A Revival In Rational Expectations Theory?

Economic theory tied to rational expectations has taken a beating in recent years, at least in some circles. Remember this contentious skewering from Paul Krugman in 2009? Defenders of the faith responded with all guns firing, including this take-no-prisoners response from “freshwater” economist John Cochrane. Whatever you think of ratex, it earned some lofty recognition yesterday with the news that the Nobel economics prize was awarded to a pair of Americans.


Economists Thomas Sargent of New York University and Christopher Sims of Princeton were given the prize for the research on “the causal relationship between economic policy and different macroeconomic variables such as GDP, inflation, employment and investments,” according to the press release from The Royal Swedish Academy of Sciences.
The Wall Street Journal notes that according to “Mr. Sargent’s influential work on rational-expectations models… people do not respond passively to changes in economic policy or circumstances. They anticipate future conditions and adjust according to their best interests.”
The New York Times says Sims’ methodology, developed in the 1970s,

has been influential in subsequent decades among economists in many fields and of different political leanings. Research using his methodology, for example, has helped lend credence to New Keynesianism, the theory that says that an economy can go into recession because there is not enough demand.

“The idea that there could be an aggregate demand failure is a very old idea, but it had been completely banished in the ’70s, ’80s and ’90s,” said Lawrence J. Christiano, a professor at Northwestern University. “Really the center of gravity of macro was very much in places like Chicago and Minneapolis. That was bumped away in part by results of applying this new methodology, and Sims is the one who originated that.”

Sargent was interviewed a year ago and was asked to defend the rational expectations branch of macro, to which he has been a key contributor:

The criticism of real business cycle models and their close cousins, the so-called New Keynesian models, is misdirected and reflects a misunderstanding of the purpose for which those models were devised. These models were designed to describe aggregate economic fluctuations during normal times when markets can bring borrowers and lenders together in orderly ways, not during financial crises and market breakdowns.

Tyler Cowen at Marginal Revolution writes

One of [Sargent's] most important (and depressing) papers is Sargent, Thomas J. and Neil Wallace (1981). “Some Unpleasant Monetarist Arithmetic.” Federal Reserve Bank of Minneapolis Quarterly Review 5 (3): 1–17. The main idea of this paper is that good monetary policy requires good fiscal policy. Otherwise the fight against inflation will not be credible. This is probably his most important paper.

As to the burning question of whether the Sargent and Sims’ research offers a solution to the economy’s current problem, Sims manages expectations down. As Bloomberg reports:

Central bankers and government officials use the work the two men have done to help determine how changes in policy affect the economy and vice versa… [But] “there’s no simple way to apply it,” Sims said by phone during a press conference after the prize was announced, in response to a question on how his research could be used to analyze the current economic situation. “It requires a lot of slow work looking at data — the methods I use and that Tom have developed are central to finding our way out of this mess.”

There are (still) no silver bullets in macro, but maybe there’s a new beginning for reviving ratex’s reputation. There’s more than intellectual vanity at stake. As the FT opines:

Sargent’s work on expectations and monetary policy has fresh relevance for western economies thrown into uncharted territory. Much of his research has focused on how inflationary episodes end. In his book The Conquest of American Inflation., he studied the rise in inflation in the 1960s and 1970s and the subsequent “great moderation”.

Relevance is one thing. As for expecting ratex to inspire calm, uncontroversial discussions from here on out, well, that’s probably just irrational thinking at this point.

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