In an economy where there is uncertainty about the future, the expectations that individ-uals have play an important role. If macroeconomics is to be able to define an equilibrium, it has to be one into which expectations enter. Clearly, in an uncertain world, what people or firms supply and demand will be based on current prices but also on their anticipation of future prices. But, if individuals may have any expectations whatsoever about future prices, it is not clear at what current prices there will be an equilibrium. One way out of this, adopted in the standard approach to economics, is to assume that all the participants in an economy fully understand its functioning and evolution. They therefore have the same anticipations, too. Such anticipations are referred to as ‘Rational Expectations’.
Bearing in mind the quote from Mervyn King given at the outset of this chapter, this seems an heroic assumption. Furthermore, there is a great deal of evidence that people do not have the same expectations. Worse, their expectations are not independent but are, rather, strongly influenced by the expectations of others, exactly as Poincaré suggested.
As such, they cannot be treated as being randomly distributed around an ‘average’ point of view. As Willem Buiter, the chief economist of Citibank, observed:
Those of us who worry about endogenous uncertainty arising from the interactions of boundedly rational market participants cannot but scratch our heads at the insis-tence of the mainline models that all uncertainty is exogenous and additive.
Buiter (2009) Many economists have expressed doubt about the notion of rational expectations which is, in reality, just a convenient way of making standard models tractable. We have no
explanation as to just why agents should come to have such expectations. As such, a more pragmatic approach would be to go back to the basics and study how, in fact, economic actors do form their expectations. As Herbert Simon said,
A very natural next step for economics is to maintain expectations in the strategic position they have come to occupy, but to build an empirically validated theory of how attention is in fact directed within a social system, and how expectations are, in fact, formed. Taking that next step requires that empirical work in economics take a new direction, the direction of micro-level investigation proposed by Behavioralism.
Simon (1984) Such a step would undoubtedly mark a major change for economics. Some progress has been made in this direction through laboratory experiments, and there is already con-siderable evidence that individuals, even though perfectly informed about the income generated by an asset in the future, can still generate bubbles in the asset’s price, thereby contradicting the rational expectations hypothesis. Again, what we see is the interaction between the individuals who observe the actions taken by others, which can generate a positive feedback. It is these features, characteristic of complex systems, which generate such bubbles.3
Conclusion
Overall, it would perhaps be wise to listen to the pragmatic and realistic point of view put forward by former chairman of the U.S. Federal Reserve, Ben Bernanke:
I just think it is not realistic to think that human beings can fully anticipate all pos-sible interactions and complex developments. The best approach for dealing with this uncertainty is to make sure that the system is fundamentally resilient and that we have as many fail-safes and back-up arrangements as possible.
Ben Bernanke, Interview with the International Herald Tribune, May 17, 2010 Notice that this is an admission that, in the context of a deregulated financial sector, no invisible hand or self-organisation of the agents in the system will necessarily lead it to a socially satisfactory solution. In fact, policy makers in Central Banks and organisations such as the International Monetary Fund (IMF) and the OECD, have come to accept that the economic system is in need of constant monitoring and corrective measures.
Given the complexity of the system, and the complication of dealing with people with different expectations, this is inevitable.
In this brief chapter I have argued that the vision of the economy conveyed by stan-dard models, particularly macroeconomic models, does not give an adequate account of how the economic system evolves. The vision of the economy as a system which
self-organises into a socially satisfactory state is the outcome of two centuries of the philosophical development of a social and political tendency toward liberalism. Eco-nomics has developed its theory so as to derive a model which is consistent with that philosophical position. Yet, as our models have become more and more mathematically sophisticated, they have tended to become more and more remote from the reality of the economic world in which we live.
Reconsidering our basic framework and viewing the economy as a complex adaptive system in which macro-behaviour emerges from the interaction between the participants in the economy would help us in a number of ways. Firstly, in such a model endogenous shocks can occur, and crises do not have to be attributed to what Adam Smith referred to as “The Invisible Hand of Jupiter”. Secondly, we do not have to attribute to individuals the remarkable capacity to calculate and acquire a complete knowledge of how the econ-omy functions that the ‘representative individual’ in standard models is assumed to have.
Lastly, we do not have to suggest that there are simple mechanical relations between actions taken and economic outcomes. In complex systems there is always the possibility of ‘unintended consequences’. Rather than claim that we know what the result of policy measures will be, a complex systems approach proposes a paradigm which makes much less authoritative claims, and requires those in charge of making economic policy to anticipate and try to moderate the evolution of the economy without being able to make precise predictions. Despite Walras’s claim that one day its laws would be as irrefutable as those of astrophysics, economics is not and never will be an ‘exact science’ in the sense that is too often claimed for it.
Notes
1 H. A. Simon, ‘The Architecture of Complexity’, Proceedings of the American Philosophical Society, vol. 106, iss. 6, pp. 467–482, 1962.
2 For an account and a model of this sort of phenomenon, see e.g Anand et al. (2013).
3 A very good account of such experiments is given in Cars Hommes (2013).
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