A Disclosure: The Hedged Economist Does NOT Get Advanced Copies.

Nor was I tipped off of the S&P downgrade

From the posting on Friday, September 23, 2011 entitled “Possible and Advisable Aren’t the Same When Borrowing.” The relevant quote is:

“The problem with their logic [of many defenses offered for stimulus] is that back in the 1970’s and 80’s economist had to modify their thinking (and if they wanted to have a chance of getting realistic results from their models, also change their models). Economists know it as a shift from adaptive expectations to rational expectations. Basically, they had to recognize the reality that people are, in aggregate, NOT stupid. Unfortunately residents of a certain city can always find some pretend economist who will ignore developments in economics since the 1980’s and defend the “greater fool” thinking many policy recommendations require.”

Little did I know that on September 24, 2011 the WALL STREET JOURNAL would run an interview with Robert E. Lucas Jr. He is often cited as the father of the rational expectations in economics. The interview is entitled “Chicago Economics on Trial.” The column on the interview is well worth reading, but a few quotes illustrate the reason for the disclosure.

“Rational expectations is the idea that people look ahead and use their smarts to try to anticipate conditions in the future.”
“The solution, which seems obvious, is to assume that people use the information at hand to judge how tomorrow might be similar or different from today. But let's be precise, not falling into the gap between ‘word processor people’ and ‘spreadsheet people,’ as Mr. Lucas puts it. Nothing is assumed: Data are interrogated to see how changes in tax rates and other variables actually influence decisions to work, save and invest.”

With a tip of the hat to rational expectations, let me repeat my words of caution from “Operation Twist, Or Is It the Logic That’s Twisted?” The caution is “The Fed needs to think about investor reactions, not economic theory.” The market dive after the announcement shouldn’t have surprised them.