The Great Man, The Economist For Our Times, decides to tell us all that it\’s rational expectations that caused all our problems.
This needs to be contrasted with the standard economics view, which is that everything can be predicted probabilistically with a a likelihood attached to the outcome. That is the basis of the theory of rational expectations. That theory, which in the obvious absence of any data on the future assumed that what would happen would be the same as what happened in the past, brought our economy and that of the world to its knees. Because a crash of the sort that happened in 2008 had not happened rational economists assumed it could not happen. That may sound stupid, but Adair Turner’s review of financial services regulation after the crash (to which I refer in the Courageous Sate when discussing this issue) made precisely this point. No one looked at the possibility of a crash because it assumed it could not happen as it had not happened.
Forgive me for having to point out that this isn\’t what rational expectations means.
It\’s usually taken as meaning that people are not systematically wrong in their predictions of the future. They are randomly so: for everyone who insists that FTSE is going to 20,000 there\’s another who thinks its about to hit zero as a very crude example.
Here is a theory that accords with what Ritchie is saying though:
Under adaptive expectations, expectations of the future value of an economic variable are based on past values. For example, people would be assumed to predict inflation by looking at inflation last year and in previous years.
That does sound very similar to what Ritchie is saying, doesn\’t it?
The thing is, what Ritchie is slagging off as rational expectations is actually the earlier theory, adaptive expectations. Adaptive expectations being what Keynes used. And a theory which has been corrected by the later rational expectations one.
It\’s remarkable how much economics Ritchie knows, isn\’t it?