Fama is a staunch defender of efficient markets and rationality, while Shiller argues, “The theory makes little sense, except in fairly trivial ways.” Shiller emphasizes “the enormous role played in markets by human error, as documented in a now-established literature called behavioral finance.” Shiller also says, with regard to rational expectations, that “Professor Fama avoids theories that describe … irrational behavior, and I think he’s wrong about that.”

Is Shiller correct? Should economists drop the assumption of rational expectations, at least in some instances?

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I think it’s a stretch to assume that people have this knowledge, but there are two responses to the objection that the economy is too complex for individuals to understand in the sense that rational expectations requires. The first is an “as if” argument. Think about a child who catches a ball thrown from some distance away.

Mathematically, catching the ball requires the child to solve a differential equation almost instantly, an impossible task. But our brains have developed a way to solve this problems that makes us act “as if’ we are finding the full mathematical solution. Perhaps our brains use similarly mysterious techniques that make us act “as if” we fully understand how the economy operates.

The other argument is that although individuals may not get things exactly correct, markets aggregate information efficiently, e.g. individual errors average out at the market level. Thus, according to this view markets overcome the errors made by individuals and it’s proper to model markets as if expectations are rational.

Is either argument correct? Our brains may be hard-wired to track and catch an object in flight, the solution to that problem comes down to a very simple rule the brain can employ, but do such simplifications and rules of thumb work in such a complex economy, one that professional economists do not fully understand? I’m skeptical that they do, and I’m also skeptical that markets can somehow magically compensate for the large and varied misunderstandings that typical households have about the economy.

Preberite več v Mark Thoma, How Economists Can Tame Irrational Exuberance, The Fiscal Times