Keynes on rational expectations

[Ted Winslow <winslow@xxxxxxxx>]

Paul writes:

>And that's the  kicker that makes it fundamentally logically incomatible
>with nonergodic Keyneian models where rational expectations are impossible
>by definition!!

In an earlier reply to James Juniper and Ric Holt, Paul wrote:

>In fact, of course, James Juniper's noise-trading argument where a smart
>elite "takes advantage of the ignorance, stupidity and herd behavior of
>others" indicates that he interprets Ric's argument as suggesting that the
>"intellectual elite somehow can possess "rational" expectations that the
>other common mortals can not!  That is, I hope, not what Ric meant at all.
>In fact that is exactly what New Keynesians believe when they discuss
>asymmetric information -- and politicians call for transparency to settle
>financial market turmoil (better term than volatility Trond!). Those on the
>plus side of the information asymmetry are conceived to be smart enough to
>extract the economic fundamentals (sorry Barkley!) that predetermine future
>outcomes.
>
>In a forthcoming article in the JPKE, Diane Zannoni and Ed McKenna set the
>record straight. It is not because the meritocracy have more - near
>rational expectations in an asymmetric world than the rest of us dullards.
>What the meritocracy knows is that the system can have very disastrous
>economic episodes -- and so, As Zannoni and McKenna correctly argue, they
>attempt to develop social institutions to prevent these catastrophes and if
>these catastrophe's occur develop institutions to buffer society from the
>effects.

Keynes explicitly claims, as in the passages from the TOM and the GT that I
quoted before, that rational "speculation" in the sense of rational
forecasting of "the psychology of the market" is possible.

His own final version of the best way to implement this as an investment
policy assumes it is possible to find stocks whose "intrinsic values" are
"enormously in excess of the market price."

"One is doing a fundamentally sound thing, that is to say, backing
intrinsic values, enormously in excess of the market price, which at some
utterly unpredictable date will in due course bring the ship home." CW XII,
p. 77

	"Credit cycling means in practice selling market leaders on a
falling market and buying them on a rising one and, after allowing for
expenses and loss of interest, it needs phenomenal skill to make much out
of it.
	"My alternative policy undoubtedly assumes the ability to pick
specialities which have, on the average, prospects of rising enormously
more than an index of market leaders.  The discovery which I consider that
I have made in the course of experience is that it is altogether
unexpectedly easy to do this, and that the proportion of stunners amongst
one's ultra favourites is quite small.  Moreover, this practice does, in my
opinion, in fact enable one to take at least as good an advantage of
fluctuations as credit cycling, though in a rather different way.  It is
largely the fluctuations which throw up the bargains and the uncertainty
due to fluctuations which prevents other people from taking advantage of
them." CW XII, p. 100

	"One can put the distinction like this: By credit cycling I mean
buying and selling according as you think shares cheap in relation to
_money_.  By my alternative I mean acting according as you think them cheap
in relation to _other shares_, with particular reference to the
possibilities of large relative appreciation; - which means buying them on
their intrinsic value when, for one reason or another, they are
unfashionable or appear very vulnerable on a short view.  One may be, and
no doubt is, inclined to be too slow to sell one's pets after they have had
most of their rise.  But looking back I don't blame myself much on this
score; - it would have been easy to lose a great deal more by selling them
too soon." CW XII, p. 101

What is involved here is not asymmetric information and forecasting "the
economic fundamentals that predetermine future outcomes."  What is involved
is rational understanding and prediction of irrational mass psychology.
Intrinsic values are those to which mass psychology will return the price
of the stock in the future in response to some presently predictable change
in "the news or in the atmosphere."  Rational speculation involves "the
anticipation of impending changes, in the news or in the atmosphere, of the
kind by which experience shows that the mass psychology of the market is
most influenced." CW VII, p. 155

What is meant here is made clear in the following passage written in 1940:

"Very few American investors buy any stock for the sake of something which
is going to happen more than six months hence, even though its probability
is exceedingly high; and it is out of taking advantage of this
psychological peculiarity of theirs that most money is made." CW XII, p. 78

The rational expectations involved in rational speculation are short run
expectations.  Keynes's claim that such rational forecasting is possible
does not contradict his claim that the long run is radically uncertain and
incapable, for this reason, of being rationally forecast.

Ted


Ted Winslow                          E-MAIL: WINSLOW@xxxxxxxx
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