Tuesday, April 8, 2014

Rule-Based Macroeconomics: A Possible Avenue for Non-Equilibrium Theorizing

If you have been reading my blog recently, you know that I have not written kindly about the integration of rational expectations and the efficient markets hypothesis into Austrian economics. This might seem strange to any readers who believe that markets work. I sympathize with that perspective, but I believe it is inappropriate to assume this. As I have noted about some modern Austrian macroeconomic models, reliance on RE and EMH assumes disequilibrium out of existence unless it is caused by an exogenous shock. RE and EMH may approximate market outcomes 99% of the time, or even 99.9% of the time, but the remainder, (1 – p), needs to be understood, especially if its source is endogenous.  Imagine if I have a 1/100 or 1/1000 chance of being struck by lightning every time I step outside. The variance of outcome in the case I am struck is high. According to a quick Google search, there is a 10% chance that I die, and some spectrum of other outcomes. I am not interested in the median result – say, I spend one week in the hospital – if 1 in 10 times I end up dead. Furthermore, in a world of fat tailed probability distributions, which seem to better describe the world of finance than Gaussian distributions, I may not want to optimize expected value if I am not sure how fat the tails are. In other words, I may know that my map of possible outcomes does not cover the entirety of possible outcomes, but I am unsure to what extent it is lacking. This is what George Shackle and Israel Kirzner refer to as surprise: outcomes that one is absolutely ignorant of. If it so happens that the possible outcomes I am missing from my probability distribution have much higher expected losses than any outcome within my probability distribution, I may want to consider not optimizing in a way suggested by RE. 

None of this is to say that RE and EMH are not useful. They provide a teleological compass for fruitful economic analysis. In many cases, however, median outcomes do not matter. In these cases, RE and EMH are better described as an Achilles heel of economic analysis.

What is needed is an economic framework that allows for emergent processes, a non-equilibrium framework. We do not know what the economy will look like in ten years – even absent exogenous shocks – neither should agents in our models. (If you disagree, extend the time frame to 100 years.) 

What is needed is not that Austrian economics “catch-up” to the modern equilibrium paradigm, “but an effort to create the contemporary analytics that might have been created had Austrian macro theorizing continued to evolve since 1940 with the same robustness that it exhibited before 1940 (Wagner, 98).” 

What is needed is a macroeconomics that foregoes determinism associated with RE and EMH and concentrates on rules that guide decision-making and human action. Individuals do not approach “truth” directly. They integrate information according to heuristics, and then act to achieve their ends according to their interpretation of information. 

Those who endeavor to develop this research program must model in terms of heterogeneous agents whose actions are determined according to rule sets. The outcomes of interactions between agents acting according to rule sets and the transformation of rule sets over time may shed light on market processes in a way that equilibrium theorizing cannot.

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