On Rational Expectations and Equilibrium Paths
Via Mark Thoma, I recently came across this post by Paul De Grauwe:
There is a general perception today that the financial crisis came about as a result of inefficiencies in the financial markets and economic actors’ poor understanding of the nature of risks. Yet mainstream macroeconomic models, as exemplified by the dynamic stochastic general equilibrium (DSGE) models, are populated by agents who are maximising their utilities in an intertemporal framework using all available information including the structure of the model... In other words, agents in these models have incredible cognitive abilities. They are able to understand the complexities of the world, and they can figure out the probability distributions of all the shocks that can hit the economy. These are extraordinary assumptions that leave the outside world perplexed about what macroeconomists have been doing during the last decades.
De Grauwe goes on to argue that rational expectations models are "intellectual heirs of central planning" and makes a case for a "bottom-up" or agent-based approach to macroeconomics.
The rational expectations hypothesis is actually even more demanding than De Grauwe's post suggests, since it is an equilibrium assumption rather than just a behavioral hypothesis. It therefore requires not only that agents have "incredible cognitive abilities" but also that this fact is common knowledge among them, and that they are able to coordinate their behavior in order to jointly traverse an equilibrium path. This point has been made many times; for a particularly clear statement of it see the chapter by Mario Henrique Simonsen in The Economy as an Evolving Complex System.
Equilibrium analysis can be very useful in economics provided that the conclusions derived from it are robust to minor changes in specification. In order for this to be the case, it is important that equilibrium paths are stable with respect to plausible disequilibrium dynamics. As Richard Goodwin once said, an unstable equilibrium is "the one place the system will never be found." But while equilibrium dynamics are commonplace in economics now, the stability of equilibrium paths with respect to disequilibrium dynamics is seldom considered worth exploring.