Guest Post: Ben Bernanke Must Be Hoping Rational Expectations Doesn’t Hold...

Tyler Durden's picture

Submitted by John Aziz of Azizonomics blog,

In the theory of rational expectations, human predictions are not systematically wrong. This means that in a rational expectations model, people’s subjective beliefs about the probability of future events are equal to the actual probabilities of those future events.

Now, I think that rational expectations is one of the worst ideas in economic theory. It’s based on a germ of a good idea — that self-fulfilling prophesies are possible. Almost certainly, they are. But expressed probabilities are really just guesses, just expressions of a perception. (Or, as it is put in Bayesian probability theory: “probability is an abstract concept, a quantity that we assign theoretically, for the purpose of representing a state of knowledge, or that we calculate from previously assigned probabilities.”) Sometimes widely-held or universally-held beliefs turn out to be entirely irrational and at-odds with reality (this is especially true in the investment industry, and particularly the stock market where going against the prevailing trend is very often the best strategy). Whether a belief will lead to a reality is something that can only be analysed on a case-by-case basis. Humans are at best semi-rational creatures, and expectations effects are nonlinear, and poorly understood from an empirical standpoint.

Mainstream economic models often assume rational expectations, however. And if rational expectations holds, we could be in for a rough ride in the near future. Because an awful lot of Americans believe that a new financial crisis is coming soon.

According to a recent YouGov/Huffington Post survey:

75 percent of respondents said that it’s either very or somewhat likely that the country could have another financial crisis in the near future. Only 12 percent said it was not very likely, and only 2 percent said it was not at all likely.

From a rational expectations perspective, that’s a pretty ugly number. From a general economic perspective it’s a pretty ugly number too — not because it is expressing a truth  (it might be — although I’d personally say a 75% estimate is rather on the low side), but because it reflects  that society doesn’t have much confidence in the recovery, in the markets, or in the banks.

Why? My guess is that the still-high unemployment and underemployment numbers are a key factor here, reinforcing the idea that the economy is still very much in the doldrums. The stock market is soaring, but only a minority of people own stocks directly and unemployed and underemployed people generally can’t afford to invest in the stock market or financial markets. So a recovery based around reinflating the S&P500, Russell 3000 and DJIA indices doesn’t cut it when it comes to instilling confidence in the wider population.

Another factor is the continued and ongoing stories of scandal in the financial world — whether it’s LIBOR rigging, the London Whale, or the raiding of segregated accounts at MF Global. A corrupt and rapacious financial system run by the same people who screwed up in 2008 probably isn’t going to instill much confidence in the wider population, either.

So in the context of high unemployment, and rampant financial corruption, the possibility of a future financial crisis seems like a pretty rational expectation to me.

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cliffynator's picture

I bet another grind-session of the S&P up to 1600+ will shake out a good number of remaining pessimists.


Just in time to have it all fall apart.

DJ Happy Ending's picture

Rational expectations? Ben Bernanke?

Ghordius's picture

it's only the name of his... religion

Eireann go Brach's picture

You need to have confidence in our leader Obama, surely the greatest business brain, outstanding negotiator, and skilled diplomat the US has ever seen!


Inmates at One flew over the cuckoos nest

Caggge's picture

Another financial crisis?  When did the last one end?

leftcoastfool's picture

"75 percent of respondents said that it’s either very or somewhat likely that the country could have another financial crisis in the near future."

Then let the games begin...

El Oregonian's picture

Yes, the other 25% are still hanging around looking for their ObamaPhone...

Papasmurf's picture

. . . or the raiding of segregated accounts at MF Global.

Why don't you call it what it was.  It was criminal theft from investor's accounts.  It has nothing to do with raiding.

Hedgetard55's picture

Ben's only expectation is the big payback from Jamie and Lloyd when he steps down.

pashley1411's picture

I'm not getting the meme here.   Every 4-6 years there is an economic downturn.   My off-the-cuff count from Sep 2008 is, hmmm, let's see, why right about now.   (Or, more probably, September-October 2013).

So some of the lemmings realize that there is a cliff ahead.   Doesn't mean they can avoid it.  

wee-weed up's picture

Methinks the lemmings have already left the cliff, and are already out in the air like Wile E. Coyote.

They totally ignored the looming cliff.

tickhound's picture

For lemmings "not getting the meme here."  Your every 4-6 year "downturn" assumes a non-$85 billion monthly buying spree.  $85 billion a month means this thing could go Dow 20k or flat out cause a collapse in confidence.  Nobody gives a shit about your lemming cliff correction.


trillion_dollar_deficit's picture

Rational expectations assumed a ceiling of ~$2 trillion on the Fed's balance sheet.


QE4EVA expectations assume an unlimited Fed balance sheet lest the complete destruction of the US economy. 

Manipuflation's picture

Alright ZH brothers(and the two or three sisters we have).  I really did not want this out there as it was more of a practice picture for what is upcoming.  But given the beating I took last night and the fact that I called out posers I am going to have to post a link.

There will be another post when the BU dimes show up.  This whole office is freaking mess, sort of on purpose, so I just grabbed whatever was nearby and this was the picture we came up with.  Supposedly, I lost this stuff in a boating accident.  I can promise that I will have another boating accident on the fishing opener because I will need to lose it again.


Fuck You Bernanke! 

Dimes bitchez.

Anusocracy's picture

Thanks for the Kokesh-Schiff video on your site.

Government being a necessary evil is like cancer being a necessary disease. Schiff is wrong, but at least he is in our foxhole.


Manipuflation's picture

Thanks.  I will help you at any time if I can.

Manipuflation's picture

Thank you ZH'ers.  I promise that next time the pic will be even more interesting.  Maybe we will even throw some AU in the shot.  Everyone needs silver dimes though.  There is nothing wrong with buying silver bars and rounds but we just need to get more people to finally figure modern fraudnance out.  I am open to suggestions.

Unfortunately, I think most folks are complete idiots.  Ron White was correct when he stated that you can not fix stupid.  How did that happen to begin with?  The public fool system?  Excuse me, the public SCHOOL system.  I just had to sign off on some of my daughter's math homework.  Any ZHer worth his salt would have signed off on it as Paul Krugman.  I would not do that would I?....yeah, I did.:-)  It led to a discussion.  

What is it all going to come to in the end?  The prospects are very scary to me.  We have a tough road ahead of us.  If I could fix it all I would but I can not. 


Professorlocknload's picture

A silver dollar still buys dinner out, and a silver quarter still puts a gallon of gas in the scooter to get there. What's changed?

Westcoastliberal's picture

These guys have already expressed their belief the economy follows the market (not the other way-round).  Isn't that the fundamental problem? Take the poll!  Yes vote up, No vote down. Personally I think that's nuts, especially with the amounts and potential repercussions for the wrong choice we're dealing with.

Bingfa's picture

Like a thief in the night, your life will change forever

They will engineer an attack

and you will probably never know what really happened

A derivative meltdown is upon us


Bear's picture

It will all happen if the FED ever mentions the idea of reducing QE (per Stockman). 

jimmyjames's picture


When the crowd gets bearish/bullish..go the other way?

I need a bullet to bite on-but sentiment rules and as Livermore said..respect the market-

HulkHogan's picture

Should I bet on Wichita State?

sangell's picture

Its the irrational expectations you need to be afraid of. That housing prices can go up forever. That the Euro is a viable monetary unit. That QE will lead to a genuine increase in real wealth and production. I'm not worried about the 75% of the people who find those things hard to believe 5 years into the GFC. I am scared shitless that people in real positions of authority actually do.

Assetman's picture

Good points.

When you have a segment of the investing population levered to the hilt going 'all in', whether its with stoxx, levered loans, Greek sovereign debt or rehypothecated derviatives, you should become sacred shitless because many of these same entities were the same ones that benefitted from 'socialized losses' in the last great financial earthquake.  One wonders whether the 'rational expectation' is one where the Fed 'has the back of the banksters' again-- or that there's an alterative reality brewing that will render the Fed powerless this next time around.

When one sees (yet again) that the Fed all along has been the Great Enabler of careless behavior in our global finanical system, yet still holds steadfastly to the belief that they are fostering "real wealth" creating policies by creating mountains of credit out of nowhere-- the gap between the rational and irrational just keeps getting wider.

That's where things get very dangerous.

the grateful unemployed's picture

another financial crisis, so what? Bernanke will reinflate, prop up the banks, liquidate or two. and leviatate the stock market. the real danger is what happens when people leave the economy, through barter, and bitcoin, and offthegrid solutions. like they said in the 60's "suppose they gave a war and nobody came" they still have wars, but the draft is gone, and no one is obliged to serve, "suppose they gave an economy and nobody paid?" the economy wouldn't mean anything.

JR's picture

Economic expectations appear to be running low, based it seems on economic reality. With opportunites for college graduates on the wane, the picture doesn't look any too rosy for non-grads, either, at least according to this, from Wenzel:

Fastest-Growing Jobs Pay Under $10/Hour | by Robert Wenzel | Economic Policy Journal

This weekend, I had a discussion with a businessman, who sits on the board of a publicly traded staffing firm. He tells me that the middle class is disappearing. The country is being split into those savvy enough to survive in the overly regulated economy and everyone else.

CNN reports on the data that demonstrates this phenomena:

Some 58% of the jobs created during the recovery have been low-wage positions, according to a 2012 report by the National Employment Law Project. These low-wage jobs had a median hourly wage of $13.83 or less.

Bottom line: The crony capitalists have built a moat around their businesses, eliminating the kind of competition that would hire high skilled labor. Obamacare, simply adds to the difficulties in hiring anything but very cheap labor. Outside of a tiny sliver of opportunity for software engineers and lawyers in Silicon Valley, you either launch something on your own or you will end up part a low paid tool for the crony machine.

Employment & wages for largest U.S. occupations: Occupation - U.S. employment - 2012 annual mean wage --

Retail salesperson - 4,340,000 - $25,310

Cashier - 3,314,010 - $20,370

Food prep worker - 2,943,810 - $18,720

Office clerk - 2,808,100 - $29,270

Registered nurse - 2,633,980 - $67,930

Waiter - 2,332,020 - $20,710

Customer service representative - 2,299,750 - $33,110

Laborer - 2,143,940 - $26,410

Janitor/cleaner - 2,097,380 - $24,850

Secretary/administrative assistant - 2,085,680 - $33,560.

Clowns on Acid's picture

QE at this stage must be considered immoral. But Bernanke and his friends are not big believers in morality.

The MSM brings the message from the new god... Consumerism.

jonjon831983's picture

It's ok guys, we can go home, everything has been fixed... "Fannie Mae posts record annual profit of $17.2 billion",0,1211915.story


On another note, I scanned a headline somewhere that the Mortgage REIT AGNC is likely buying up all sorts of Mortgage debt.

dunce's picture

There seems to be a fairly large disconnect between rationality and being right. Mayor Bloomberg makes billions yet comes up with some new irrational idea every week. Howard Hughes was about as eccentric as anybody and was very successful.

GeoffreyT's picture

TD, you do yourself no favours letting folks attack straw men (unless it's in the comments, in which case the playing condition reads something like "maximise lulz subject to the internet's capacity for hate generation", which is awesome).

Rational expectations does not mean that agents will not be systematically wrong. It means that agents will form expectations based on all information available at the time of the decision (with the decision to acquire non-costless information itself requiring some guess at expected rates of return on the marginal unit of information), and will do so consistent with some model that is known at the time (otherwise the model should be changed, obviously).

So to make a required amendment to Aziz's statement... "This means that in a rational expectations model, people’s subjective beliefs about the probability of future events are equal to the actual probabilities of those future events..." at the time the decision is made and only for agents whose information set is the market information set.

In a world with non-costless information, very few participants will have the market information set... and none of them will be a bureaucrat. And it's easy to say that no agent has 'the' model.

So anyway... folks decide on how much information they need, and they form their expectations. Then shit happens (sometimes hitting the fan).

And you're not going to get out of it by gabbling about measures of central tendency, either (i.e., that 'on average' agents will get it 'right') - because the 'model' under consideration is not bijective for the variables of interest (that is, there are multiple sets of outcomes for 'exogenous' variables, that will result in the same outcome for any given non-exhaustive vector of the endogenous variables) and so you don't have a stable Jacobian (or Hessian).

If your model is not bijective, you can't make probabilistic statements about outcomes without doing a massive modelling job that no individual is capable of performing in their head in real time.

But anyhow - back to the main point: pretending that the theory of expectations has not moved since the Lucas critique is both disingenuous and unhelpful.

I'm no fan of TheBenBernank (and I was downright hostile to Greenspan since before Y2K - as David Hale qould attest if he recalled our pre-9/11 resaerch meeting in which I gave him a torrid time when he name-checked Greensplatt: I was the one half-drunk on a half-decent Reisling someone else was paying for). But even prior to that, I advised our (Oz's) treasury on how to model expectations in the financial sector of their macroeconometric model... that was about 20 years after Lucas, and almsot 20 years ago.

Gruen and Gyzicki (sp?) also showed categorically that a small cohort of specifically non-rational agents can survive into the long run if certain conditions are met. (That was a forex paper for the Reserve Bank oif Oz called "Explaining forward discount bias - is it anchoring?")

TL;DR: model-consistent expectations are the best of a bad bunch (but better is quasi-rational expectations of the type Powell, Malakellis, Transom and Marshall (1997) imposed in TRYM in 1997 - a blend of adaptive and 'model consistent' with an imposed transversality condition on the slope of expectations variables upon convergence to a steady state.. and adaptive expectations in goods, factor, and debt markets).


I guess Aziz could not spin an entire column from the phrase "Central banking is based on the idea that money-fooling persists in the long run (or at the very least, long enough for the central bankers' cronies to bank fat stacks, yo").

Pareto's picture

Trying to ascertain the slop of adaptive expectations means that the model captures all the relevant elements that comprise human action that is dynamic and infintiely distinct.  Aggregation is just as much of a problem as trying to model accurate expectations - adaptive or otherwise.  Having said that, it doesn't appear, at least to me, the the FED is even trying to take into account the stuctural and behavioural inadequacies of econometric modeling that Lucas identified 36 years ago.  They are still chasing 6.5 and 2, as if the Philips curve was discovered just yesterday.


The fact is that at the micro level, indifference curves identify infinite utility schedules and preferences that are dynamic and nobody NOBODY is capable of capturing that data to any degree of success of predictability.  At the Buttonwood conference last year, for example, Hugh Hendry actually contends that in all its wisdom of stimulating the economy in the hopes of encouraging investment (cap ex) and spending (consumption), the government is more likely encouraging the precise opposite affect.  This is because people will believe that a tax hike must occur to pay for increasing debt, and that becuase rates have decreased, will likely save more in the present (not less) in anticipation of higher taxes and reduced savings.  On the production side, firms produce more as a result of a volume signal, not price.  Input costs have risen for most everything in production, so, given the relatively inelastic demand for their goods, they raise price and capture the margin.  But, they do not ramp up prpduction because it is not associated with any volume (real demand).  So, don't expect cap. ex to increase any time soon either.


The FED's ZIRP has artifically propped up prices, but, it has not encouraged investment.  Rather it has encouraged firms to eat themselves in an effort to preserve cash.  Without even knowing it human action has responded precisely how we might expect it to respond to price fixing of nominal rates.  Speculation, yes.  Real economic growth, naaa uhhhh.  And an excellent proxy for this decline in real demand is the diminishing volume being exercised in the stock market.


The Wall Street Journal interviewed Lucas a year ago or so.  When asked of Bernake's ZIRP et al., he admitted flatly that he doubts it will do any good and will probably do more harm, for precisely the incentive distortions identified above.  I don't disagree with what you are saying entirely, but, you are giving way too much credit to the FED who, in my opinion, is still stuck in 1957.  It is ironic that Krugman assaults Stockman on antiquated thinking when it is Krugman that is still pushing theoretical constructs that have largely been shelved by economists since Lucas.  Our discipline is increasingly losing its relevance.   

Pareto's picture

Addendum:  And when I read the comments below of all the other ZH'ers I realize just how many distinct measures of rationality there can be with no one perspective being any more or less significant as a rational response than any other.

Ghordius's picture

excellent remark worth repeating: "The FED's ZIRP has artifically propped up prices, but, it has not encouraged investment.  Rather it has encouraged firms to eat themselves in an effort to preserve cash.  Without even knowing it human action has responded precisely how we might expect it to respond to price fixing of nominal rates.  Speculation, yes.  Real economic growth, naaa uhhhh.  And an excellent proxy for this decline in real demand is the diminishing volume being exercised in the stock market."

Acet's picture

The FED's and other Central Banks' actions are representative of the modern style of management that brought us to the current situation:

- Focus on the first-order, easy to measure effects of an action and ignore the second-order and further effects.

The world is made up of cycles and feedback loops and just the immediate effects (say you punch somebody shouting at you in the face and he goes down) are often far less important that the deeper effects (the guy you just punched is your boss, so you get fired. You can't find a job and your family suffers. Your marriage breaks up from the strain. You fall all the way down and end up a bum, living on the streets).

Yet, high-level modern management is almost entirelly filled with tacticians rather than strategists. They're great at ralying the troops to take a single hill, crap at spotting how taking that hill will pin-down a significant portion of the battalion for little strategic advantage.

So you see companies employing the cheapest possible store employees on short-term contracts (rather than expert, long term employees with a commitment to the company) and then being "surprised" that people stop going to stores and just buy things over the Internet or you see them outsourcing customer support to countries where people barelly speak English and be "surprised" that customer's opinion of the company's support goes down.

You also see governments get into wars in far away places to "liberate" a people and then be "surprised" that they don't embrace the foreign "liberators" with open arms.


I'm afraid we live in the Age of Stupid, Superficial & Fickle and unless our societies change at a deeper level, we're condemned to fall.

GottaBKiddn's picture


The only thing that Benny the Liar is hoping is that patriots don't string him up like Saddam. He knows exactly what he's doing, and that is exactly  what he was hired to do, impoverish the masses and create total economic chaos. The elite are planning to pick up the pieces and enslave and destroy everyone who tries to get in the way. Hope has nothing to do with it.

unirealist's picture

Unfortunately, of that 75% who believe another financial crisis is coming, only 1% have don anything to prepare for it.

Maybe the rational expectation of the 75% is that the crisis will be so catastrophic that no preparation will help.

If the crisis causes a few more Fukushimas around the globe, I'm going to be pissed I spent resources on preparations instead of Cuervo and chicks.

q99x2's picture

Something is going on with BITCOIN


+40% per day now and acceleration increasing.



Keiser's latest guest says $790,000 per BitCoin within a year.

Non Passaran's picture

Maybe the Fed dispatched their FreedomKill task force to Bubble and Destroy bitcoin...

DavidC's picture

"..but only a minority of people own stocks directly and unemployed and underemployed people generally can’t afford to invest in the stock market or financial markets".

Quite. And when al he's doing is fueling inflation, which hurts everyone who needs to buy food and fuel, and making it harder for anyone on a fixed income, he's actually making the problem WORSE, not better.


Sandmann's picture

Max Frisch wrote a play: Biedermann und Die Brandstifter  - known in American as The Fireraisers


It describes perfectly what happens when Middle of the Road People let Extremists loose....and how they cannot act otherwise than as they do, viz. Scorpion and The Frog.

Americans let Hank Paulson set them up with TARP - the Goldman Sachs Welfare Fund and so it goes on.


Debt Slave's picture

Americans let Hank Paulson set them up with TARP - the Goldman Sachs Welfare Fund and so it goes on.

Short sightedness my friend. Recall late September and early October of 2008, when the calls into Congress running 9x% against TARP. Congress voted NO and the stock market dove a couple hundred points. A couple of weeks later, when people were aghast at their 401(K)s, the calls reversed in favor and Congress voted again this time in the affirmative. TARP passed and the market tanked by early 2009 anyway.

The people got what they thought they wanted. Goldman got what they needed. If it is one thing our rulers know how to do, it is how to herd and corral the sheep for regular fleecings.

Downtoolong's picture

Imagine twenty homeless eTrade babies demanding food stamps on Ben’s doorstep one morning, abandoned by their parents for losing the last of the family nest egg in the stock market.

I bet Ben didn’t expect that either.

Bicycle Repairman's picture

eTrade baby got his EBT app.  he all set.

Bicycle Repairman's picture

"The stock market is soaring, but only a minority of people own stocks directly and unemployed and underemployed people generally can’t afford to invest in the stock market or financial markets. So a recovery based around reinflating the S&P500, Russell 3000 and DJIA indices doesn’t cut it when it comes to instilling confidence in the wider population."

Keep in mind that wage income is in fact much more reliable than stock market income.  The two collapses of the stock market in the 2000s also make stock owners far more risk adverse than the same people were in the 1990s, and less likely to spend their "stock market" wealth "nilly willy".  Same for real estate.  The bubble in confidence has popped.  Irretrievably.

Therefore, the idea of using the stock market or real estate market to create a "wealth effect" and revitalize the economy is doomed to dismal failure.

Bicycle Repairman's picture

However the beatings will continue until confidence returns.

andrewp111's picture

Anyone who sees what is happening in Europe has to have rational expectations of another financial crisis. Especially after the Cyprus debacle where the EU proved that it is run by circus clowns.