10

The economics of rationality and the rationality of economics

Ralph A.Rector

INTRODUCTION

In this essay I question whether or not a frequently employed standard of economic rationality can be defended. Numerous economists now use models based on a ‘rational expectations’ hypothesis by which decisionmakers are assumed to make rational economic projections. Economists typically define rational expectations (RE) as predictions that are based on all relevant information. The rational expectations hypothesis has been criticized for not realistically describing the way decisions are actually made. This lack of realism is usually substantiated by psychological studies of ‘real’ people in experimental situations. The first section of this paper introduces an alternative critique which, rather than challenging the empirical realism of RE directly, tentatively adopts the RE view to determine whether it produces expectations that are epistemically justified.

Imagine that we were suddenly able to communicate with ‘agents’ in an RE model. Among other things, they could tell us what they expect the future to look like. It is usually taken for granted that agents in RE models are rational by definition; but suppose we questioned the rationality of some of their projections. These agents would tell us that their beliefs are justified by the assumption of economic rationality used in RE models. Economic rationality would, in this case, be virtually synonymous with epistemic justification. We could then analyse the claim that agents in RE models are rational, by investigating the epistemic dimension of their beliefs. In the second part of this paper I develop an epistemological framework for analysing rational expectations.

An important similarity between epistemic justification and economic rationality is the element of definitiveness they provide. Theories of epistemic justification are designed to eliminate the relativist problem of having several contradictory beliefs which seem to be true. Such conflicts cause practical difficulties. More important, relativism has been characterized as a serious theoretical problem because it seems to lead to the sceptical conclusion that we lack knowledge altogether. The economic assumption of rationality is designed to prevent a similar problem in formal models. It helps ensure that there will be a

THE ECONOMICS OF RATIONALITY 193

single, determinate mathematical solution to equations in these models. The RE hypothesis does not guarantee that expectations will always be precisely correct. However, it does ensure that agents in the same model would not disagree about how expectations should be formed.

Agents in an RE model that lacked some standard of justification would be left with beliefs that were relativistic; they would have no reason to favour one expectation over another. From the economists’ perspective, this would result in mathematical models that could not be solved. If all predictions about the future were relative, then each would carry equal weight; one belief would be no better than another, so there would be no justification for relying on any one belief. Viewed theoretically, agents would not possess any knowledge of the economy because their beliefs could not be justified. This is clearly at odds with the intent of RE theorists, who assume that subjects in their models know a great deal about the economy.

In their attempts to avoid the problems of relativism and scepticism, philosophers have proposed two basic types of justificatory theories: foundationalism and coherence. These theories are described and evaluated in the third and fourth sections of this chapter. I intend to show how the economic assumption of rationality could be viewed in the context of foundational and coherence theories, and to indicate why both theories lead to relativistic beliefs for agents in RE models. If I am right in this claim, then, according to the prominent theories of knowledge and the standard definition of rationality, agents in RE models are not rational after all.

In light of the objections raised against foundationalist and coherence theories I also examine an alternative account of rationality and justification. The fifth section of the chapter briefly describes how Hans-Georg Gadamer’s work in philosophical hermeneutics can be used to analyse epistemic justification and address the problem of relativism. Finally, I indicate in the sixth section some of the changes that would be required in our understanding of the economy and economic theory if we were to adopt a hermeneutical view of rationality. The analysis offered in this concluding section can be viewed as a prima facie defence of the newly emerging practice of economic analysis known as ‘the interpretive approach’.

Description of RE theory

John Muth is generally credited as the first to employ the rationalexpectations hypothesis in an economic model (Muth 1961).1 According to Muth, expectations are formed rationally when they forecast outcomes that do not contain any systematic errors. For Muth, rational expectations are not ‘perfect’ in the sense that they are error-free. Instead, expectations are rational when all the relevant data have been taken into account. By examining the relevant data, all consistent statistical patterns can be identified and incorporated in the formation

194 ALTERNATIVE VIEWS OF HERMENEUTICS

of expectations. Only random factors, which by definition are inherently unpredictable, prevent these rational expectations from being perfect.2

Muth devised an ingenious method for incorporating the hypothesis of rational expectations into economic models. He recommended that the theories used to model rational economic events also be used to model predictions concerning future economic situations. According to Muth:

expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory. At the risk of confusing this purely descriptive hypothesis with a pronouncement as to what firms ought to do, we call such expectations ‘rational’.

(Muth 1961, p. 316)

Incorporating the rational expectations hypothesis into economic models involves three conceptual steps. Economists first develop techniques for describing economic data and expectations in terms of probability density functions. These functions express numerical ‘facts’ about the economy (e.g. unemployment rate, inflation rate) as the result of underlying or ‘structural’ relationships in the economy. Second, they model the processes of expectationsformation as a series of solutions to probability density functions. Finally, they define the expectations-formation functions to be the same as the structural functions which produce data observed in the actual economy. Economists commonly believe that the expectations made by subjects in their models are rational because the functions used to generate expectations are equivalent to those used to model the underlying structure of the economy.

Psychological versus philosophical critiques of RE

Since the early 1970s, something of an academic ‘growth industry’ has emerged, with an increasing number of economists using RE models to analyse publicpolicy questions. Despite their widespread application, RE models have been sharply criticized by some economists and by scholars in other disciplines. Among the many criticisms that have been made, the one most frequently raised is the implausibility of assuming that economic agents always, or even frequently, form expectations that meet the RE standard of rationality. In its general form, this complaint is similar to the critique developed in this essay. The difference is that the standard objection is commonly based on psychological studies of decision-making,3 whereas the approach taken here is based on a philosophical analysis of the rationality hypothesis. More specifically, the focus of this study is on the epistemic authority that agents in rational expectations models may be said to possess. It is important to distinguish between the psychological and epistemic critiques, because RE theorists have already developed more or less persuasive responses to challenges offered by

THE ECONOMICS OF RATIONALITY 195

psychologists. If the philosophical and psychological critiques are the same, then economists may already have answers to the questions raised in this essay.

The psychological and philosophical critiques of economic rationality differ in two respects. First, different types of agents are studied. Psychological critiques often rely on experiments which demonstrate that when individuals are faced with certain kinds of choices they frequently violate the laws of probability and are therefore not rational. Economists typically reject the relevance of these results because they concern the rationality of real decision-makers. For the positivist, the decision to include the RE hypothesis is based on tests regarding the accuracy of predictions made by these models. From this perspective, economic models need only assume that it is ‘as if’ real agents were rational. The criterion of predictive success and the use of ‘as if’ assumptions may answer the challenge posed by the psychologist; it does not answer the epistemic question regarding the meaning of rationality, and it does not address the problem of defending the claim that RE models are populated by rational agents.

A second difference is that psychological studies test for the truthfulness of beliefs while philosophical studies include tests for the justification of these beliefs. Behavioural psychology deals primarily with the efficacy of beliefs. From this point of view there is little to distinguish the choices made by humans and those of other animals: both are information-processing organisms that make decisions which are, to a greater or lesser degree, correct. In psychological studies involving humans, the ‘subjects’ predict which event is most likely to occur, or they choose which wager has the greatest expected pay-off. In a related set of experiments, economists have observed the behaviour of rats to determine if their choices are consistent with economic assumptions of rationality (Kagel 1981). Behavioural studies such as these focus on the decision-makers’ abilities to make accurate choices. Both psychologists and philosophers study the context in which truthful beliefs are formed. Philosophers extend this analysis to include beliefs that are true and justified. Richard Rorty notes that:

Awareness in the first sense is manifested by rats and amoebas and computers; it is simply reliable signaling. Awareness in the second sense is manifested only by beings whose behavior we can construe as the utterance of sentences with the intention of justifying the utterance of other sentences. In this latter sense awareness is justified true belief knowledge— but in the former sense it is ability to respond to stimuli.

(Rorty 1979, pp. 182–3)

If the distinction between truth and justification is ignored, then rationality can be defined as correctly employing the laws of probability. According to this definition, agents in RE models may indeed be rational. The philosophical view of knowledge is different from the psychological account of rationality because knowledge involves more than arriving at a correct conclusion.4 Lehrer notes that knowledge ‘is not merely the acquisition of information but the certification