Book Review: Rethinking Expectations: The Way Forward for Macroeconomics | Enterprising Investor

19/08/2013

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15 August 2013

Book Review: Rethinking

Expectations: The Way Forward for
Macroeconomics
By Rodney Sullivan, CFA

Rodney
Sullivan, CFA

Categories: Economics, Portfolio Management

Follow @rnsullivan
on Twitter

Rethinking Expectations: The Way

Forward for Macroeconomics.
2013. Roman Frydman and Edmund S.
Phelps, eds.

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Rethinking Expectations: The Way

Forward for Macroeconomics originated
from a 2010 conference organized by
Columbia Universitys Center on Capitalism
and Society. The conference honored the 40th anniversary of the
publication of the landmark Phelps volume (also known as the Phelps
microfoundations volume), Microeconomic Foundations of Employment
and Inflation Theory. Edited by Edmund S. Phelps, winner of the 2006
Nobel Prize in Economics, that book is commonly credited with
pioneering the currently dominant approach to macroeconomic analysis.
In his innovative research, Phelps based macro relationships on explicit
microfoundations. These foundations distinctive feature was to accord
market participants expectations an autonomous role in economists
models of aggregate outcomes. The Phelps volume provided radically
new accounts of the co-movements of macroeconomic aggregates
notably, inflation and unemployment. The books contributors also cast
serious doubt on the validity of policy analysis based on then-popular
Keynesian macroeconomic models.
In Rethinking Expectations, Roman Frydman, professor of economics
at New York University, and Phelps, who directs the Center on
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Book Review: Rethinking Expectations: The Way Forward for Macroeconomics | Enterprising Investor

Capitalism and Society, contribute a fascinating introductory chapter

that summarizes the books 13 papers. Frydman and Phelps conclude
that the majority of macroeconomic and finance models developed over
the last 40 years derailed, rather than built on, Phelpss
microfoundations approach.
The contributors to the Phelps volume recognized the importance of
according market participants expectations an autonomous role in
economists models of aggregate outcomes, but economists
subsequently began to embrace the rational expectations hypothesis
(REH), whereby market participants expectations are essentially the
same as the predictions of the relevant economic theory. In contrast to
the contributors to the Phelps volume, REH theorists presume that the
role of market participants expectations in driving outcomes is not
autonomous from the models other components. Because REH models,
by design, rule out an autonomous role for expectations, they are best
viewed as undermining, rather than developing, the microfoundations
approach.
Early critics of REH, including Frydman and Phelps, pointed out its
epistemological flaws. They argued that REH is inadequate for
representing how even minimally reasonable profit-seeking participants
forecast the future in real-world markets. For various reasons, however,
an overwhelming majority of economists have embraced REH as the way
to represent how rational individuals think about the future.

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The failed REH explanations of aggregate outcomes gave rise to

alternative approaches most notably, behavioral finance models.
Although economists have proposed alternatives that differ in important
respects from the one promoted in the Phelps volume, the recent flurry
of theoretical efforts has been notable for approaches that bring us back
to the Phelps volumes major theme: non-REH modeling of market
participants expectations and their active role in driving aggregate
outcomes. Columbias 2010 conference brought together researchers
engaged in developing alternatives to REH.
One of the primary themes of Rethinking Expectations is nonroutine
change and its relationship with imperfect knowledge economics.
Discussed in the introductory chapter, this topic is explored in greater
detail in two later chapters. According to Frydman and Michael D.
Goldberg, we can trace the root of REHs insurmountable
epistemological difficulties and widespread empirical problems to a
single overarching premise that underpins contemporary
macroeconomics and finance theory: Nonroutine change, or change
that does not follow mechanical rules and procedures, is unimportant for
understanding outcomes.
Most contemporary models must assume away the importance of
nonroutine change. These models assume that an economist can fully
pre-specify, in terms of some set of causal factors, how individuals make
decisions and how the resulting market outcomes unfold at all points in
time. This approach presupposes that, in principle, there are no limits to
what economists can know about change. However, assuming away
nonroutine change does not eliminate its importance for understanding
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Book Review: Rethinking Expectations: The Way Forward for Macroeconomics | Enterprising Investor

19/08/2013

outcomes in capitalist economies particularly in financial markets,

whose participants revise their forecasting strategies at moments and in
ways that they cannot fully foresee. Because these nonroutine revisions
alter how market outcomes unfold over time, any overarching model of
the outcomes eventually becomes inadequate. That is why contemporary
macroeconomic and finance models have repeatedly been found to be
highly inconsistent with time-series data.
Frydman and Goldberg argue that these models also suffer from
epistemological flaws, and they trace the models empirical and
theoretical difficulties to the core premise that fully predetermined
accounts of change are possible. Contemporary economists quest for a
model that can predict the complete set of future market outcomes in
probabilistic terms is not the first such endeavor in the social sciences.
Contemporary behavioral finance models rest on the same core premise
as their REH-based counterparts. Behavioral finance theorists claim that
their portrayal of individual behavior is more realistic. However, their
assumption that nonroutine change is unimportant for understanding
individual decision making suggests that their models, too, lack plausible
microfoundations.
As previously mentioned, the contributors to Rethinking Expectations
sketch an alternative approach to modeling individual behavior and
aggregate outcomes: imperfect knowledge economics (IKE). IKE opens
macroeconomics and finance models to nonroutine change and the
imperfect knowledge it engenders, which is necessary to render the
authors microfoundations both plausible and compatible with individual
rationality. They argue that recognizing the importance of nonroutine
change and imperfect knowledge enables us to, among other things,
better understand the process by which financial markets help society
allocate its capital. IKE explores the frontier of what formal
macroeconomic and finance theory can deliver.

Rethinking Expectations provides fresh approaches to macroeconomic

analysis. These new approaches are needed, given the recent Great
Recession and spectacular boom and bust in asset prices. REH models
implied that such discontinuities could never occur.
More book reviews are available on the CFA Institute website or in
the Financial Analysts Journal.

Please note that the content of this site should not be construed as investment
advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Tags: book reviews, economics, portfolio management

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