In spite of an intense academic activity over previous decades, the current crisis suggests that economic theory has failed to provide an appropriate global understanding of the recent events. Two key assumptions underlying most existing theories have been rightly questioned.
One group of critics has proposed that agents in financial markets are less rational than has been assumed in most economists’ models. Departures from the standard paradigm of rationality constitute the substance of what has come to be known as behavioural economics. Integrating behavioural economics into finance is clearly a promising avenue for research.
A second group of critics questions the “rationality of expectations”. The Rational Expectations Hypothesis (REH) assumes that economic agents have an unbiased, statistically correct, view of the future. REH is not a consequence of the classic Rationality Hypothesis, nor is the standard Rationality Hypothesis a necessary ingredient of models fitting REH (Non-expected utility maximizers may be given rational expectations). Hence this second axis is conceptually distinct and broadly independent of the first one.
The project presented here focuses on the critique of REH, a critique which applies to many areas of analysis, notably the study of financial markets and the study of macroeconomics. Indeed, most theories in finance, as well as in macroeconomics, have tended to adopt REH axiomatically. We believe that REH, in its standard version, is a key ingredient of the excessive optimism that economic theory currently conveys regarding the working of the financial system. This excessive optimism has fuelled the excessive confidence in the self regulating capabilities of the system, which, as is now argued by many, is at the heart of its recent failures.