One aspect of modern economies that deserves more attention is the variety of beliefs that inform the decision making of households, firms, and governments. Every asset market includes bulls who believe prices will rise and bears who believe they will fall. Central banks and national governments draw on diverse macroeconomic models in their policy making, which is evident in the conflicting predictions about the effects of quantitative easing. And Nobel Prizes in economics have been awarded to economists advancing sharply divergent theories, the most recent example being the 2013 Prizes awarded to Eugene Fama and Robert Shiller.
On its face this multiplicity of views seems incompatible with the hypothesis of rational expectations. If all agents have access to the same information and the same (correct) model of the economy, then, instead of a multiplicity of expectations, we would see a uniformity of expectations. Some of this real-world diversity of expectations can, of course, be explained by “information partitions” in which market participants have access to different pieces of the “information pie.” The force of this explanation is diminished, however, by the broad dissemination of government statistics and the widespread use of information technology to organize and analyze this data. Moreover, economists with access to the same data and information processing capabilities nevertheless produce conflicting explanations of historical trends and events, divergent forecasts of future trends, and opposing predictions about the effects of various monetary and fiscal policies.
This multiplicity of outlooks, whether in the form of theories, models, beliefs, or expectations, calls into question the usefulness of the postulate that economies are always in equilibrium. Even if a rational expectations, representative agent, model could be calibrated to track some time series of economic data, it could hardly explain the obvious presence of agents with diverse and, often conflicting, views. Furthermore, if market participants are acting on the basis of inconsistent expectations, then at least some of these expectations will disappointed and some plans will have to be revised. To insist on characterizing an economy in which the participants are planning to buy and sell at different prices as being in equilibrium is simply to insist on a stipulated definition come what may.
In their Anti-Keynesian manifesto, Lucas and Sargent (1979) criticize the lack of microfoundations in the Keynesian models that were developed in the 1950s, 60s, and early 70s. Many reasons have been offered in defense of microfoundations as a necessary feature of a good macro model, including an implicit appeal to the familiar notion of autonomous agents who form and act upon their own plans and forecasts. Thus, Lucas and Sargent chastise “economists who ten years ago championed Keynesian fiscal policy as an alternative to inefficient direct controls [now] increasingly favor the latter as ‘supplements’ to Keynesian policy” (original stress). But it’s the gloss they add to their argument that’s most revealing. Mocking these old fashioned Keynesians they write, “The idea seems to be that if people refuse to obey the equations we have fit to their past behavior, we can pass laws to make them do so” (original stress). Free and independent agents keep changing their minds in response to new information, so their “past behavior” is, at best, an imperfect guide to their future behavior.
A closer look reveals that the New Classical demand for microfoundations straddles two incompatible ideas. On the one hand, Lucas and Sargent insist on microfoundations because they believe economic outcomes depend on the rational choices of individuals rather than on the behavior of aggregates. What is “the Lucas critique” if not a vigorous statement of this point? On the other hand, genuinely autonomous agents, who choose their own objectives and the means of achieving them, will often hold different views about the future. Indeed, this a reasonably good description of what happens in societies when the unquestioned guideposts of custom and tradition give way to some measure of individualism and self-determination. Thus, while the demand for microfoundations appeals to the idea of independent agents constructing their own action-guiding scenarios, the variety of beliefs that emerge from, and guide the actions of, these agents is suppressed by the premise of rational expectations. If we really want macroeconomic models that are consistent with free and independent agency, then we need a new “microfoundations of autonomy.” I’ll return to this topic in a future post.