Ex Ante, Ex Post: Making Sense of Rational Expectations and the Efficient Market Hypothesis

The move from a predominantly Keynesian paradigm in macroeconomics to the success of monetarist and the new classical macroeconomics that followed represents a shift from a general skepticism of markets within economics to a belief in market efficiency. The most extreme version of this is represented by real business cycle theorists who model the macroeconomy without using an upward sloping short-run aggregate supply curve. (This is actually how I prefer to teach disequilibrium effects associated with changes in aggregate demand.) The emphasis of these models is equilibrium which is, on average, reached in the economic system these models are built on. The results obtained from these models have been successful. In the long-run, the quantity theory holds true. In the long-run, the economy tends to grow at a steady rate, affected mostly by impediments to production and exchange driven by policy. What could be wrong about a field that has generated a tremendous amount of explanatory power?

John Maynard Keynes objected to long-run analysis of the classical economists, meaning most economists who preceded him. This included many of his contemporaries. He claimed that the agents of economic theory were assumed to have higher quality knowledge and decision-making abilities than they actually had. In a sense, Keynes was correct, but he overstated his case. "In the long-run, we're all dead" is a catchy slogan. It is also an abuse of economic ontology. The efficacy of the assumption of rational expectations and of the efficient market hypothesis depend on this distinction between long-run and short-run. Given time for adjustment and a lack of external perturbations, we expect markets will reach equilibrium prices and outputs for different goods. In the long-run, markets select for agents whose knowledge, as reflected by their action, is superior in light of the outcomes these actions generate. In the long-run, agent action is tightly constrained by one's budget constraint. In the short-run, an agent can act with little regard for one's budget constraint. This may be unwise, especially if taken to the extreme case, but eventually, bills must be paid or else that agent loses his power. Second, we must consider the rate of feedback that economic agents receive concerning their investments. Information cascades dominate human decision-making (Bikchandani, Hirshleifer, and Welch, 1998; Earl, Peng, and Potts, 2007). That is, agents learn from one another, copying those who appear to be successful and what appears to be common wisdom. The intelligence of one or a few are shared among many. Think about responses of investors, lay and professional, to perceived opportunities in the last two booms that dominated U.S. financial markets. Common perception went something like:

"The housing market is looking good and remember that the average price of real estate almost never falls!" 

"Have you heard about investments in tech? Better profit from the rise of the internet while we still can!"

Why didn't investors see these "bubbles" coming if markets are truly rational?

Markets are rational, but we sometimes forget to ask what it is that makes them rational. Failure makes them rational. Rational expectations and the efficient market hypothesis reflect the equilibrium arrived at by the market process. If there are above market rates of profit to be gained by pursuing one investment over another, those who invest in those markets will grow their total wealth and, in the process, push the rate of profit for that investment back down toward the market average. Those who miss out on these opportunities will grow at a lower rate relative to those who gained from them. Likewise, those whose investments return a below average rate of profit will be encouraged to pursue other avenues in light of opportunity cost. Those from this category whose profits are actually negative receive a strong signal to scale down their efforts or leave the market. In this process, many agents may guess wrong.

Ex post, after the fact, the market tends to select out those whose efforts fail. This tends to empower agents whose expectations ex ante, before hand, are more correct. Market selection make rational expectations and efficient market hypotheses hold in the long-run. The existence of short-run fluctuations are well observed. In the short-run, changes in stock prices follow a Cauchy distribution (Fama 1965). Whatever their form, we do not experience these distributions themselves. Rather, we experience states that, over time, comprise these distributions. Rational expectations and the efficient market hypothesis don't dispute this. The long-run models derived from them acknowledge that markets are, on average, right, even if they are unstable at times.

How do we describe the short-run? Criteria for efficiency hold constant agent belief, but it is this belief that can experience tremendous flux in the short-run.Without a theory of agent knowledge and the market process driven by this knowledge, a robust theory of the short-run in economics lies out of reach. History matters. Changes in nominal aggregates may not affect real aggregates in equilibrium, but they do affect the structure of society and they matter outside of equilibrium. We must take care in elaborating the implications of macroeconomic models. Short-run deviations can have long-run affects on capital structure. This is true in terms of physical capital in markets as well as social capital. Thus, the Great Depression radically changed economic, political, and academic landscape. In our own field, it allowed for the "Keynesian Diversion" that lasted for several decades! From a given point of departure, it may lead to a realization of an inferior adjacent possible, which economic theory should consider.