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Imperfect Knowledge Economics 1 Our capacity to predict will be confined to...general charac- teristics of the events to be expected and not include the capacity for predicting particular individual events....[However,] I am anxious to repeat, we will still achieve predictions which can be falsified and which therefore are of empirical significance.... Yet the danger of which I want to warn is precisely the belief that in order to be accepted as scientific it is necessary to achieve more. This way lies charlatanism and more. I confess that I prefer true but imperfect knowledge...toapretence of exact knowledge that is likely to be false. Friedrich A. Hayek, “The Pretence of Knowledge,” Nobel Lecture Contents Foreword by Edmund S. Phelps xiii Acknowledgments xxi List of Abbreviations xxiii PART I From Early Modern Economics to Imperfect Knowledge Economics 1 1 Recognizing the Limits of Economists’ Knowledge 3 The Overreach of Contemporary Economics 3 The Aim of This Book 6 Contemporary Models in a World of Imperfect Knowledge 8 The Non-Fully Intelligible Individual 13 IKE Models 14 IKE of Exchange Rates and Risk 20 Imperfect Knowledge and Policy Analysis 23 From Contemporary Economics to Imperfect Knowledge Economics 24 2 A Tradition Interrupted 26 The Stranglehold of the Contemporary Approach 27 The Non-Fully Intelligible Individual in Early Modern Economics 34 Jettisoning Insights from Early Modern Analysis 38 vii viii Contents 3 Flawed Foundations: The Gross Irrationality of “Rational Expectations” and Behavioral Models 41 Conventional and Behavioral Representations of Preferences with Uncertain Outcomes 42 Self-Interest, Social Context, and Individual Decisions 45 Individual Behavior and Aggregate Outcomes 48 From Early Modern to Phelps’s Microfoundations 49 “Rational Expectations”: Abandoning the Modern Research Program 49 Diversity of Forecasting Strategies: The Gross Irrationality of “Rational Expectations” 51 Inconsistency in Behavioral Models 54 4 Reconsidering Modern Economics 58 Sharp Predictions and Fully Predetermined Representations 60 Qualitative Predictions of Change in Fully Predetermined Models 65 IKE Models of Change 66 IKE Causal-Transition Paths 70 Appendix 4.A: Fully Prespecifying Change in the Social Context 71 Appendix 4.B: Modeling Change in Outcomes with Fully Predetermined Probabilistic Rules 72 5 Imperfect Knowledge Economics of Supply and Demand 74 Fully Predetermined Representations of Supply and Demand 76 Supply and Demand Analysis in Contemporary Models 79 History as the Future and Vice Versa 81 Supply and Demand Analysis in IKE Models 82 Irreversibility of History in IKE Models 86 PART II “Anomalies” in Contemporary Models of Currency Markets 89 6 The Overreach of Contemporary Models of Asset Markets 91 Describing Forecasting Behavior 92 Fully Predetermined Representations of Forecasting Strategies and Their Revisions 93 Modeling Economic Change with a Time-Invariant Structure 96 Models with Fully Predetermined Changes in Structure 101 Contents ix Prespecifying Collective Beliefs in Currency Markets: Bubble Models 104 Appendix 6.A: A Conventional Macroeconomic Model 107 7 The “Puzzling” Behavior of Exchange Rates: Lost Fundamentals and Long Swings 113 Exchange Rates and Macroeconomic Fundamentals: The Futile Search for a Fully Predetermined Relationship 114 The Exchange Rate Disconnect Puzzle: An Artifact of the Contemporary Approach 120 Macroeconomic Fundamentals over Long Horizons: Self-Limiting Long Swings 121 Can REH Models Explain Long Swings in Exchange Rates? 126 REH Bubble Models and the Pattern of Long Swings in Real World Markets 131 Lost Fundamentals and Forsaken Rationality: Behavioral Models 134 8 “Anomalous” Returns on Foreign Exchange: Is It Really Irrationality? 138 The Record on Foreign Exchange Returns 140 An REH Risk Premium? 144 Is Irrationality the Answer? 147 The Forward-Discount “Anomaly”: Another Artifact of the Contemporary Approach 151 PART III Imperfect Knowledge Economics of Exchange Rates and Risk 153 9 Modeling Preferences in Asset Markets: Experimental Evidence and Imperfect Knowledge 155 Prospect Theory and Speculative Decisions 159 Endogenous Loss Aversion and Limits to Speculation 167 Experimental Evidence and Behavioral Finance Models 170 Moving beyond Behavioral Finance Models 173 IKE Representations of Preferences in Asset Markets: Individual Uncertainty Premiums 176 Imperfect Knowledge and Preferences over Gambles: Endogenous Prospect Theory 179 Appendix 9.A: Limits to Speculation under Endogenous Loss Aversion 180 x Contents 10 Modeling Individual Forecasting Strategies and Their Revisions 183 Theories Consistent Expectations Hypothesis 185 IKE Representations of Revisions: An Overview 191 Trend Restriction 192 Conservative Revisions 194 Revisions of the Expected Unit Loss 197 11 Bulls and Bears in Equilibrium: Uncertainty-Adjusted Uncovered Interest Parity 203 Momentary Equilibrium in the Foreign Exchange Market 204 Equilibrium under Risk Aversion 205 Uncertainty-Adjusted UIP 210 12 IKE of the Premium on Foreign Exchange: Theory and Evidence 218 An IKE House Money Model: Time-Varying Preferences 220 An IKE Gap Plus Model: Autonomous Revisions in Forecasting Strategies 223 Confronting the Gap Plus and House Money Models with Time-Series Data 225 The Gap Plus Model and the Frequency of Sign Reversals 238 Avoiding the Presumption of Gross Irrationality 241 Appendix 12.A 242 13 The Forward Discount “Anomaly”: The Peril of Fully Prespecifying Market Efficiency 243 Bilson-Fama Regression and the Forward Discount “Anomaly” 245 Structural Instability of the BF Regression and the Gap Plus Model 246 BF Regression and Market Efficiency 252 14 Imperfect Knowledge and Long Swings in the Exchange Rate 258 A Monetary Model 260 Invariant Representations and an Unbounded Swing Away from PPP 266 Fixed Policy Rules and Invariant Representations? 272 An IKE Model of Exchange Rate Swings 272 Conventional and Behavioral Views of Reversals 278 Imperfect Knowledge and Self-Limiting Long Swings 279 Appendix 14.A: Solution with an Invariant Representation 283 Appendix 14.B: Exchange Rate Swings and Sticky Goods Prices 283 Contents xi 15 Exchange Rates and Macroeconomic Fundamentals: Abandoning the Search for a Fully Predetermined Relationship 292 Structural Change in the Causal Mechanism 295 Macroeconomic Fundamentals and the Exchange Rate in the 1970s 297 Are the Monetary Models Consistent with Empirical Evidence? 304 Macroeconomic Fundamentals and the Exchange Rate in the 1980s 309 Appendix 15.A: Description of Data 312 References 313 Index 331 Foreword Edmund S. Phelps Much has been written by historians and sociologists as well as business commentators about the modern economy—the kind that supplanted the traditional economy in several nations in the nineteenth century and many more in the latter half of the twentieth century. The pre-capitalist system dominated by the self-employed and the self-financed gave way to finance capitalism. To call this a “great transformation” was no overstatement. A traditional economy is one of routine. In the usual illustrative exam- ple, rural folk periodically exchange their produce for the goods of the town. The sole disturbances are not of their doing and are beyond their control—rainfall, temperature, and other exogenous shocks. This was the economy modeled in the neoclassical theory of economic equilibrium from Ricardo and Bohm-Bawerk¨ to Walras and Samuelson. It is also the econ- omy described in the subsequent stochastic models of “rational expectations equilibrium” in the face of shocks that were pioneered by Arrow, Samuelson, Muth, and Lucas. The modern economy is marked by the feasibility of endogenous change. Modernization opens the door for individuals to engage in novel activity—most importantly, the financing, developing, and marketing of new products and methods. Furthermore, such innovations, when success- ful in the marketplace, have unforeseen effects on production possibilities, prices, the differentiation of goods, and the specialization of work. The author is McVickar Professor of Political Economy at Columbia University; director of the Center on Capitalism and Society, Earth Institute, at Columbia University; and the winner of the 2006 Nobel Prize in Economics. xiii xiv Foreword For decades, economics students have quietly asked themselves whether the equilibrium theory of the classroom is adequate for modeling the mod- ern economy. It is one thing to know the prices at hand, another to know all prices far and wide and over the whole future and for every state of the world that shocks might land the economy in. Equilibrium theory implicitly takes the mechanisms that constitute the economy to be completely known: participants have a full understanding of how this organism works, so ev- eryone knows the probability distribution of outcomes to expect in this or that state. This in turn implies that everyone knows this understanding to be common knowledge, so there is no diversity of views that would have to be guessed at in estimating what others intend to do. History records a small band of economists who have called attention to points of dissonance between the modern economy and equilibrium theory, including the theory of rational expectations equilibrium, in which expectations (and thus prices) are taken to be appropriate for equilibrium in each possible current state.1 In fact the growing perception, starting from the turn of the century, that the new modern economies were generally out of equilibrium, sometimes frighteningly so, is one of the hallmarks
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