Why it's worth defending rational expectations theory
RSuleiman, a commentator over at Ezra Klein, writes:Having just finished reading the paper, it seems very much of a piece
with Professor Cowen's other post-crash writings, and yes, it does seem
to be designed as a defense of the rational markets hypothesis.He is referring to my piece on the crash. Suleiman's is a common response but it is neglecting why rational expectations (RE) models are so powerful and also, at least among economists, so popular. Economists try to fit various phenomena into RE models to show that the mechanisms underlying those phenomena are general and not relying on some very specific set of assumptions about expectations. The goal is not to convince everyone that expectations, or markets, are indeed rational. They're not, at least not always. The goal of an RE model is to establish the universality (or lack thereof) of a specified problem. There are people who misuse rational expectations techniques, but don't let those mistakes mislead you. Krugman and Stiglitz also have used RE a lot as a modeling device, although they are (properly) willing to abandon it as a descriptive assumption in many cases. A market failure argument with RE is often more powerful than a market failure argument without RE.
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