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Life after “Rational Expectations”? Imperfect Knowledge, Behavioral Insights and the Social Context

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Many people regard the recent financial crisis as a painful addition to an already massive body of evidence that demonstrates the inadequacy of today’s economic models of “rational” markets.

According to these models, so long as financial markets are populated by “rational” participants, excessive upswings in asset prices, such as those in housing and equity markets in the run-up to the crisis, should not occur. The sudden reversals of these upswings are often pointed to as the proximate cause of the crisis.

But very few have interpreted the inability of “rational” market models to account for such swings as a potentially decisive indication that economists’ approach to modeling rational decision-making is irreparably flawed. The debate triggered by the crisis, summarized by The Economist in two articles addressing “[w]hat went wrong with economics [a]nd how the discipline should change to avoid the mistakes of the past,” has largely overlooked the key problem: the impossibility of establishing a standard approach to modeling how a rational individual makes decisions in every situation.1

Precisely the presumption that economists’ have found such a standard has come to underpin models of rational decision-making in a wide variety of contexts – diverse economies, markets, and even fields of inquiry, such as political science and law. In order to arrive at such a universal approach, economists’ standard of rationality must abstract as much as possible from differences in individuals’ interpretations of the social context, including the process driving market outcomes, history, norms and conventions, and public policies and institutions. For the last three decades, the vast majority of economists, including those following the behavioral approach, have considered the “Rational Expectations Hypothesis” (REH) to be the cornerstone of this standard.

In this paper we sketch the emergence of REH and how it evolved to become the centerpiece of contemporary macroeconomics and finance. We focus on major arguments advanced by the promoters of the hypothesis that seemed to have contributed to its rapid and broad acceptance. We argue that REH models are fundamentally flawed on epistemological and empirical grounds and thus cannot serve as a foundation for thinking about markets and public policy.

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