In a strict rational expectations model, we might expect some people to overtrust others and one view of rational expectations is that investors’ errors will cancel one another out in each market period. Another view of rational expectations is that investors’ errors will cancel one another out over longer stretches of time but that the aggregate weight of the forecasts in any particular period can be quite biased owing to common entrepreneurial misunderstandings of observed recent history. In the latter case, entrepreneurial errors magnify one another rather than cancel one another out. That is one simple way to account for a widespread financial crisis without doing violence to the rational expectations assumption or denying the mathematical elegance of the law of large numbers.
Then Ezra writes:
I’d like to see what Justin Fox — author of the excellent new book The Myth of the Rational Market — would say in response. Luckily, he has a blog where he could write such a response, and hopefully this link combined with that book plug will act as a bat signal of sorts.
He wrote that Monday. With a reaction time like this, I’d clearly never make it as a superhero. Even if I had superpowers.
What Cowen says in the above quote seems like a reasonable stretching of rational expectations theory to accommodate observed reality. But when you stretch it like that it ceases to mean all that much. The Fischer Blackian business-cycle theory that Cowen describes in his paper, for example, can be summarized in two words: s&*t happens. Think I’m kidding? Cowen says the same thing in 24 12 times as many (there was some Jack-Bauer-related confusion about the meaning of “24”):
Black’s revolutionary idea was simply that we are not as shielded from a sudden dose of bad luck as we would like to think.
There are far worse economic theories out there. S&*t certainly does happen. The lesson Black drew from this is the same that wearers of “S&*t Happens” T-Shirts are presumably out to teach: that we should just learn to live with it. As Black said in an interview with Fortune in 1979:
We shouldn’t blame Washington for the downturns and fluctuations that occur. If anything, we should be asking it to remove its controls and its tax distortions. That would probably have the effect of increasing the amplitude of business cycles, but would also make us better off.
I think there’s something to be said for this in the context of the normal business cycle: The occasional recession is just part of economic life, and frantically attempting to avert every incipient downturn is a counterproductive waste of resources. But a once-in-75-years credit bubble and bust seems to be a different sort of phenomenon, for which there may be more useful explanations available than s&*t happens.
I should note that researching and writing my book turned me into one of the world’s biggest Fischer Black fans. But I’ll get into that in another post. This one has gone on long enough.