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Discovery
In addition to the physical theories that the
discovery systems recreated, consideration might
also be given to the behavioral and social theories
that Simon and his colleagues had not attempted to
address with their discovery systems.
Why did this Nobel laureate economist never
attempt to construct an economic theory with a
discovery system?
Perhaps one might ask instead: is Simon
actually a Romantic in his philosophy of social science?
One possible answer is that the economic
theory of greatest interest to him, his thesis of
bounded rationality, does not lend itself to any
discovery system like those he or his colleagues
have yet designed. This is an answer in terms of technology rather than
philosophy. When
Simon found that behaviorism posed a philosophical
impediment to his agenda for cognitive psychology,
he rejected this variation on the Positivist
philosophy, even though he had previously been
sympathetic to it. Similarly one might expect that he should not have been
deterred by any version of Romanticism; he
demonstrated sufficient philosophical sophistication
to distinguish empirical from ontological criteria
for criticism.
Criticism
Simon's view of scientific criticism is based
on his theory of heuristics and discovery systems.
Philosophers of science such as Hanson, whose
interests were focused on the topic of scientific
discovery, found that the Positivist separation of
the "context of discovery" and the
"context of justification" fails to
appreciate the interdependent interaction between
these two functions in scientific research. He also
notes this interaction between discovery and
justification in Scientific Discovery, because it is integral to his theory of
heuristics and to his discovery system designs. His principal thesis of problem solving is that the
availability of evaluative tests during the
successive stages of the discovery process carried
out with heuristics is a major source of the
efficiency of the discovery methods.
Each step or group of steps of a search is
evaluated in terms of the evidence it has produced,
and the continuing search process is modified on the
basis of the outcome of these evaluations.
The confirmation of partial results
accumulates and makes the confirmation of the final
hypothesis coincide with its generation.
Yet Simon does not fail to see the need for
predictive testing by observation or experiment of
the hypotheses generated by the discovery systems
which only find patterns in limited available data.
Muth's
Rational Expectations "Hypothesis"
Simon distinguishes three rationality
postulates: the neoclassical postulate of global
rationality prevailing in academic economics, his
own thesis of bounded rationality, and the rational
expectations hypothesis.
The reader of Simon's autobiography, however,
would never guess that about two decades after its
first appearance, the rationality expectations
hypothesis had occasioned the development of a
distinctive type of discovery system, the Bayesian
Vector Autoregression or BVAR
discovery system.
In fact it is doubtful that even its creator,
Robert Litterman, or his colleagues recognize the
system as a discovery system, even though it does
what discovery systems are intended to do: it
makes theories.
This irony is due to the fact that the
prevailing philosophy of science in economics is
Romanticism, which has led economists to view BVAR models as "atheoretical.” But if the term "theory" is understood in the
contemporary Pragmatist sense, the equations created
by the BVAR
system are economic theories.
Before taking up the BVAR system, firstly consider the rational expectations
hypothesis.
One of the distinctive aspects of Simon's
autobiography is a chapter titled "On Being
Argumentative.”
In this chapter's opening sentence Simon
states that he has not avoided controversy, and he
adds that he has often been embroiled in it.
And on the same page he also says that he has
usually announced his revolutionary intentions.
But revolutionaries occasionally find others
revolting against them.
In the preceding chapter of his autobiography
he describes a tactical retreat in the arena of
faculty politics: his eventual decision to migrate
from Carnegie-Mellon's Graduate School of
Industrial Administration to its psychology
department, which as it happens, is not an
unsuitable place for his cognitive psychology.
This conflict with its disappointing
denouement for Simon was occasioned by the emergence
of the rational expectations hypothesis, a thesis
that was first formulated by a colleague, John F.
Muth, and which was part of what Simon calls the
ascendancy of a coalition of neoclassical economists
in the Graduate School of Industrial Administration.
Muth's rational expectations hypothesis,
which Simon says deserves a Nobel prize even though
he maintains that it is unrealistic, was set forth
in a paper read to the Econometric Society in 1959,
and then published in Econometrica (1961) under the title "Rational Expectations and
the Theory of Price Movements.”
Muth explains that he calls his hypothesis
about expectations "rational", because it
is a descriptive theory of expectations, and is
not a pronouncement of what business firms ought to
do. The
idea of rational expectations is not a pet without
pedigree. It
is a continuation of an approach in economics
known as the Stockholm School, in which expectations
play a central role, and which Muth references in
his article. A
brief consideration of the Stockholm School is in
order, to see how the rational expectations
advocates depart from it, especially in their
empirical modeling.
One of the best known contributors to the
Stockholm School is Bertil Ohlin, a Nobel laureate
economist, who is best known for his
Interregional and International Trade (1933),
and whose elaboration on the monetary theory of Knut
Wicksell anticipated the Keynesian theory in
important respects.
He called his own theory of underemployment
the "Swedish theory of unused resources.”
In 1949 he published his Problem
of Employment Stabilization, which contains his
own macroeconomic theory and concludes with a
critique of Keynes' General
Theory from the Stockholm School viewpoint. In his critique Ohlin draws upon a distinction between ex
ante or forward-looking analysis and ex
post or backward-looking analysis, firstly
proposed by 1974 Nobel laureate economist Gunnar
Myrdal (1898-1987), his colleague of Stockholm
School persuasion and fellow critic of Keynes.
Later in life Myrdal evolved his theory of ex
ante analysis into an Institutionalist economic
theory, and in his Against the Stream (1973) he uses it to explain a phenomenon that is
problematic for Keynesian economics:
"stagflation", the co-existence of
economic stagnation and inflation. However, Myrdal does not address the effect of institutional
change on the structural parameters in econometric
models, and apparently does not think well of
econometrics. In
the first chapter, "Development of Economics:
Crises, Cycles", he says that when he was still
in his "theoretical stage" of thinking,
i.e. pre-Institutionalist stage, he had something
to do with the initiation of the Econometric
Society, which he says was planned at the time as a
defense organization against the advancing American
Institutionalists, an advance which was halted in
the economics profession by the Keynesian
revolution. He
says that Keynesian theory is now in crisis as a
result of problems such as stagflation and
structural unemployment, and that the future
development of economics will be interdisciplinary
and Institutionalist.
Ohlin, who is not an Institutionalist and
remains a neoclassical economist, maintains that ex post analysis alone cannot provide an explanation in economics,
because any explanation must run in terms of factors
that govern actions, and actions refer to the
future. Any
economic explanation must therefore contain ex
ante analysis, which consists of the
expectations or plans of the actors in their
economic roles.
Ohlin notes that Keynes theory may be said to
contain an ex
ante analysis of investment, because it includes
the marginal efficiency of capital, which is similar
to Wicksell's "natural" rate of interest:
the expected return from newly constructed capital. But Ohlin took exception to Keynes' exclusively ex
post analysis of saving, in which saving is
merely the residual of aggregate income net of
aggregate consumption.
On the Stockholm School view there must be an
ex ante
analysis of saving, and Ohlin theorizes that ex
ante saving is determined by the difference
between current consumption and the level of
income in the prior period.
He calls the
ex ante saving rate the average propensity to
save. Ohlin's
Stockholm School approach is significant not only
because Ohlin offers an explanation of how
expectations are formed, but also because it
accounts for expectations by explicit variables, the
ex ante
variables, so that their effects need not be
incorporated implicitly in the statistically
estimated parameters of the econometric models.
Ohlin's explanation notwithstanding, Muth
blithely criticizes the Stockholm School for failing
to offer an explanation of the way expectations
are formed, and he advances his rational
expectations hypothesis as the explanation.
Muth notes two conclusions from studies of
expectations measurements, which he says his
rational expectations hypothesis
"explains.”
The principal conclusion is that the averages
of expectations made by economic actors in an
industry are more accurate than the forecasts made
with naive models, and are as accurate as elaborate
equation systems, although there are considerable
cross-sectional differences of opinion.
The rational expectations hypothesis
explains this accuracy by the thesis that expectations
viewed as informed predictions of future events are
essentially the same as the predictions of the
relevant economic theory.
Muth says that he is not asserting that the
scratch work of entrepreneurs resembles a system of
equations in any way, although he says that the way
expectations are formed depends on the structure
of the entire relevant system describing the
economy. His
more precise statement of his hypothesis is as
follows: that expectations of firms (or, more
generally, the subjective probability distribution
of outcomes) tend to be distributed, for the same
information set, about the prediction of the theory
(or, the "objective" probability
distributions of outcomes).
Muth argues that if expectations were not
moderately rational, then there would be
opportunities for economists to make profits in
commodity speculation, running a business firm, or
selling information to present owners.
In his discussion of price expectations, he
offers an equation for determining expected price in
a market, and references a paper to be published by
him. The
equation says that expected price is a
geometrically weighted moving average of past
prices. He
also argues that rationality is an assumption that
can be modified to adjust for systematic biases,
incomplete or incorrect information, poor memory,
etc., and that these deviations can be explained
with analytical techniques based on rationality.
The second conclusion is that reported
expectations generally underestimate the extent of
changes that actually take place.
Like the Stockholm School, Muth's hypothesis
does not assert that there are no expectations
errors. He
states that in the aggregate a reported expected
magnitude such as a market price is an unbiased
predictor of the corresponding actual magnitude
except where a series of exogenous disturbances
are not independent.
Muth's explanation of the reported
expectations errors of underestimation is his
argument that his hypothesis is not inconsistent
with the fact that the expectations and actual data
have different variances.
Muth references Simon's "Theories of
Decision-Making in Economics" in American
Economic Review (1959), and describes Simon as
saying that the assumption of rationality in
economics leads to theories that are inconsistent
with or inadequate to explain observed phenomena,
especially as the phenomena change over time.
Muth comments that his view is exactly the
opposite of Simon's: dynamic economic models do
not assume enough rationality.
Simon's critique of the rational expectations
hypothesis is set forth in the second chapter
titled "Economic Rationality" in his Sciences
of the Artificial (1969).
In the section titled
"Expectations" he notes that expectations
formed to deal with uncertainty may not result in a
stable equilibrium or even a tendency to stable
equilibrium, when the feed forward in the control
system has destabilizing consequences, as when
each actor is trying to anticipate the actions of
others and their expectations.
The stock example in economics is the
speculative bubble.
In the next section titled "Rational
Expectations" Simon references Muth's 1961
article. He
characterizes Muth's hypothesis as a proposed
solution to the problem of mutual outguessing by
assuming that actors form their expectations
"rationally", by which is meant that the
actors know the laws that govern the economic
system, and that their predictions of the future
position of the system are unbiased estimates of the
actual equilibrium.
Simon says that the rational expectations
hypothesis precludes destabilizing speculative
behavior. More fundamentally Simon maintains that
there is no empirical evidence supporting the
rational expectations hypothesis. And he doubts that business firms have either the knowledge
or the computational ability that would be required
to carry out the expectations strategy.
He concludes that since economists have
little empirical knowledge about how people do in
fact form expectations about the future, it is
difficult to choose at present among the models that
are currently proposed by competing economic
theories to account for cyclical behavior of the
economy.
Ostensibly Muth proposed his rational
expectations hypothesis as an explanation of two
conclusions about expectations measurements.
These empirical measurements should be used
to provide the independent semantics and magnitudes
needed for empirical testing of the rational
expectations hypothesis.
What might rationally have been expected of
the rational expectations advocates is an attempt to
construct conventional structural-equation
econometric models using ex ante expectations data, to demonstrate and test their explanatory
hypothesis. But
neither Muth nor the rational expectations advocates
took this approach.
On the basis of his rational expectations
hypothesis Muth shifted from an explanation of
empirical measurements of reported expectations to
consideration of a forecasting technique that he
proposes be used by neoclassical economists.
This semantical shift has had three
noteworthy effects on subsequent empirical work in
the rational expectations school: Firstly there was
a disregard of empirical measurements of
expectations, measurements that would serve as
values for ex
ante variables; then secondly there was an
attack upon the conventional structural type of
econometric model and the development of a new type
of empirical model as an implementation of the
rational expectations hypothesis but with no
independently collected expectations measurements;
and thirdly there evolved the design and implementation
of a computerized procedure for constructing this
new type of model, a computerized procedure which is
a distinctive type of discovery system.
This semantical shift has been consequential
for econometric modeling.
Haavelmo's structural-equation type of
econometric model has been definitive of empirical
economics for more than half a century, and it is
still the prevailing practice in the economics
profession. To
the dismay of conventional econometricians the
rational expectations advocates' attack upon the
conventional structural-equation econometric model
is, therefore, hardly less subversive to the status
quo in the science, than Simon's attack on the
neoclassical rationality postulate.
And this outcome certainly has an ironic
aspect, because the structural-equation econometric
model had been advanced as the empirical
implementation (at least ostensibly) of the
neoclassical economic theory, while the rational
expectations hypothesis has been advanced as
offering greater fidelity to neoclassical theory
by extending rationality to expectations.
To understand such a strange turn of events,
it is helpful to consider the still prevailing,
conventional concept of econometric model, the
structural-equation model.
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