The present state of economics is one of rational expectations.The New Classical economists developed the rational expectations hypothesis to demonstrate the uselessness and even harm of governmental interference with market process.Old classical economists believed that ,if wages and prices were completely flexible, there could be no persistent unemployment.They accepted the ignorance about future events and could justify government intervention to provide employment. The new classical economist(beloved by conservatives) abolishes this assumption because they state that wages and prices will adjust instantaneously to new conditions because the conditions will have been anticipated and incorporated in the prices which people charge and expect to pay for services.According to the new classical economists,Greenspan's "underpricing of risk worldwide" is impossible. Moreover,because people are always at their preferred position,government efforts to improve their position will be ineffective.Unwanted unemployment is banished and is a voluntary choice of leisure(tell that to the unofficial 20% that are unemployed today).Government should get out of the business of second-guessing private preferences.
The rational expectations hypothesis was built on a sophisticated intellectual structure whose starting point is the existence and precise knowledge of future events.This is derived from all the information available about both past and present circumstances and that it implies economic actors will not make the systematic mistakes in predicting the future.This rules out the possibility of large crises(Great Recession) except as a result of surprises(bad formulas that didn't take into account of harmful debt to asset ratios or inflated assets).
The REH economists follows a model of economy that behaves in a predictable way.The model assures that the universe exhibits stability over time and that the future can be inferred from the past and the present.The important policy implication of this belief is not just that stimulus policies will fail to stimulate,but they would lead to inferior outcomes.New Keynesian's accept REH but also admit the existence of "frictions"(lack of new investment) which impede almost instantaneous adjustments to new conditions. This allows allows them to advocate government interventions to improve outcomes.The crucial assumption of REH is not perfect competition,but perfect information. Had the Soviets been able to concentrate information as markets do now,there would have been no technical reason why its choices should not have been perfectly rational in a way postulated by REH. A single Platonic guardian would make no mistakes.
New Keynesian economists believe that the outcome at any future date is a statistical shadow of past and present market prices.Some believe a financial system which transforms investment into speculation will eventually be followed by a collapse.At times when the markets are faced with significant changes(Black Swans),economic models cease to work.Typically,these are times when herd behavior is most obvious.New Keynesian's understand the snares of statistics(bell curve)and human behavior as factors to monitor.
The policy regime which followed the Reagan-Thatcher revolution reflected to a large extent the ideas of the New Classical economists.Consumer price stability became the main,and often only,goal of macroeconomics policy and monetary policy was considered sufficient by itself to ensure stability.Concern with credit, banking,asset price,and financial stability was downgraded.Efficient market theory also lay behind the extensive deregulation of the last twenty years:repeal of the Glass-Steagall Act,the acceptance of bank self-assessment of risks,the failure to regulate the market for derivatives(all positions the Republicans and many Democrats still support).
More from "Keynes-Return of the Master" by Robert Skidelsky coming in the future.
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