Skip to main content

Rational Expectations and Assuming the Consequent

Here's John Kay giving an example of something that has always bothered me:
I used to tell students who queried the premise of “rational” behaviour in financial markets – where rational means are based on Bayesian subjective probabilities – that people had to behave in this way because if they did not, people would devise schemes that made money at their expense.
Here's another example from David Levine:
Take an example: how we might predict stock market crashes? Suppose that two behavioral psychologists, call them "Kahneman and Tversky," produce a model of "cognitive biases" that predicts when crashes will occur. The model tells us that the stock market will crash on October 28. Since the model is reliable and has a perfect track record, we naturally believe this prediction. So what would you do? You would sell all your stock on October 27. But of course if enough people do this the stock market will crash on October 27 and not October 28. So this apparently reliable model will be proven wrong.
The idea here is that markets can incorporate expectations about pretty much anything. So if you make a public, reliable predication about something that will happen, people will arbitrage the thing into reality before the predicted time. Hard to deny that scenario.

But all the work in this scenario is being done by "we naturally believe this prediction." Well, suppose "we" don't? Suppose you're an agoraphobic computer programmer living in a basement in Silver Spring, Maryland, and you make a financial model. Your model predicts a crash on October 28th this year. But no one believes you. Maybe you're dismissed as a crank in the lickspittle financial press. (Imagine that.) Or maybe you're really unconvincing in person. But your model is correct, and your prediction comes true, at precisely the time you said.

Being able to predict the precise time of a crisis is not common, of course, but the function of belief in validating this kind of argument for rational expectations is critical. To say that financial crises are unpredictable because people will arbitrage any model, and therefore rational expectations theory obtains, seems perilously close to saying "because rational expectations, therefore rational expectations."

In fact, many people have been in the general situation of our computer programmer. People like Michael Burry, who didn't predict exactly when the financial crisis would happen, but knew that it would happen at some point, and predicted correctly in broad outline and detail how it would happen. And what did people in his little fund do when he told them what was going to happen? They didn't believe him! Even after he made them millions of dollars, they still resented him for it for some reason.

Anyway, the idea that people will take widely accepted models into account seems true in a boring and obvious way. But to derive from that a rational expectations theory seems unjustified.


Popular posts from this blog

Why Did Reality Winner Leak to the Intercept?

So Reality Winner, former NSA contractor, is in federal prison for leaking classified information — for five years and three months, the longest sentence of any whistleblower in history. She gave documents on how Russia had attempted to hack vendors of election machinery and software to The Intercept , which completely bungled basic security procedures (according to a recent New York Times piece from Ben Smith, the main fault lay with Matthew Cole and Richard Esposito ), leading to her capture within hours. Winner recently contracted COVID-19 in prison, and is reportedly suffering some lingering aftereffects. Glenn Greenwald has been furiously denying that he had anything at all to do with the Winner clusterfuck, and I recently got in an argument with him about it on Twitter. I read a New York story about Winner, which clearly implies that she was listening to the Intercepted podcast of March 22, 2017 , where Greenwald and Jeremy Scahill expressed skepticism about Russia actually b

Varanus albigularis albigularis

That is the Latin name for the white-throated monitor lizard , a large reptile native to southern Africa that can grow up to two meters long (see pictures of one at the Oakland Zoo here ). In Setswana, it's called a "gopane." I saw one of these in my village yesterday on the way back from my run. Some kids from school found it in the riverbed and tortured it to death, stabbing out its eyes, cutting off its tail, and gutting it which finally killed it. It seemed to be a female as there were a bunch of round white things I can only imagine were eggs amongst the guts. I only arrived after it was already dead, but they described what had happened with much hilarity and re-enactment. When I asked why they killed it, they said it was because it would eat their chickens and eggs, which is probably true, and because it sucks blood from people, which is completely ridiculous. It might bite a person, but not unless threatened. It seems roughly the same as killing wolves that

Internet Writing and the Content Vacuum

It's been a few times now I've had full weekday control of the Monthly 's headline blog, Political Animal, and I feel like I have a decent idea now what it's like being at the top level of blogging. (Not to say that I am  at the top level, of course, just that I've walked in those shoes for a few days and gotten some blisters.) Anyway, the first thing I've noticed is that it is really, really hard to do well. I've had days before when I just didn't have anything to do and ended up at home writing 4-5 posts in one day on this site, but pro blogging is an entirely different beast. The expectation is that during the day you will write 10-12 posts. This includes an intro music video, a lunch links post, and evening links and/or video. So that means 7-9 short, punchy essays on something , with maybe 1-2 of those being longer and more worked out thoughts. This ferocious demand for content is both good and bad. The iron weight of responsibiliy—the knowledge