Sunday, August 07, 2011

Philip Pilkington On Rational Expectations Theory

Philip Pilkington writing in Irish Left Review (6 August) (HERE):
Nails the erroneous assumptions of neoclassical ‘rational expectations’ and open the way to a more accurate assessment of Adam Smith’s concept of “self-interest” (and the invisible hand).

Neoclassical Dogma : How Economists Rationalise Their Hatred of Free Choice

Rational expectations is indeed an obscure doctrine. It essentially holds that people operating within a market generally act in line with the expectations of neoclassical theory. This tautology – for it is a tautology – can be traced back to Adam Smith’s ‘invisible hand’ which we explore in more detail later on.
But this goes beyond simple tautology. The neoclassical assumptions are themselves especially stringent and seem to be wholly counterfactual to any observer of human behaviour. Rational expectations theory expects people to act, well, rationally. More specifically it assumes that people always act in order to ‘maximise their utility’ and that such actions result in optimal behaviours that ensure that prices are always perfectly in keeping with what they ‘should be’ – that is, an equilibrium price that perfectly balances supply and demand. Prices then become a pristine and perfect measurement; they translate consumer desire perfectly and are beyond question

Philip Pilkington is to be congratulated for asking the right questions and implying scepticism in his assertions. Neoclassical assumptions are not just contrary to the behaviours of human beings in their societies, for the record they are also contrary to how Adam Smith formulated human behaviour. The former, of course, is a more significant criticism of neoclassical rational expectations, but in so far as Adam Smith is drawn upon in support of them, as he is, we should understand this calumny imposed on his legacy.

The use of the metaphor of “an invisible hand” on two occasions in his published Works (1759, 1776) is widely interpreted to be about “markets”, “supply and demand”, and “equilibrium”. Smith made no such claims at all; that is a modern invention, made popular by Paul Samuelson in 1948. Smith never used the IH metaphor in relation to “markets”, etc., but neoclassical authors (and graduates of their courses) wrap up “invisible hands” in their assertions about “miraculous markets”.

In Moral Sentiments, Adam Smith did not restrict behaviour to “self interest” also being solely self-regarding; he also wrote of self-interest” as “other-regarding” too. In Wealth Of Nations he did this very clearly in the oft-quoted passage about persuading the famous “butcher, brewer and baker” to provide our dinners, where he specifically advises us not to “talk of our own necessities” but to address their “self-love”. In short, we serve our self-interests by serving the self-interests of others - in contrast to that nasty libel of Smith’s legacy by Gekko of ‘Wall Street’ fame. His contemporary, Mirabeau, was right: 'we think we serve ourselves by our actions, but we really serve others'.

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