The Overlooked Importance of Benjamin Friedman’s Original, 1979 Critique of the Foundations of Rational Expectations Supplied by Lucas and Sargent: The Fallacy of Long Runism (Conditional a Priorism)

Abstract

Lucas, Sargent, and all other proponents, advocates, users and supports of the Rational Expectations Hypothesis have overlooked the fact that their claim that decision makers can learn about and apply in the short run knowledge of the long run convergence properties of objective frequency probability distributions, as the number of observations in the series approaches infinity, is problematic. The argument, that they can learn, grasp and apply such long run knowledge and apply it in any short-run period of time, is called the fallacy of long runism (conditional apriorism). Nicholas Rescher demonstrated this repeatedly in work published in the mid to late 1970s. This error was originally made by Charles Sanders Pierce and Hans Reichenbach in their theoretical frequentist approaches to probability.

Benjamin Friedman noticed the dependence of the Lucas–Sargent( 1979) claim, that decision-makers can come to know the long run convergence properties of the mechanism that is generating the long run series of observations, knowledge of which can only be learned in the distant, very long run as the limit is approached as the number of observations approaches infinity, about the applicability of the rational expectations hypothesis. Lucas-Sargent sidestepped this criticism by claiming that they could use the Bayesian, Subjective theory of probability as their foundation instead. However, in the early 2000’s, Anderson, Hansen, and Sargent (2003) and Hansen and Sargent (2011) stated that they could not use the subjective theory of probability as the foundation for the Rational Expectations Hypothesis because a large number of restrictions imposed by the rational expectations hypothesis conflicted directly with the theory of subjective probability as developed by L J Savage in 1954. Anderson, Hansen, and Sargent (2003) and Hansen and Sargent (2011) reverted to the claim that the foundation of the Rational Expectations Hypothesis was objective frequentist probability theory. However, they simply repeat the original position published in 1979 by Lucas and Sargent. Benjamin Friedman’s original critique of rational expectations in 1979 is applicable again.

The failure of any user, proponent or advocate of the rational expectations hypothesis to demonstrate the forecasting superiority of the rational expectation’s hypothesis over other approaches, through the use of proper scoring rules in the nearly 60 years that have passed since the publication of Muth’s original exposition of the rational expectation’s hypothesis, calls into question the claims made by Lucas and Sargent in 1979 about rational expectations.

It is difficult to find a specific theory of probability upon which proponents, advocates, user, or supporters of the rational expectations hypothesis in the literature agree is to be used to support their claims. Currently, the combined use of both subjective and objective theories of probability, which often occurs many times simultaneously in the same literature, fails to recognize that there are no objective theories of probability that recognize any role for subjective probability, and no subjective theories of probability that recognize any role for objective probability. This is most clearly specified by B. de Finetti by his famous saying that “Probability(objective) does not exist.”

Rational expectationists have apparently now realized that the subjective theory of probability can’t serve as a foundation for rational expectations. They originally sought to use objective frequentist probability for their foundation until challenged by B. Friedman in 1979. They have now gone back to this foundation but have failed to deal with the objections that were originally leveled in 1979.