To the best of my understanding rational expectations assumes that people use the best information available to them to make their decisions. A key features of this is that people in this mode will also “rationally” realize the limits of their expertise and when the cost of acquiring more knowledge exceeds the benefits they will instead rely on experts in the field or vague heuristics for decision making. The model assumes that people are generally really good at making this decision making (both when they make professional prognostications based on expertise and when they rely on the expertise of others) with all errors being random.

I have two problems with accepting this. First their seems to be an assumption that the random nature and distribution of errors (presumably following a normal distribution) means that all errors will cancel out. I don’t think most markets work this way. Say the price of lunch at the local store varies day by day in response to local conditions. I’m worried about buying cookies if I have extra money so I want to minimize the amount of money I bring. If I guess right, all is well. But if I guess wrong and bring too little or too much money, my whole afternoon is ruined. Random errors don’t cancel each other out, rather the degree of deviation from the correct answer diminishes my overall utility.

This critique is of course begging the question of whether we can really predict very well at all, even given some kind of error term. In simple scenarios I can see we could be fairly decent at this. I buy myself lunch, I know that lunch was worth it, you buy me a present and reason using your expert knowledge of me that I’ll like it. But if we look at more complicated financial devices we soon are faced with a lot more hidden information. I buy a stock. The value of the stock is, in general, based off what someone else is willing to pay for it.  Now the stock might be for a plumbing company. As I am a master of all things related to plumbing I can look at the company and figure, based on the secret plumbing techniques that I know, about how much the plumbing company should be able to earn and thus how much I can expect it to be worth in the future. But most people are not me. They don’t have the secret knowledge of all thing related to plumbing graven deeply into their hearts. So when they try and discern the worth of the plumbing stock the only thing they can look to is the past prices and people past willingness to pay. But there’s a problem. My informed decision has a measure of error in it. I might be over valuing it or undervaluing it but surely I have not perfectly priced it. So when the uninitiated looks for the value of a plumbing company and makes his judgment as to its worth he’s going to be wrong, because the information he was basing his decision on was wrong, and then he’s going to be wrong again, because everyone has some small amount of error in their judgments.

Now this won’t always lead to tragedy.  The concept I dismissed in my first example, where random variations and errors cancel each other out, could indeed fix problems a fair percentage of the times. But as long as a large percentage of the market is making their own decisions on market actions, solely on the perceptions of others, you have a system that is in fact not rational because errors within the system will systematically become larger, like waves. I buy many shares of the plumbing company do to my plumber-iness. Sometimes this will reflect a true new discovery of real value. But often I will merely be mistaken. Nevertheless outsiders won’t know I’m mistaken. They’ll see an uptick in the price of stocks and, as their only way of knowing the worth of something is assuming that “the market” will set the prices at the appropriate level,  buy more stock. This causes a further uptick in the stock, and so on and so forth. As long as other peoples perceptions, invariably flawed, are included with the model, error terms will occasionally multiply, making the market, made up of rational individuals, occasionally act in an irrational manner.

I’m curious how close the explanation of booms and bust fits, both with established econ explanations and with the data we have on booms and bust. Suffice to say that it defies rational expectations, that a theory called rational expectations, would seem to posit that we behave in ways that don’t coordinate towards maximum efficiency. As always interested in logical flaws in my argument.