On Paul Davidson’s Critique of Rational Expectations: Aiming at the Wrong Target Using the Wrong Theoretical Construct for the Wrong Reasons

Abstract

Paul Davidson’s nearly 40 years long critique of Rational Expectations is centered primarily on his claim that the Rational Expectations Hypothesis was built on a foundation that assumed ergodicity. However, the rational expectations hypothesis is not built on the assumption of ergodicity. The concepts of ergodicity and non-ergodicity belong to the Limiting Frequency interpretation of probability. Rational Expectations was supposed to have been built on the Subjective interpretation of probability.

Rational Expectations is built on the claim, originally introduced in 1961 in R. Muth’s Econmetrica article, that the subjective probability distributions, for a given information set, are distributed around a true, correct, objective probability distribution. This assumption is incoherent, inconsistent, incomprehensible, and contradictory because there is no existing theory of probability (Classical, Logical, Propensity, Frequency, Subjective) that allows Subjective probabilities (distributions) to become equal to Objective probabilities (distributions). The only restriction allowed by the subjective theory of probability on the preferences of individual decision makers, which is applicable only at the micro level, is that the probabilities, be they initial or updated, are additive and linear. No other restriction is allowed by the Ramsey-Savage-de Finetti subjective Bayesian theory of probability. Rational expectation advocates, proponents, and practitioners add a very large number of additional restrictions on the subjective preferences of decision makers in order to transform subjective probability into an alleged true, correct, right objective probability (distribution). The fatal Achilles’ Heel of Rational Expectations is that there is no extant probability theory that allows subjective probabilities to be transformed into objective probabilities at the macro level or inter temporally throughout time. Savage made in very clear in 1954 in The Foundations of Statistics (p.16) that such an approach was “utterly preposterous” and “complete nonsense” since, as Bruno de Finetti had pointed out, “(objective) probability does not exist”.

Paul Davidson’s critique completely overlooks the fundamental error committed in all theories of rational expectations, which is that at some point in time, subjective probabilities become objective probabilities. Nelson Goodman pointed out an additional, fundamental problem for the rational expectations approach of how this change can be expected to occur in the future, which was equivalent to his grue-bleen problems, where at some point in the future, empirically, well established green objects all of a sudden become blue or empirically, well established blue objects all of a sudden become green.

Paul Davidson’s critique of rational expectations is completely and fundamentally flawed because Davidson’s “ergodic-nonergodic” duality has absolutely nothing to do with the rational expectations' hypothesis, which is that the subjective probability distributions are distributed around an objective, true distribution for a given information set.

Keywords: Rational Expectations, Objective Probability, Subjective Probability, Muth, Lucas, Sargent, Davidson, Ergodic, Non Ergodic

JEL Classification: B10, B12, B14, B16, B20, B22