Rational expectations theory

Rational expectations theory which is based on rational choice theory is used in game theory and may macroeconomic models. It was formulated by the American economist John Muth in 1961 and has been in vogue 1970's thanks to Robert E. Lucas Jr., Stanley Fischer and others.

In essence it is a theory that says that individual expectations of specific events in the future may be in error but on average they are correct. It assumes that individual expectations are not systematically biased and that individuals use all relevant information is reaching a decision on the best course for their economic future without bias.

In other words people will make the right decision more often and only make a wrong decision infrequently and randomly.

Now there is something that is visceral about this theory because it includes all of us in its definition. And it says we are reasonable and will continue to acquire information until the point of diminishing returns to come to a valid judgement. Now how can anyone disagree with that? They would be calling themselves incompetent or biased at the very least. And of course we all know we are neither.

But thanks to the Austrian school of economics we know that people make decisions in uncertainty. And in today's world where all markets are manipulated people can't acquire all the information or even acquire factual information. Don't believe markets are manipulated, haven't you been keeping track of high frequency trading, dark pools, shadow banking, the presidents working group on markets (i.e. Plunge Protection Team)?

Another critique of rational expectation theory is that it assumes that a market or the economy as a whole has only one equilibrium point. Leave it to an economist to simplify to absurdity. As all good engineers know a complex system can have many equilibrium points several of which can be small points within highly unstable regions.

Another flaw with the theory is the assumption that a group of individuals will in aggregate act the same as a single individual. Even if all individuals have rational expectations the aggregate of the individuals may not. It has been shown time and time again that a heard mentality can take hold and all rationality is lost even If only for brief instants. However those instants can cause enormous damage and trigger other events.

The response of economists to the apparent flaws in the theory has been to either ignore them or make minor patches. This parallels the path of science in early history. This is one of the reasons that the sun was thought to revolve around the earth for so many centuries. An unwillingness to accept facts as observed over illogical beliefs.