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Friday, May 07, 2010

Rational expectations

I recently, in another venue, had this exchange with a younger economist:
Other economist (OE): The idea that tenure confers lifetime employment has turned out false across many departments and programs across the country. This story about potential program cuts at UNLV has a choice quote:

Me: I've said for years that tenure makes you slightly harder to fire...but harder to fire than if you don't have tenure. So it has some value. Which is why a lot of studies suggest that tenured faculty members actually work at a discount.

OE: Absolutely. Yet this is the first widespread fiscal crisis for my generation of economists. I think for many if my generation of academics, tenure was perceived as essentially job-for-life type of security where you could only get fired for cause or, theoretically for failing post-tenure review. The past two years have been an eye-opener to the fragility of that thinking.

Me: Financial exigency was always there in the provisions, even if people ignored it. And now, given the condition of many state government budgets (Illinois is about as bad as any, which makes me glad I don't work in a state-supported institution there; Indiana, where I am, is not so bad), financial exigency is alive and kicking.

OE: Of course, but my generation of academics probably dismissed that possibility. Now, not so much.

Me: Ah, irrational expectations...

OE: Well, it is might be irrational but then personal experience means a lot in these things. My grandparents used to sing the praises of annuities and downplayed equity. During my early career, I scoffed at this advice. Now, through our recent experience, I am a bit more sympathetic to that view. Similarly, the idea that financial exigency would be invoked is not something that any of my mentors ever mentioned - is it because it hadn't been invoked even during their careers? Clearly the language is in every faculty handbook for a reason, but I am not sure if I call it irrational if we have never seen a situation in which FE would be invoked on such a wide-spread basis.

I cite this exchange for a reason. Rational expectations theory argues that people form their expectations about the future using all available information. And I have known the other economist, when dealing with macro theoretical issues, to invoke the rational expectations hypothesis. But note that, in this case, we clearly see expectations being formed without taking into account all the available information. (There's literally no way that anyone mentoring graduate students over the past 25 years would not have known about the actual use of financial exigency to revoke tenure. It was not simply a contractual possibility that was never invoked.) And these are expectations, not consistent with rational expectations theory, of someone trained in and conversant with rational expectations theory.

So why sould we think that rational expectations theory provides us with a coherent explanation for decision-making when we know that even those who profess it don't use it? (And, yes, I know that anecdote is not evidence, but sometimes the opportunity is just too good to pass up.)


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