Ready for a truly wacky-sounding theory? How about a theory that does not believe in involuntary unemployment? How about a theory that promotes dart throwing as a method of choosing stocks? How about a theory that does not believe that the government can hurt or help the economy very much? What a bizarre ending to our study of economic history! We began with the mercantilists, who said government generally helps the economy. Then Smithians said government hurts. Keynesians said government helps. Monetarists said government can help but often hurts. Public Choice economists said that government usually hurts. Now the Rational Expectations (or New Classical) economists laugh at all their predecessors and proclaim that government intervention is an illusion, like a magician’s trick, which cannot change reality very much.
To reach this startling conclusion, New Classical economists follow some tricky logic. When they finish, however, they have a neat model that is admirable for its theoretical beauty. Their critics, though, look scornfully at the pristine but unrealistic model, better suited for an art gallery than for the Council of Economic Advisers.
The old guard of economists—the Tobins, Samuelsons, and Friedmans—find their life’s work belittled by these newcomers, who trace their origins to a 1961 paper by a young Carnegie Tech professor named John Muth. The youthful Rational Expectations movement attracts a significant proportion of young model-building scholars, charmed by its mathematical precision and opportunities for new discoveries. Old Keynesians fear that the new scholars will leave them behind, just as they surpassed the classical teachers who refused to follow Keynes during the Great Depression. The challenge to mainstream economics is to mine Rational Expectations for bits of truth and then add these to mainstream theory.
Let’s find out why no one completely dismisses Rational Expectations theory. Its first tenet states that all markets clear, meaning that prices always adjust simultaneously to get rid of any surplus or shortage. No gluts may exist. If fish produce too much caviar, the price will fall. If demand for labor falls, wages will plunge. Now, most economists agree that markets eventually clear, but monetarists and Keynesians allow for longer transitions. Keynesians point to “sticky wages.” Monetarists point to lags in the transmission of monetary policy. Baloney, say the Young Turks.
Second, they contend that people consider all available information in making economic decisions and continually update their models or expectations of the economy. Compare old-fashioned adaptive expectations with rational expectations. If people act adaptively, they look at the past behavior of variables and only gradually adjust their outlook. If prices have risen at 6 percent per year for the past few years, yet rise 10 percent this year, people might expect prices to rise 7 percent next year under the adaptive model, which heavily emphasizes past data. They wait for experience to knock them on the heads rather than change their expectations on the basis of new information. What if they heard that the federal government had unleashed the money supply and fiscal spending for a wildly expansionary policy? Under adaptive expectations, they would not vary their predictions until they had seen hard evidence.
Suppose that the cartoon character Wile E. Coyote waits on the corner of Hollywood and Vine for a bus to take him home. Past experience teaches him to take two steps away from the bus stop at 5:30 p.m. every day, because every day at that time a five-ton anvil accidentally drops fifty stories from the roof of the Acme Anvil Company. One day Wile E. waits at the corner. The anvil falls fifteen minutes late and squashes him at 5:45. If Wile E. has adaptive expectations, what will he do the next day at 5:45? He will stand at the bus stop again, thinking that the anvil seldom falls at 5:45 p.m. Squashed again. Finally, after a week of flattening (as can only happen to cartoon characters), he may get the idea that the Acme schedule has changed.
What if Wile E. had rational expectations? After the first hit, he would walk up to the anvil factory as soon as he popped back into three dimensions and find out what was going on. He would reformulate his schedule. He would forget the past data if new information made them obsolete.
John Muth, the shy, awkward man who sparked rational expectations, was raised in the Midwest and built his reputation on hogs. By studying hogs, Muth learned economics from the ground up and never seemed interested in the glory achieved by some of his glittering colleagues, who included Nobel laureates Herbert Simon, Franco Modigliani, Merton Miller, and John Nash, the subject of the book and movie A Beautiful Mind. Modigliani praised Muth’s mind but said that the bearded, slightly hunchbacked researcher “took pains to appear as an oddball.”1 At one point, while teaching at Indiana University’s business school, his MBA students marched into the dean’s office waving a petition to have Muth fired because he befuddled them with his brilliant but seemingly impenetrable mathematics.
What in the world did hogs have to do with higher math? Before Muth came along, most people believed that hog markets suffered wild, irrational booms and busts. When bacon was expensive, every farmer seemed to respond by raising more hogs. Then all the hogs would simultaneously stampede onto the market, sending bacon prices into a tailspin. Now faced with low prices, farmers would purportedly stop raising hogs, which once again led to a shortage and expensive bacon. “Hogwash!” Muth concluded. He dug up data on hog prices, and showed that farmers were not so stupid as to assume that today’s high prices would guarantee high promises tomorrow.2 Farmers were rational, Muth said, disproving John Kenneth Galbraith’s view that farmers had strong backs and weak minds.
If people have rational expectations, they will not make systematic mistakes. They may be fooled or surprised once, but they will work to prevent a second error. As Star Trek’s engineer Scotty put it, “Fool me once, shame on you; fool me twice, shame on me.”
The stock market provides the most persuasive evidence of rational expectations. Academic economists report that the stock market almost instantaneously absorbs information. In other words, once information becomes public, share prices instantly reflect it. If yesterday you read online that Tiffany’s expects a good year, you’re too late to take advantage of the information. Tiffany’s stock will have risen immediately on the basis of next year’s outlook, and information that everyone has is useless. In another example, suppose you cleverly observe that millions of college students flock from Boston to New York right before Thanksgiving. You discover that Kiddy Airlines carries many of the students. In September, two months before the Thanksgiving rush, you buy Kiddy stock, expecting that in November the price will skyrocket. Dumb move. The price of Kiddy stock already reflects the expected profits during Thanksgiving. Everyone knows that Thanksgiving is a good time for Kiddy. And prices are based on the expected profits and dividends, not just on current financial data.
If this model, called the Efficient Market Hypothesis, is correct, you cannot beat the average return on stocks by religiously following companies, reading financial returns, or tracing past price movements. The market already efficiently estimates the future returns. Stocks cannot be “overvalued” or “undervalued” (unless just about everyone misunderstands some characteristic of the company, or there is undisclosed information). The market price becomes an infallible icon, until new information justifies a new price. (Nonetheless, the stock market “crash” of October 1987, the collapse of technology stocks in 2000–2002, and the financial meltdown of 2008 probably indicate that primordial “animal spirits” still lurk beneath the crisp white shirts of stock traders.)
You’d probably do just as well to choose a stock by throwing a stockbroker against a dartboard as to listen to his advice—and you’d save money. Here’s a plan, consistent with the Efficient Market Hypothesis, for doing as well as famous stock advisers: Place two bowls of dog food in front of your dog—one with the name IBM glued on the front, the other with Mobil. Now buy stock in the company that the pet goes to. If she isn’t hungry, place your money in a corporate bond fund.
The snorting bull market of the 1990s, which pushed the Dow Jones average from 3,500 in 1993 to 11,700 in January 2000 to 27,000 in 2020, left money managers in the dust, as passive “index” funds outperformed almost every professional stock picker. By the time people pay for advertising expenses, research costs, and commissions, the vast majority of mutual funds return a little bit less than a big dartboard. Paul Samuelson long ago suggested that “most portfolio decision makers should go out of business—take up plumbing, teach Greek.” Of course, according to the Efficient Market Hypothesis, a bad portfolio manager would not muck things up too much (since it takes extraordinary ineptitude to perform far worse than the proverbial dart thrower), whereas a bad plumber could do some real damage!
Plenty of brokers and publicists rave about their predictions. Careful studies uncover little reason to believe them.3 Sure, some may enjoy lucky streaks. But Las Vegas bettors sometimes beat the odds also. The point is not that brokers usually lose money. The point is that they do not consistently beat the average. Even when some superstar analyst discovers a winning way to interpret data, others follow, and the method becomes obsolete. So why pay extra money in commissions and financial advice for an average return? You might as well obtain a well-diversified portfolio that balances various risks, or invest in a broad market index that moves with the market average. Faced with this logic, in 2019 major brokerage houses like Charles Schwab cut their commissions on stock trades to zero.
Rational Expectations theorists, including the 1995 Nobel laureate Robert Lucas and Thomas Sargent, state that government has little power over markets. They start with the stock market and then analogize to wider markets in the economy. What if the government tries to temporarily raise the price of Kiddy Airlines by buying shares? The original price represents the current, “correct” feeling about future earnings and dividends, which would give a fair rate of return. If the government buys stock and bids up the price, shareholders will immediately sense that the stock is artificially overvalued and will sell. If the government dumps its stock, forcing down the price too far, investors will buy, sensing that the stock deserves a higher price. In the end, no matter what the government does, the price will return to its “correct” value unless new information convinces investors that a new price is justified.
Before applying the analogy to macroeconomics, let’s examine two important points. First, note that the Efficient Market Hypothesis does not include inside information, secret knowledge of future profits or losses that company officials may have. Investors with nonpublic information may achieve higher-than-average gains. This seems logical but unfair. The poor slob without a seat on the board of directors will not reap the same gains as insiders. For this reason, insider trading is illegal. The Securities and Exchange Commission monitors stock trading by insiders and establishes penalties for illegal activity, including prison terms and the “disgorging” of profits. Of course, not everyone gets caught, nor do the laws cover everyone with inside information. Should they? In 2004, Martha Stewart, a cultural icon known for such dangerous work as decorating her home with Christmasy pine cones and coaching television viewers on how to torch crème brûlée, spent five months in prison and more time under house arrest because her stockbroker’s assistant told her that a pharmaceutical company president had sold his own shares in the company. The president had inside information that the FDA was going to turn down its drug approval application. Stewart was convicted, not for selling her shares in the company but for lying to the FBI about her conversation with her broker’s assistant. Her case was memorialized in the film Martha Stewart: Behind Bars.
Suppose Fido Inc. surreptitiously plans to take over the Spot Corporation by buying its stock. Fido managers will run Spot more efficiently, thus boosting the value of Spot’s assets. For this reason, Fido is willing to pay a higher price for the stock. Spot shareholders who sell their stock will earn lots of money. The takeover plan is a secret. Only the presidents and vice presidents of Fido and their attorneys know. Naturally, if Fido’s chief officers personally buy Spot stock before the takeover attempt is publicized, they can be arrested for insider trading. But what if the employee of a printing press that prints the forthcoming publicity documents buys Spot stock before the public announcement? Should he be considered an insider and punished? According to the Supreme Court, no.
Ironically, when Vincent Chiarella, the printer acquitted by the Supreme Court, was asked whether Ivan Boesky, who was convicted of insider trading a few years later, should be punished, he said, Throw the book at him.4
A second important point about the Efficient Market Hypothesis brings up another irony. Stock picking is ineffective because so many people engage in research and stock analysis. The current prices “correctly” reflect expectations because so many people buy and sell on the basis of available information. You have little chance of consistently interpreting the information in a superior way. If no one but you researched, however, you could outpredict a random approach. Therefore, the advice of Efficient Market believers to select randomly becomes itself obsolete if everyone takes the advice!
Until fairly recently, Wall Street managers and economists found little to talk to one another about. After all, economists like Samuelson were dousing portfolio managers with frigid water, telling them to take up plumbing. While Princeton professor Burton Malkiel wrote a book espousing the Efficient Markets Hypothesis titled A Random Walk Down Wall Street, Wall Street titans told economists to take a hike. The movers and shakers replied that academicians were simply too timid to bet on winners and losers in the financial markets. And most of them, outside of Keynes, did not succeed when they did get the nerve to roll the dice.
While some economists were deriding Wall Street’s stock-picking powers, others were devising inventive ways to design portfolios and to put a value on companies and stock options. These were extremely difficult technical challenges, requiring advanced mathematics and economics. The problem for the researchers, though, was that in the 1960s and 1970s, no single discipline wanted them. Economists thought their work was too technical, and mathematicians thought their research too mundane. No matter, in 1990 the Nobel Committee awarded the Nobel Prize in Economics to three pathbreaking financial economists who actually sought to help Wall Street rather than tear it down.
In 1952, a young graduate student named Harry Markowitz began a revolution in finance by publishing a paper called “Portfolio Selection.” The paper built an analytical framework for a simple aphorism, “Don’t put all your eggs in one basket.” At first this seems so obvious that you might be inclined to deliver the Nobel Prize to Mother Goose’s or Aesop’s heirs. Five hundred years ago, Shakespeare’s merchant of Venice told us that
My ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of the present year;
Therefore my merchandise makes me not sad.
Still, this folk wisdom was little more than a wives’ tale or a rule of thumb until Markowitz put his mind to work. In fact, the great Keynes rejected the notion, arguing that a big investment in a company you know well is safer than many smaller investments. Markowitz did not simply show that more is better—that a portfolio is safer with stocks of five airlines. He demonstrated that the kind of stocks should be diverse. Your investments should truly be diverse—that is, not correlated with each other. Better to own stock in Delta Airlines and Johnson & Johnson rather than in two airlines or two pharmaceutical companies. Despite initial doubts, Wall Street has been following Markowitz’s lessons for the past fifty years.
It’s not easy to be a pathbreaker, though. Markowitz tells how Milton Friedman worried Markowitz when the graduate student had to defend his dissertation. Markowitz had been telling himself, “I knew this deal cold. Not even Milton Friedman can give me a hard time.” A few minutes into his defense, though, Friedman piped up: “Harry, I don’t see anything wrong with the math here, but I have a problem. This isn’t a dissertation in economics, and we can’t give you a Ph.D. in economics for a dissertation that’s not economics. It’s not math, it’s not economics, it’s not even business administration.” Then others spoke the same complaint. Markowitz sat in the hall to await the committee’s decision. Minutes later, a senior professor walked into the hallway, looked him in the eye, and said, “Congratulations, Dr. Markowitz!”5
Markowitz’s co-laureates in 1990 were William Sharpe of Stanford and Merton Miller of the University of Chicago. Sharpe designed the Capital Asset Pricing Model, which warrants at least one chapter in every book on corporate finance, as well as the concept of beta, which helps investors figure out how risky a particular stock may be. In particular, beta tells you whether a stock will move in sync with the market as a whole. Starbucks has a beta of 1.0, which means that if the New York Stock Exchange rises by 10 percent, Starbucks shares will likely climb 10 percent too. That makes sense, since a strong market signals a strong economy, and consumers can afford to buy fancy coffee if they are feeling richer. Other kinds of stocks may have a low beta. People will keep buying candy even if the economy sours. No surprise, then, that Tootsie Roll has a lower beta of just 0.51, meaning that if the overall market falls by 10 percent, this candy company will slip by about half that proportion. When people look to diversify their portfolios, they keep track of the beta calculations to make sure that all their stocks do not go up—and down—together.
Merton Miller achieved his fame by studying the way corporations organize themselves. Prior to Miller’s work with Franco Modigliani, many corporate treasurers thought that their firms would look more profitable if they funded their operations by issuing more bonds and selling fewer shares of stock. That way, a smaller number of shareholders would split the profits among themselves. Miller and Modigliani showed, though, that no matter how you slice up the ownership, the total value of the firm depends on the future earnings. If, for example, the firm got loaded up with debt (issued a lot of bonds), lenders would demand higher interest payments, which would offset the benefit of having fewer shareholders.6
Miller offered a colorful analogy that begins with a tub of whole milk. The farmer could sell the cream separately, which fetches a higher price. But then he would be left with only skim milk, which sells for less. The cream plus the skim would bring the same total revenues as the whole milk. A tub of milk is a tub of milk, no matter how you mix it. Likewise, a stream of corporate profits is a stream of profits, no matter who you pay it to.
By focusing their economic training on financial markets, the three 1990 Nobel laureates enriched Wall Street, and didn’t do so badly themselves! Sharpe and Miller have consulted with many of the leading firms on Wall Street. John C. Bogle, chairman of the famous Vanguard Group of mutual funds, admonished investors not to ignore the economists: “While there is a lot of witchcraft in the academic lore . . . the most solid academic thinking, however complex, abstruse . . . will find its way into actual practice, and into the investor marketplace as well.”7
Alas, even Nobel laureates must learn humility. The two 1997 Nobel laureates, Robert Merton and Myron Scholes, who won for their work in valuing financial derivatives, joined a high-flying investment group called Long-Term Capital Management. Their fund crashed in August 1998, disrupting financial markets throughout the world. The firm had recklessly borrowed far too much money and placed massive bets that world interest rates would move closer together. They bet wrong and racked up billions of dollars in losses. Long-Term Capital proved not so durable after all, losing its capital within days. Can we blame Merton’s and Scholes’s Nobel Prizes? Possibly. After all, the banks that lent Long-Term Capital so much money felt confident such luminaries and their illustrious partners would not misjudge risk. Einstein may have been the greatest scientific mind of the century, but you probably would not have wanted him to change your radiator fluid. Likewise, just because people have Nobel Prizes does not mean that you should hand over your money to them.
Before disputing Rational Expectations theory, let’s follow its striking implications for the macroeconomy. Remember that rational actors continually update their model of the economy. Therefore, the first lesson is that econometric models are obsolete because they are based on past data, and statistical models cannot predict the effect of a new government policy. For example, if the government finds a stable, historic relationship between baseball games and GDP and therefore attempts to raise GDP by increasing the number of baseball games, economic actors will see this policy as new information and refine their model. Thus, their old behavior provides a poor basis for creating new policy. This implication is known as the Lucas Critique.8 Robert Lucas, a professor at the University of Chicago, proved to be too good a teacher of rational expectations. When the Nobel Committee in Stockholm announced his prize in October 1995, his ex-wife’s lawyer revealed that she had foreseen his possible winning. Seven years before, she inserted a clause in their divorce settlement to claim half his Nobel Prize money, should he win. That clause, based on her rational expectations, was worth $500,000.
Following the Lucas Critique, Robert Hall submits that mainstream models of consumption that rely on past income, wealth, interest rates, and inflation fail to predict as well as a simple model with only two factors: last year’s consumption and a random variable. Hall argues that the only difference between next year’s and this year’s consumption levels can be explained by random surprises—that is, new information.9
The second lesson trashes the government’s stabilization policy: only a surprise strategy has any effect. Suppose the economy tumbles into a deep recession marked by high unemployment. Mainstream economists would likely urge an expansionary policy. According to most economists, higher aggregate demand would lead to higher output and more hiring, and the economy would climb out of the doldrums.
Not according to Rational Expectation theorists. They argue that actors have learned that the federal government always leaps in to cure recessions by boosting demand. Rather than allow their prices to fall during the recession or raise their output, therefore, firms will simply raise their prices. They anticipate government policy. Since higher demand is just around the corner, they have learned not to let prices fall in a recession. It is as if the government passed a law that whenever unemployment reaches 7 percent, the Federal Reserve Board will press on the monetary accelerator. As evidence for their argument, theorists show that recessions prior to World War II saw prices fall, whereas post–World War II recessions, under the anticipation of demand-side responses, saw more stable prices. The Employment Act of 1946 guaranteeing maximum employment virtually notified firms that Uncle Sam always comes to the rescue. In sum, if Uncle Sam does what he is expected to do, he ends up doing nothing. Only surprise moves will affect the level of output.
Imagine how this theory shocks Keynesians and monetarists. Their advice appears as useless as the comedian Gracie Allen’s absurd offer to solve the California–Florida border dispute.
Here’s another shocker. If this theory is right, the Federal Reserve Board should find it easy to reduce the inflation rate. Why? Under mainstream approaches, a contractionary policy will first lead to a recession and finally to a reduction in inflation. Under rational expectations, though, if a credible Federal Reserve Board announces that the money supply will grow at zero percent, people will automatically expect lower prices and reduce their prices and wages. They will automatically accept a lower inflation rate based on the Fed’s policy. Since they do not have adaptive expectations, they need not see a wrenching recession before they reduce their price predictions.
Now that Rational Expectations has thoroughly insulted Keynesians and monetarists, let’s briefly look at the barbed arrows they shoot at Public Choice economists. James Buchanan maintains that politicians foster deficit spending and therefore cheat future generations. Bruno Frey, another Public Choice economist, maintains that political cycles exist in democracies, with politicians manipulating inflation and unemployment in order to win elections.
Both these claims clash with Rational Expectations theory. First, take the Political Cycle theory. Say politicians try to toy with policy tools in order to lift election chances. According to Rational Expectations, voters will catch on after the first attempt. They will figure out that a booming economy in an election year presages high inflation, and they will take steps that will spoil the false prosperity, for they will quickly learn that the government will slam on the brakes after the election. This explanation makes sense and probably explains the rather flimsy evidence for consistent political cycles. As for persistent budget deficits, Harvard economist Robert Barro argues (on behalf of Rational Expectations theory) that investors and savers calculate future burdens into long-term interest rates.10 Higher long-term interest rates surely affect the performance of the economy in the present. Thus, future aspirations and expectations are actually represented in today’s capital markets. Barro’s argument actually descends from David Ricardo (and is called Ricardian equivalence); he noted that public debt and taxes are quite similar, since rational people know that the debt will have to be repaid at some point in higher taxes. Therefore, government bonds used to finance deficits push up future expectations about taxes. A Public Choice economist like James Buchanan would respond by noting that future generations have no political voice yet, even if they have an indirect voice in the bond market. After all, Buchanan sees the issue as a moral question as much as an economic one.
In recent years the Japanese Ministry of Finance has cited Ricardian equivalence to explain why it cannot spur the economy by simply writing checks to the public. Since Japan is so indebted (its debt-to-GDP ratio tops the international comparison charts at about 200 percent), the Finance Ministry believes that Japanese households hoard extra income, because they know that someday they, or their children, will need to pay back the staggering debt.
Incidentally, Rational Expectations theorists can muster evidence that people catch on to political tricksters. Consider Margaret Thatcher in the early 1980s, who pledged to reduce the British budget deficit and even raised taxes in the middle of a recession in order to keep her promise. Might her two reelections show that Britons had figured out and rejected the freewheeling policies of the old Labour Party?
The Rational Expectations professors get an assist in the real world from “bond vigilantes.” What is this notorious-sounding gang? They don’t carry guns or knives, but they can make a country’s finance minister tremble in his boots. Bond vigilantes are traders and investors who buy and sell government bonds based on a country’s economic performance and outlook. They can play a useful role in disciplining reckless governments. In the early 1990s, bond and foreign exchange traders looked at Sweden and saw a weak economy, a huge trade deficit, a bloated government sector, and a currency that was so strong that Swedish exporters could not compete abroad. In a few years, public debt had doubled and the deficit had multiplied tenfold. Sweden was teetering. Vigilant traders foresaw the country hurtling toward a future in which it could not afford to repay its debts to the rest of the world.11 Skandia, a giant Swedish financial firm, announced it was “boycotting government bonds in light of the record budget deficit and fast-rising debt.”12 Bond and foreign exchange traders outside Sweden began dumping Swedish assets and driving up interest rates, and frightened the government into radically restructuring its finances. Faced with so many forward-looking traders, the government slashed the deficit from a mind-boggling 12 percent of GDP in 1994 to 2.6 percent in 1997, and then to an actual surplus in 1999. Since the mid-1990s, Sweden has looked like a ferocious competitor in international markets. Give the bond vigilantes some grudging credit.
Finally, it is time to lash back at Rational Expectations theory, and it does deserve some lashes. Almost every economist feels insulted by the upstarts. We will first discuss some theoretical difficulties and then turn to real economic events.
Rational Expectations theorists can be an intimidating, frustrating lot to argue with. Like Koran-thumping fundamentalist Shi’ites, they have a quick, adamant answer for any question. Their works contain many freaky assumptions, such as instantaneously adjusting markets and superhuman capacities to absorb information. If we grant these assumptions, the theory appears impenetrable. How can we attack? To demolish an economic model, we must do more than laugh at unrealistic assumptions. As Milton Friedman (following Karl Popper) argued, the true test of a model is in its predictions, not its scrupulously faithful depiction of the actual economy.13
Around the same time that Rational Expectations theory started gaining traction, Joseph Stiglitz and George Akerlof (2001 Nobel laureates) were pointing to a frequent problem in business deals, namely that one party often knows much more than the other. For example, if you shop for a used car, the dealer is far more likely to know whether the car is a lemon than you are. An insurance company selling you fire insurance is far less likely than you to know whether you smoke in bed, or what you smoke. These “information asymmetries” complicate rationalist models.
In macroeconomics, Rational Expectations theory predicts that government stimulus does not spur the economy and that government contraction does not hurt. Let’s start with the latter. How does 10.6 percent unemployment in 1982 sound? Following a monetary squeeze in 1980 and 1981, the economy plummeted into a recession. Following a similar crunch in 1975, the economy also slid downhill. It took severe unemployment rates to drive down inflationary expectations in those periods. Lucas and his cohorts might respond by deeming the monetary collapse a “surprise.” “Who knew whether the Fed would stick to its tight intentions?” they might ask. Despite the rebuttal, it took quite a few long, depressing fiscal quarters before people adjusted their inflationary expectations. Rational Expectations theory is hollow if it can escape criticism by calling every economic event a surprise.
How about the government spurring the economy? If Rational Expectations theorists are right, tax cuts will not affect consumption when they are implemented. As soon as the tax bill is signed, people will adjust their consumption, even if the actual cut comes years later. Yet the Kennedy and Reagan tax cuts showed consumption stable and then rising after implementation. Alan Blinder, a Keynesian from Princeton, finds this snub of fiscal policy by the Rational Expectations theorists especially annoying: “Barro once said to me that there isn’t any evidence in the world that fiscal policy is effective. Just open your eyes and see episodes of tax-cutting and government spending increases. How about World War II? That had big effects on output.” Blinder also blasts the claim that markets always clear: “That also has to be ridiculous. Somehow, some people are able to look at the world and not see involuntary unemployment. I think I see it all over the place during cyclical downturns. I also think I see unsold goods all over the place, like automobile lots.”14 Can Rational Expectations defenders explain with a straight face the Great Depression as twelve years of “new,” surprising information?
Why do most economists tend to agree with Rational Expectations theorists when they talk about the stock market yet explode in disagreement when speaking of the macroeconomy? The fact is, the stock market is a more efficient market than most others. It is quite liquid—one can buy and sell easily. Transaction costs are few. An investor may even use a discount broker to handle his or her purchases. In contrast, real markets for goods and services show more complexity and rigidity. Can you quit your job as easily as you can sell stock? Can a corporation fire employees, close down a plant, or build a new plant as quickly and easily as one can buy and sell shares? Of course not.
In real markets, contracts play a large role. They increase the level of certainty regarding the nominal price of labor, capital, and equipment. But they reduce the degree of liquidity and flexibility. Even if Kiddy Airlines expects prices and salaries to fall, it may be bound by three-year union contracts to keep up salaries. Even if its managers have rational expectations, contracts lock them into an adaptive path. Critics of Rational Expectation actually ask two questions: (1) Do people have rational expectations rather than long-standing habits? (2) Even if they do have rational expectations, can they act as adroitly as they think? To the extent either answer is no, Rational Expectations theory incorrectly portrays the economy.
Psychologists have also eagerly piled onto the stack of bodies trying to bury Rational Expectations. You can understand the eagerness of psychologists to jump in. After all, if people were perfectly rational, you would not need so many psychologists. With a great faith in reason, Immanuel Kant actually suggested that the insane should be tutored by philosophers. The insane reason badly. Therefore, experts in sound logic and reasoning would help them most. Since Kant’s time, we have learned that when people are so deluded that they cannot reason clearly, they likely have gross emotional problems or, perhaps, chemical imbalances. Sitting them in a room with a Kant or Descartes might drive the philosopher crazy, rather than help the patient. Just as Kant may have overstressed the capacity of rational thought, so, too, might some economists. Let’s say you are shopping for a new camera and discover that the ABC store sells the same model as the XYZ store but charges $200, which is $10 cheaper than XYZ’s price. Most people will drive an extra mile to save the $10. Now let’s say you are buying a new car and discover that the ABC dealership charges $30,080, which is $10 more than the XYZ dealer. Most people would ignore the difference. But $10 is $10, the psychologists point out—why should $10 off a camera lead you to drive a few blocks, while $10 off a car’s price doesn’t register on your brain waves?
Two Israeli researchers, who started developing their ideas while serving in the armed forces in the 1950s, compiled a virtual encyclopedia of irrational economic behavior based on interviews and real experience. Daniel Kahneman, who decades earlier (as a twenty-one-year-old lieutenant armed with only a bachelor’s degree) had designed a psychological screening test for the Israeli army, and Amos Tversky showed that people will quickly switch from risk-averse to risk-seeking. They both knew a great deal about risk and fear. As a boy, Kahneman had escaped Nazi guards and their French collaborators while hiding in France with his family. Not all his family made it out alive, and at one point his father was sent to an internment camp, just one stop before execution. Though his father avoided the gas chamber, the family was constantly on the run and knew what it “felt like being hunted. We had the mentality of rabbits.” This was not an abstract metaphor for the boy, since the family lived for some time in a chicken coop.15 Tversky, who was a few years younger than Kahneman, was a true war hero. In 1956, he was a nineteen-year-old paratrooper in the Israeli Defense Forces when a young soldier placed a grenade at the base of a barbed-wire fence and then “froze” in place, literally lying on top of the explosive, unable to free himself. Knowing that the bomb would explode within seconds, the future expert on risk ran to the young man, picked up his body, and threw him to safety, just as the explosive burst, injuring Tversky. For that, the Israeli government awarded him the highest military honors.
Kahneman knew, of course, that people do not generally think like rabbits, but he was also fairly certain that they did not think like homo economicus, the thoroughly rational textbook model. After completing his service with the Israeli army, he focused on the connection between stress and the human body, and he published a novel study showing that when people are required to concentrate more intently, their pupils dilate.16 Though he was trained as a psychologist, not an economist, it did not take long for him to surmise that if stress can change the size of one’s pupils, it might also impact one’s financial decisions. The two Israelis joined together and began developing their theories while working with Israeli fighter pilots. Here is an example of quirky but common economic thinking: A survey revealed that people would prefer to let inflation rise rather than permit the jobless rate to climb from 5 to 10 percent. Yet when instead asked whether they would prefer higher inflation rather than letting the employment rate fall from 95 to 90 percent, they said no.17 The two choices are the same; only the phrasing and answers are different.
Likewise, another experiment asked participants how they would prefer combating an Asian disease outbreak. Program A would save two hundred people. Program B would have a one-third chance of saving six hundred and a two-thirds chance of saving nobody. Seventy-two percent of the respondents prized the certainty of Program A. People like certainty. Behavioral economists have discovered that people hate to lose and sometimes feel paralyzed into standing in place. Stock market investors hate to sell their shares at a small loss, even when they are warned that big losses could come. They may become emotionally attached to their stocks, their homes, and their jobs.18
A modest man who died of cancer in 1996, Tversky said that he examined things that every used-car salesman and advertiser already knew. How questions are semantically or mathematically framed can mean the difference between a bestseller and a flop. Tversky appeared on the front pages of newspapers in 1988 when he disproved the “hot hand” theory of basketball, demonstrating that a player making a basket did not have a greater chance of getting the next ball through the hoop. He examined every basket that the Philadelphia 76ers had scored in the past year and a half. (In 2018, however, other researchers reexamined the data and reached the opposite conclusion.)19 Tversky’s best work, though, was with his friend Kahneman, who said in his Nobel Prize autobiography essay, “Amos and I shared the wonder of together owning a goose that could lay golden eggs—a joint mind that was better than separate minds.”20
For quite a few years, Richard Thaler, currently a professor at the University of Chicago, had described economic anomalies in The Journal of Economic Perspectives, which kicked off many classroom and faculty meeting discussions. But when the Nobel Committee awarded its 2002 prize to Kahneman, behavioral economics instantly became a star subject, attracting many more graduate students and corporate benefactors. Books like Daniel Ariely’s Predictably Irrational and Kahneman’s Thinking, Fast and Slow hit bestseller lists. Popular works tickled readers who learned of studies that found, for example, job interviewers who were handed a warm mug of coffee before meeting a job candidate were more likely to like the individual than interviewers who received a cool drink. Ariely and Kahneman both cited a study showing that when test subjects were exposed to words related to old age, like “bingo” and “ancient,” they walked out of the room more slowly. The exposures to mugs and old-age terms somehow “primed” and “framed” their encounters and biased them. A more serious topic for economists is intertemporal choice, how people value the future. Behavioral economists suggest that people discount the future too much. They want instant gratification, which may lead them to ignore their shrinking retirement savings and their expanding waistlines. Behavioral economists point out that about one-third of American workers have ignored their company’s 401(k) retirement savings plans, many of them leaving free money on the table if the employer matches their contribution. Using the research of behavioralists, in 2006 Congress passed and President Bush signed a law making it easier for companies to set up automatic enrollment. Previously, workers had to actively choose to participate. Now, eligible workers are automatically enrolled, unless they actively opt out. Rational Expectations thinkers do not spend much time worrying about inertia; behavioral economists do.
Intertemporal surveys can certainly confound. David Laibson, a Harvard behavioral economist, says that if you ask people whether they want chocolate or fruit today, they will say “chocolate.” But if you ask them what they will order next week, they’ll respond “fruit.”21 We will read John Grisham’s thrillers on the beach today; someday we will wade through Proust. To the behavioral economists this is a problem. Nonetheless, a study showed that when you ask those old people who displayed discipline whether they are happy that they ate less chocolate and more bran-filled granola, they shout no! In retrospect, they wish they had “lived it up” even more!
Should the psychological games and quizzes that Kahneman and Tversky uncovered lead us to throw away all economic theory and replace the Federal Reserve Board with the American Psychological Association? Do oldfangled supply and demand curves simply trace the magic wand of mesmerizing magicians? Probably not. Mainstream economics need not assume that everyone is rational all the time—instead it assumes that economic forces will, over time, push people and institutions toward more rational behavior. In the 1930s, Joseph Schumpeter admitted that the assumption that “conduct is prompt and rational is in all cases a fiction.” But he added that the fiction is “sufficiently near to reality, if things have time to hammer logic into men.”22 Remember the Rule of Repeats, which suggests that people eventually catch on to the reputations of others. The boy who cried wolf may have been a great behavioral psychologist—the first few times.
In the 1950s, the polymath decision-theorist Herbert Simon coined the term “bounded rationality” and noticed that many people do not aim to maximize but instead are “satificers,” a mashup of “satisfy” and “suffice.” Doing “good enough” is good enough for many people because they are too busy to suss out or digest all available information. You might decide to take up golf and be content to average 100 on a 72-par course because you don’t have the time or passion to improve. But does satisficing work in a competitive marketplace over a longer period of time? Sears was once the premier retailer in the United States, placed its name on the tallest skyscraper in the world, and advertised that it was “where America shops.” By the 1990s, Sears was known for drab styles and mediocre service. Because its executive officers acted like satisficers, while the bosses at Costco, Walmart, and Target invested in new supply-chain technologies, Sears executives had a front-row seat in bankruptcy court. Their golf game might have been better than their retail game.
The late, not-so-great chef but wonderful food writer Anthony Bourdain warned the public in his bestselling and salty Kitchen Confidential not to eat fish at a restaurant on Mondays, because the dried-out fillet was likely delivered on Friday. Even worse, he said, was the fancy-sounding, gummy fish surprise that chefs would whip up in a blender for Sunday brunch to get rid of the rotting stuff, with names like scrod terrine, mackerel mouselline, and trout galantine. After Bourdain’s widely discussed exposé, the verbal menu tricks did not work so well, and restaurateurs had to do better.
In the financial markets, while the behavioral economists may be right that many people grow irrationally attached even to their losing stocks, professionals do not get giddy over their losers. Eventually, the sharpshooting, bloodless pros trample the amateurs, teaching the amateurs one of two lessons: get out of the game, or get rid of your emotional attachment.23
Another investment example will help here. During the early 1980s, some researchers discovered that shares in small companies seemed to outperform stocks in big companies, delivering greater profits to investors. That sounded like an irrational result, confounding the Efficient Market Hypothesis. Yet since the time of those findings, so many people have piled into small stock funds that during the 1990s they lagged behind bigger stocks. Rational investors looking for a bargain corrected the irrational historical trend.
Behavioral psychologists and economists have occasionally stumbled in methodology as well, and in 2012 Kahneman himself fired a missive across the social sciences, warning that disciplines were losing credibility because too many experiments published in journals could not be replicated, including the famous old-age walking study that he cited in his bestselling book. In Kahneman’s open letter, he called priming the “poster child for doubts about the integrity of psychological research.”24 Often, an initial study would grab headlines, get reposted on social media, and then fail to hold up on further testing. A multi-university report showed that only thirteen of twenty-one oft-reported behavioral studies that appeared in the journals Nature and Science yielded statistically significant results when replicated. They included a 2012 study claiming that when people are primed to act more analytically, they are less likely to believe in God. In the initial study, the researchers showed a few dozen Canadian undergraduates a photo of Rodin’s The Thinker (analytical) and then asked if they believed in God. A separate group of undergraduates were shown a photo of a neutral statue. Sure enough, the Rodin-inspired group was less devout than the neutral group.25 The paper was cited hundreds of times, including in an article titled “Why Obamacare Could Produce More Atheists.”26 Beyond the small sample size, the inquiry suffered from a common plague among such reports: the subjects were college students. Too many studies that purport to demonstrate broad biases rest on a narrow sliver of society that lives in dorm rooms.
These two young schools of thought, Rational Expectations and Behavioral Economics, often battle each other. We could use valid insights of behavioral economists to barbecue the bold Rational Expectations school of thought till it was burned crispy. But we can also fillet the behaviorists, who have pointed to particular biases and anomalies but have yet to put together consistent, robust paradigms. Each deserves better. If we relax rational expectations and assumptions about full information and magically clearing markets, we are left with several ideas that mainstream economists are currently trying to graft onto their standard frameworks. People do catch on to political and economic tricks after a while. People will refine and discard previous expectations faster than a gradual adaptive model would depict. The challenge is to include these insights while recognizing the problems of contracts and imperfect information.27
In their radical voice, Rational Expectations theorists sound like they just leaped off the pages of Marvel comic strips. If one assumes that people always act fully rationally, why not also credit them with X-ray vision and the ability to fly? Surely, the planet Krypton never had stagflation. In the radical form, Rational Expectations theory gives us a model too perfect for the real world. We certainly can’t ignore the discrepancies. As James Tobin put it, using this pristine theory to explain the world is like looking for a lost purse only under the streetlamp.28 The problem is that the lost purse usually lies in the dark. And while you futilely bend down in the mesmerizing light of the streetlamp, you’ll probably be bopped on the head by reality.29