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This introductory paper offers a look into the intellectual and technical progress that led Robert E. Lucas to his seminal paper entitled Expectations and the neutrality of money. It is argued that...

This article argues that the field of asset pricing theory is undergoing a scientific revolution in Kuhnian terms. The orthodox view is one of determinate change in causal processes and inherent stability whereby financial markets, left unfettered, allocate nearly perfectly society's scare capital. However, decades of mounting anomalous evidence against the implications of stable causal processes perpetuated by conventional models based on efficient markets and the rational expectations hypothesis have paved the way for alternative avenues of research. Although various approaches are being developed, the imperfect knowledge economics (IKE) class of models has emerged as a potential new paradigm in the field of macro-finance. By stopping short of fixing in advance the specification of individual forecasting behavior and the causal process, the IKE class of models has been able to reconcile many of the puzzles found within the literature on asset price behavior and risk.

That the rationality of individual people is ‘bounded’ – that is, finite in scope and representational reach, and constrained by the opportunity cost of time – cannot reasonably be controversial as an empirical matter. In this context, the paper addresses the question as to why, if economics is an empirical science, economists introduce bounds on the rationality of agents in their models only grudgingly and partially. The answer defended in the paper is that most economists are interested primarily in markets and only secondarily in the dynamics of individual decisions – specifically, they are interested in these dynamics mainly insofar as they might systematically influence the most useful approaches to modeling interesting markets. In market contexts, bounds on rationality are typically generated by institutional and informational properties specific to the market in question, which arise and are sustained by structural dynamics that do not originate in or reduce to individuals' decisions or psychologic...

Soros' theory of reflexivity is meant to apply to a variety of social processes. In economics, it implies that many processes will be subject to “boom-bust” patterns in which expected outcomes deviate for a considerable time from the actual path, and that the actual path in turn deviates from the underlying fundamentals. This is in sharp contrast to the reigning notions in orthodox economics. The hypothesis of Rational Expectations (RE) requires that the views of all participants will converge to a “single set correct of expectations” and the Efficient Market Hypothesis (EMH) posits that actual outcomes deviate from equilibrium in a random manner save for occasional exogenous shocks. In this paper I show that Soros' argument is similar to the classical and Keynesian notions of equilibration as a turbulent process in which actual and expected variables gravitate around some fundamental value. But Soros makes the important further contribution of emphasizing that the fundamental value itself will generally ...

George Soros makes an important analytical contribution to understanding the concept of reflexivity in social science by explaining reflexivity in terms of how his cognitive and manipulative causal functions are connected to one another by a pair of feedback loops (Soros, 2013). Fallibility, reflexivity and the human uncertainty principle. Here I put aside the issue of how the natural sciences and social sciences are related, an issue he discusses, and focus on how his thinking applies in economics. I argue that standard economics assumes a ‘classical’ view of the world in which knowledge and action are independent, but that we live in a complex reflexive world in which knowledge and action are interdependent. I argue that Soros's view provides a reflexivity critique of the efficient market hypothesis seen as depending on untenable claims about the nature of random phenomena and the nature of economic agents. Regarding the former, I develop this critique in terms of Cauchy distributions; regarding the lat...

The failure of models based on rational expectations to explain the “boom and bust” of financial markets does not support Soros’ critique of mainstream economics or his call for a theoretical revolution. Contrary to what Soros says, standard rational choice theory has the conceptual resources to analyse reflexivity. The dynamic of feedback loops for example can be described by simple models based on multiple equilibria and informational cascades. The problem is that agents and theorists sometimes lack the information required to identify equilibria and tipping points.

Nature does not care … whether we penetrate her secrets and establish successful theories about her workings and apply these theories successfully in predictions. In the social sciences, the matter is more complicated and in the following fact lies one of the fundamental differences between these two types of theories: the kind of economic theory that is known to the participant in the economy has an effect on the economy … There is thus a “backcoupling” or “feedback” between the theory and the object of the theory, an interrelation which is definitely lacking in the natural sciences … In this area are great methodological problems worthy of careful analysis.” (Oskar Morgenstern, 1972, p. 707).

This paper argues that contemporary macroeconomic and finance models suffer from insuperable epistemological flaws and that their empirical difficulties – which are particularly apparent in modeling market participants' expectations – can be traced to economists' core premise that they can adequately specify in probabilistic terms how individuals alter the way they make decisions and how the processes underpinning market outcomes unfold over time. We refer to such accounts of change as determinate. The first part examines how this core premise has derailed the development of macroeconomic analysis for the last four decades. The second part sketches how imperfect knowledge economics (IKE) jettisons conventional models' core premise and how doing so helps to overcome these models' epistemological flaws. By opening economic models to change, that is, at least in part, indeterminate, and by recognizing imperfect knowledge on the part of economists, IKE explores the frontier of what empirically relevant mathem...

Coleman (1990) describes ‘calculative trust’. He states that, in order to trust, the value of trust has to be larger than the value of mistrust. So if subjects have (not personally but on average) rational expectations about the trustworthiness of their transaction partners, we should expect the frequency of trust to increase with the average net profitability of trust. In a meta‐study of trust experiments, Coleman's Hypothesis could not be confirmed while, in our own experiment with a wider parameter range, it is supported. We explain this finding by the parameter choices of experimenters. They choose pay‐off parameters resulting in situations where decisions are ‘difficult’, i.e. to make the alternatives ‘trusting’ and ‘non‐trusting’ seem equally profitable. Thus, such experiments are concentrated on a specific subspace of parameters and are inadequate for certain meta‐studies.

Commonsense rational choice explanations exploit a form of intentional causation, an idealized version of which underpins the formal rational modelling of modern economic theory. Following John Searle, it is argued that the deliberations and activities of economic actors do not bottom out in intentional states, but in various nonintentional or 'Background' capacities and dispositions. It is shown why the formal version of rational choice theory employed in economics does not have the resources to address such capacities and dispositions, and that the prevailing commitment to this theory thereby reinforces their neglect. Examples are given of the impact of Background phenomena in the economic realm.

In order to vindicate rational-choice theory as a mode of explaining social patterns in general - social patterns beyond the narrow range of economic behavi- our - we have to recognize the legitimacy of explaining the resilience of certain patterns of behaviour: that is, explaining, not necessarily why they emerged or have been sustained, but why they are robust and reliable. And once we allow the legiti- macy of explaining resilience, then we can see how functionalist theory may also serve us well in social science; we lose the basis - the empty black box ar gument - on which the rational-choice critique of the theory has mostly been grounded.

There are at least two elements of theory completion necessary for measurement: (1) a measurement formula and (2) standardization of that representation. Standardization is based on the search for stability. The more stable the correlation which the measurement formula represents is, the less influence other circumstances have. Then, the interconnection between testing, mathematical representation and standardization is of a hierarchical order. By testing a model one tries to find out to what extent the model covers the data of the phenomenon, while to be a candidate for a measurement formula the model must represent the whole data range. And among the possible representations the standard model represents the most stable correlation under different circumstances. Lucas' model of the Phillips curve has been used to investigate this interconnection between testing, representation and stability.

This paper illustrates the interplay between theory development and data analysis by considering the ability of the rational expectations hypothesis to explain the empirical cointegration structure found in the term structure. It finds that although a standard no-arbitrage theory that incorporates rational expectations can explain some of the properties of Treasury Bill yields, this theoretical explanation is incomplete. A broader-based explanation that accounts for government debt and time-varying risk premia can improve predictions of yield movements, relative to those predictions based solely on a bill yield spread.

Influenced by changes in his environment in the early 1980s, Thomas Sargent tried to serve his interest in finding conceptual integrity of theory and method by using rational expectations to link general equilibrium theory and vector autoregressions. Dead ends loomed large on Sargent's horizon when he tried to fit the a priori bias towards symmetry in general equilibrium theory into this framework and when he became aware of the consequences of his initial decisions. In particular, he turned out to be unable to tackle the hurdles of symmetry among analysts and actors, no-trade theorems, information gathering, error term justification, and policy recommendations.

Kevin Hoover (1955–) received a D.Phil. in economics from Oxford University after an undergraduate major in philosophy, and his work reflects this dual competence. He has contributed both to contemporary economics (especially macroeconomics) and to economic methodology, serving for a decade as the editor of The Journal of Economic Methodology . After more than two decades at the University of California, Davis, Hoover is now a professor of economics and a professor of philosophy at Duke University. The Lucas Critique Perhaps the principal challenge to the use of econometric models in economic analysis is the policy non-invariance argument, popularly known as the ‘Lucas critique’. Robert Lucas (1976) attacks the use of econometric models as bases for the evaluation of policy on the grounds that the estimated equations of such models are unlikely to remain invariant to the very changes in policy that the economist seeks to evaluate. The argument is originally cast as an implication of rational expectations. Among the constraints people face are the policy rules of the government. If people are rational, then, when these rules change, and if the change is correctly perceived, they take proper account of the change in adjusting their behavior. The rational expectations hypothesis implies that changes in policy will in fact be correctly perceived up to a serially uncorrelated error.