The random
shock that clinched a brave Nobel Prize
By John Kay
Last week,
Thomas Sargent was awarded the Nobel Prize for economics. The idea most
economists would associate with him is “rational expectations”. But the
citation does not use the term. It asserts that his methods have been adopted
around the world, but gives little clue what these are, hinting only they can
be applied to the study of macroeconomic relationships.
The Swedish
Academy is brave, but not very brave. It sensed that in present circumstances a
prize to those who claim to understand the business cycle might encounter
criticism. The public suspects that economists who specialise in this subject
are of little use, and some professional critics agree. Willem Buiter has
observed that the macroeconomics in which Prof Sargent is a central figure has
been a “privately and socially costly waste of time and other resources” and
represented “self referential, inward-looking distractions at best”.
Needless to
say, this is not how Prof Sargent sees it. In an interview published last year
on the Federal Reserve Bank of Minneapolis website, he dismissed critics of the
state of macroeconomics as too ignorant to deserve a response. Asked to explain
how his research illuminated the recent crisis, he makes much of the finding
that deposit insurance can halt bank runs. This insight is not, however, unique
to Prof Sargent, who must be aware that the establishment of the Federal
Deposit Insurance Corporation precedes the paper he cites by 50 years.
As the
Nobel committee observes, “economic behaviour depends on expectations about the
future and economists must consider how such expectations are formed”. In a
brilliant linguistic coup, Prof Sargent and colleagues appropriated the term
“rational expectations” for their answer. Suppose the economic world evolves
according to some predetermined model, in which uncertainties are “known
unknowns” that can be described by probability distributions. Then economists
could gradually deduce the properties of this model, and businesses and
individuals would naturally form expectations in that light. If they did not,
they would be missing obvious opportunities for advantage.
This
approach, which postulates a universal explanation into which economists have
privileged insight, was as influential as it was superficially attractive. But
a scientific idea is not seminal because it influences the research agenda of
PhD students. An important scientific advance yields conclusions that differ
from those derived from other theories, and establishes that these divergent
conclusions are supported by observation. Yet as Prof Sargent disarmingly
observed, “such empirical tests were rejecting too many good models” in the
programme he had established with fellow Nobel laureates Bob Lucas and Ed
Prescott. In their world, the validity of a theory is demonstrated if, after
the event, and often with torturing of data and ad hoc adjustments that are
usually called “imperfections”, it can be reconciled with already known facts –
“calibrated”. Since almost everything can be “explained” in this way, the
theory is indeed universal; no other approach is necessary, or even admissible.
Asked “do you think that differences among people’s models are important
aspects of macroeconomic policy debates”, Prof Sargent replied: “The fact is
you simply cannot talk about their differences within the typical rational
expectations model. There is a communism of models. All agents within the
model, the econometricians, and God share the same model.”
Rational
expectations consequently fail for the same reason communism failed – the
arrogance and ignorance of the monopolist. In their critique of rational
expectations, Roman Frydman and Michael Goldberg employ Hayek’s critique of
planning; the market economy, unlike communism, can mediate different
perceptions of the world, bringing together knowledge whose totality is not
held by anyone. God did not vouchsafe his model to us, mortals see the present
imperfectly and the future dimly, and use many different models. Some agents
made profits, some losses, and the financial crisis of 2007-08 decided which
was which. Only Prof Sargent’s econometricians were wedded to a single model
and could, as usual, explain the crisis only after it had occurred. For them, the
crisis was a random shock, but the occasion for a Nobel prize.
No comments:
Post a Comment