeeded spectacularly in the recent past tends to begin look very rational no matter how bad an idea it is.
Interfluidity had a good point about rationality as a tragedy of the commons.
Isn’t saying people be wrong on their house just using the word wrong?
Well, they can’t be wrong about their preferences but they can certainly be wrong about their predictions and expectations.
That would be “revealed preferences,” right? Of course rational expectations “can be wrong” if you irrationally expect booms and busts to go on forever. But so what?
Was rational expectations ever anything more than a simplifying assumption so that large-scale models can be constructed? Just like the EMH, railing against the “orthodoxy” of rational expectations seems to be a bit of a straw man.
Wasn’t “rational expectations” suppose to mean that the average expectation of people (weighted by market power) is the actual outcome. This allows for the majority of people to believe in a housing bubble, as long as some small fraction balances out this belief. If the minority are a few savvy investors and banks with a lot of market power, they could be rather invisible to the general discourse.
Addressing information asymmetry seems like the more productive course for economics than trying to model irrationality. To paraphrase Leo Tolstoy, “Rational investors are all alike; every irrational investor is irrational in his own way.” The idea of information asymmetry carries this principle at its heart.
Arnold, I was under the impression that Mordecai Kurz’ theory of rational beliefs was a general equilibrium model that was consistent with bubbles and crashes, and constituted an extension of rational expectations. It’s been around for quite a while. Am I wrong?