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Rational Expectations is just a mathematical version of Benthamite Utilitarianism, June 6, 2010
This review is from: Economics, Economists and Expectations: From Microfoundations to Macroapplications (Routledge Studies in the History of Economics) (Hardcover)
The authors of this book cover a number of different economists .They range from Keynes to Muth ,Lucas,Friedman and Hayek,and others.They attempt to cover their views on expectations looked at from both a micro and macro perspective .Unfortunately,they lack a basic understanding of the Benthamite Utilitarian foundation of the economic thought and philosophy of Muth,Lucas,Friedman and Hayek, as opposed to Keynes,who completely rejects Bentham's position except as a very special case.
The authors of this volume are correct that there was no real ' rational expectations ' revolution.However,the arguments and evidence they present lend little support to their position.The publication of Jeremy Bentham's 1789 book,titled "The Principles of Morals and Legislation" represented a profound breal in how one approached the study of political economy. From the ancient Hebrew,Israelite prophrets of the Old Testament ,the New Testament,Plato,Aristotle,Augustine,Aquinas and Adam Smith,the field of political economy was viewed as a sub field of ethics,moral philosophy,politics ,philosophy or aesthetics. The primary problem that was identified was the use of money for speculative purposes only. Such a use was divorced from the use of money to buy and sell productive goods(consumer and producer goods)and services.Closely related to this problem was the role that the rate of interest played .The unanimous conclusion was that some form of usury law was necessary to prevent the dominance of the speculative demand for money over the transaction demand for money.
Bentham's view changed all that.Classical,Neoclassical,and Modern Economics is simply Bentham's basic model dressed up in different forms of mathematics and statisitcs.Monetarism,rational expectations,supply side economics,real business cycle theory and Austrian economics are simply different versions of Benthamite utilitarianism.
Bentham's model is based on pp.29-32 and pp.187-188 of his book.The goal of a decision maker is to maximize his utility subject to a number of constraints that the decision maker can calculate precisely.Bentham states that the decision maker can figure out the outcomes and the uncertainty(probability) of each outcome.This is Bentham's microeconomics.Bentham's macroeconomics is merely the claim that the sum of all of the individual microeconomic decisions must be the macro outcome.The whole is merely the sum of each of the individual parts.This requires the assumption that all economic functions are linear and additive.
Bentham naturally was opposed to all usury laws and speculative activities because this would interfere with individuals maximizing their utility.Bentham had no understanding of the concept of negative externalities and/or spillover effects.
J M Keynes completely rejected Bentham's philosophy and model .Keynes sought to return economics to the place it had occupied up until 1789.The problems Keynes identified in the 20th century were the same problems that had been evident in all previous centuries- first,massive speculation in land,real estate,and precious metals and then in stocks and other financial assets ;second ,the interest rate was too high relative to the marginal efficiency of capital .Keynes's analysis was rejected,and would have been rejected even if economists had been able to work through the mathematical analysis in chapters 20 and 21 of the General Theory(1936),which they were not capable of doing,because he rejected the foundation of economics which was,and is,Benthamite Utilitarianism.
This foundation argues ,like Bentham,that expectations of the future can be calculated.Rational expectations(Muth ,Lucas)simply involves translating the basic Bentham model into the basic statistical gas- particle model of Khinchin's macroscopic physics model,which postulates a system of millions of independent and identically distributed atoms(,for Lucas,consumer-producers) that randomly collide with each other(for Lucas,engage in market transactions) .Each collision(for Lucas,market interaction) results in some atoms losing/ gaining energy(electrons).Muth -Lucas interpreted this to mean gain /lose utility and /or money/profits.The Law of large numbers and central limit theorem lead to all outcomes being normally distributed.Based on maximum likelihood estimation ,the only expectation can be the mean outcome.
Keynes had already rejected this approach in his A Treatise on Probability (TP;1921).He rejected it again in his debate with Tinbergan.Tinbergan's approach is of the same type as the Muth-Lucas approach.Milton Friedman and Hayek also are in this category.Friedman also relies on the assumption of a normal distribution.Hayek relies on the claim that all of the bits and pieces of dispersed information are concentrated into price vectors that allow the entrepreneur to solve the problem of uncertainty.Hayek's concentrated price vectors only make sense if thay are essentially normally distributed so that one can view the expected result,or expectation,as an average value.Hayek's discussuions of probability,expectations ,and uncertainty are also very vague,hazy and ambiguous.Hayek never explains the process of how entrepreneurs are able to dicipher the uncertaintes.I will append Keynes's mathematical treatment of expectations below for the interested reader below.A careful reading will demonstrated the special case nature of Bentham's model and hence also the work of Friedman,Hayek,Lucas, Muth and Tinbergen.
Keynes presented a very precise analysis demonstrating that an analysis of uncertainty introduced non additivity and non linearity into the formal representation of decision making. The subjectivist, Bayesian approach regards probability as another name for the purely mathematical laws of the probability calculus that requires additivity and linearity. The Subjectivist approach makes the crucial error of conflating probability theory with decision theory.Keynes realized that ,due to the impact of the weight of the evidence (confidence)on decision makers ,as well as the optimism-pessimism of the decision maker,decision theory would have to be able to take into account the importance of non linearity and non additivity. The concept of expected value or utility is crucial to the Ramsey-De Finetti approach.Keynes demonstrated that expected value or expected utility can ,at best,be a special case only of a much more general theory .
The Ramsey-De Finetti approach is the mathematical translation of Jeremy Benthem's Benthamite Utilitarian approach.Bentham's approach was that the whole can not be anything more than the sum of the individual ,atomic parts. However, this requires the assumptions of additivity and linearity.Bentham assumed also that all decision makers can calculate the odds.Keynes showed that this was not the case. Keynes's demonstration ,taken from chapter 26 of his A Treatise on Probability(1921;TP),of the special case nature of any expected value(utility) approach ,based on the purely mathematical laws of the probability calculus,shows this to be a very special case when w=1.Bentham claimed that all individuals have the capability to calculate the odds and outcomes and act on the expected utility (the probability times the utility of the outcome) in a rational way.This can be expressed by the following ,where p is the probability of success,q is the probability of failure, and A is the outcome:
Maximize pA.
The modern version of this is to Maximize pU(A),where p is a subjective probability that is additive,linear,precise,and exact and U(A) is a Von Neumann-Morgenstern Utility function. The goal is to
Maximize pU(A).
The modern name for Benthamite Utilitarianism in neoclassical economics is SEU theory(Subjective Expected Utility). Therefore,a microeconomic foundation based on Utility Maximization is just Benthamite Utilitarianism updated with modern mathematical probability techniques.Modern macroeconomics is all disguised SEU theory.
Keynes rejected Benthamite Utilitarianism as a very special case that would only hold under the special assumptions of the subjectivist, Bayesian model-that all probabilities were additive,linear,precise,single number answers that obeyed the purely mathematical laws of the probability calculus.
Keynes specifies his conventional coefficient of risk and weight,c, model in chapter 26 of the TP on p.314 and footnote 2 on p.314,as a counter weight to the Benthamite Utilitarian approach of Ramsey.
Essentially, Keynes's generalized model is given by
c=2pw/(1+q)(1+w),
where w is Keynes's weight of the evidence variable that measures the completeness of the relevant, available evidence upon which the probabilities p and q are calculated.(Benthamite Utilitarians always assume that the value of w is always 1.)w is an index defined on the unit interval between 0 and 1,p is the probability of success,and q is the probability of failure.p+q sum to 1 if they are additive.This requires that w=1.Keynes's c coefficient can be rewritten as
c=p [1/(1+q)][2w/(1+w)].
Now multiply the above by A or U(A).One obtains
cA =p[1/(1+q) ][2w/(1+w)] A or
cU(A)= p[1/(1+q)][2w/(1+w)]U(A).
The goal is to maximuze cA or cU(A).The weight 1/(1+q) deals with non linearity of probability preferences.The weight 2w/(1+w) deals with non additivity.Modern Macroeconomics amounts to nothing more than the claim that c=p or cA [cU(A])= pA [pU(A)] .
It is now straightforward to see that the neoclassical microfoundations of macroeconomics assumes that all probabilities are additive and linear.This is nothing but a special case of Keynes's generalized decision rule to maximize cA,or cU(A),as opposed to the Benthamite Utilitarian rule to maximize pA or pU(A). Economists today have only a very...
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