William Paul Bell Queensland University Researcher

Why is mainstream economics not a social science but ideological mathematics?

Real Business Cycle (RBC) and Rational Expectations Hypothesis (REH) contributing to the Global Financial Crisis (GFC) and the Dynamite Prize

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This article discusses how neoclassical economics has contributed to the Global Financial Crisis (GFC).   In particular, how two neoclassical theories, the Real Business Cycle (RBC) and the Rational Expectations Hypothesis (REH) contributed to the GFC and how these theories are false and unscientific.

Edward C. Prescott and Finn E. Kydland were awarded the 2004 Nobel prize in economics for their work in developing the RBC and Robert E. Lucas Jr. was awarded the 1995 Nobel prize in economics for developing the REH. They have been nominated for The Dynamite Prize in Economics that is to be awarded to the three economists who contributed most to enabling the GFC.  The Dynamite Prize in Economics nominates Prescott and Kydland ‘for jointly developing and popularizing “Real Business Cycle” theory, which by omitting the role of credit greatly diminished the economics profession’s understanding of dynamic macroeconomic processes’ and nominates Lucas for ‘his development of the rational expectations hypothesis, which defined rationality as the capacity to accurately predict the future, both served to maintain Friedman’s proposition that monetary factors do not affect the real economy and, in the name of “rigor”, distanced economics even further from reality than Friedman had thought possible.’

Regarding the RBC and REH, two quotes from Prescott indicate how unscientific neoclassical economics has become. In the first quote, Prescott (1977, p. 30) claims, ‘Like utility, expectations are not observed, and surveys cannot be used to test the rational expectations hypothesis. One can only test if some theory, whether it incorporates rational expectations or, for that matter, irrational expectations, is or is not consistent with observations.’ However, the Efficient Market Hypothesis (EMH), General Equilibrium Theory (GET), Computable General Equilibrium (CGE) and RBC provide examples of theories that incorporate REH and are inconsistent with observation.

The inconsistencies in EMH were discussed in my posts Capital Asset Pricing Model (CAPM) and Efficient Market Hypothesis (EMH) Contributing to the Global Financial Crisis (GFC) and Hormonal Male Traders producing a Momentum Effect contrary to the Efficient Market Hypothesis and Rational Choice.  The inconsistencies of GET, CGE and RBC were discussed in my posts The G8 protests and the logically inconsistent foundations of neoclassical economics and G8 or G20 Protests and Computable General Equilibrium (CGE) modelling and its Dual Instability Problem.

In the second quote, Prescott (1988, p. 84) acknowledges that the RBC models are ‘necessarily false and statistical hypothesis testing will reject them.’ However, Prescott and Robert Lucas stillhave Nobel prizes that provide these false theories with credibility.  Furthermore, Stadler (1994, p. 1766) discusses five criticisms of the RBC. One, there is a lack of evidence for sufficiently large real shocks to drive the model. Two, testing the RBC is purely subjective. Three, RBC fails to capture the business cycle because it lacks suitable transmission mechanisms. Four, the RBC does not explain recession well. Five, the representative agent makes the model unsuitable for welfare or policy development. A solution to these problems is discussed in my posts EU acknowledges the failure of traditional economics to predict so adopts agent based modelling and Progressing from game theory to agent based modelling to simulate social emergence.

A complete list of the other nominees for The Dynamite  Prize in Economics and their reason for nomination is below.  Notable is that the list contains many other Nobel laureates and  neoclassical economists.  This high correlation is unsurprising when one  reads the relationship between Assar Lindbeckand the Nobel  Prize in Economics.  You can vote for the three economists who  contributed most to the GFC at The Dynamite  Prize in Economics.  One final note, the work of the 2009  Nobel laureates is a move away from neoclassical economics.

The nominations for the Dynamite Prize

Fischer Black and Myron Scholes
They jointly developed the Black-Scholes model which led to the explosive growth of financial derivatives.  The importance given to their hypothetical calculation of derivative prices was baneful not just because it was bogus, but also because it meant that relevant and often urgent real-world economic research was widely neglected by the profession.

Eugene Fama
His “efficient market theory” provided the moral umbrella for all sorts of greed, predatory behaviour and incompetent corporate management.  It also provided the rationale for deregulation.  And his theory’s widespread acceptance meant that “discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse.”  In these three ways Fama’s work created the environment which made possible the GFC.

Milton Friedman
He propagated the delusion, through his misunderstanding of the scientific method, that an economy can be accurately modeled using counterfactual propositions about its nature.  This, together with his simplistic model of money, encouraged the development of the financial theories with unrealistic assumptions that facilitated the GFC.  In short, he opened the door for everyone subsequently to theorize without fear of having to be attached to reality.

Alan Greenspan
As Chairman of the Federal Reserve System from 1987 to 2006, he both led the over expansion of money and credit that created the bubble that burst and aggressively promoted the view that financial markets are naturally efficient and in no need of regulation.  Before a Congressional committee on 28 October 2008 Greenspan confessed that his theoretical beliefs of 40 years were now proven to be without foundation, hence his total confusion and failure at his job.

Assar Lindbeck
By working to make the Riksbank Prize in Economic Sciences (“Nobel Prize in Economics”) almost exclusively a prize for neoclassical economists, this Swedish economist has contributed significantly to the conversion of the economics profession and of world public opinion to market fundamentalism.

Robert Lucas
His development of the rational expectations hypothesis, which defined rationality as the capacity to accurately predict the future, both served to maintain Friedman’s proposition that monetary factors do not affect the real economy and, in the name of “rigor”, distanced economics even further from reality than Friedman had thought possible.

Richard Portes
As Secretary-General of the Royal Economic Society from 1992 to 2008, he helped suppress worries expressed by non-mainstream economists about developments in the financial sector.  In 2007 he wrote a Report for the Icelandic Chamber of Commerce giving a clean bill of health to Icelandic banks only a few months before they collapsed.  When investigators called attention to the real state of Icelandic banking, he wrote a series of letters to the Financial Times defending the soundness of Icelandic banks and imputing professional incompetence to those who doubted it.

Paul Samuelson
Through his textbook Economics: An Introductory Analysis (19 English language editions and translated into 40 languages), he popularized neoclassical economics, contributing more than any other economist to its diffusion and thereby to the deregulation of financial markets which made possible the GFC.

Larry Summers
As US Secretary of the Treasury (formerly an economist at Harvard and the World Bank), he worked successfully for the repeal of the Glass-Steagall Act, which since the Great Crash of 1929 had kept deposit banking separate from casino banking.  He also worked with Greenspan and Wall Street interests to torpedo efforts to regulate derivatives.


Procedures
The voting is being conducted using PollDaddy.  Its system uses cookies to prevent repeat voting.  A voting box showing the short-listed candidates and a link to their dossiers will remain till voting closes near the top of the right-hand column on the home page of the Real-World Economics Review Blog.  Voting is open to all interested parties. Each voter can vote for up to three of the listed candidates.  The ballots are secret.  Voting will remain open for several weeks.  No results will be announced before closing the poll.

References

Prescott, EC 1977, ‘Should Control Theory be Used for Economic Stabilization’, Carnegie-Rochester Conference Series on Public Policy, vol. 7, pp. 13-38.

— 1988, ‘Theory ahead of business cycle’, in JE Hartley, KD Hoover & KD Salyer (eds), Real business cycles: a reader, Routledge.

Stadler, GW 1994, ‘Real Business Cycles’, Journal of Economic Literature, vol. 32, no. 4, pp. 1750-83

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