Subjectivism and Economic Analysis: Essays in memory of Ludwig ...

THE SUBJECTIVISM OF ACTIVE MINDSactions of economic actors. This is a kind of test. If your modelrequires that we imagine agents acting on unreasonable psychologicalexpectations, the model is unreasonable. If the psychologicalexpectations at work are reasonable, the model passes the test.Dispositional and psychological expectations are distinct objects.On narrow logical grounds, any combination of them is possible.But it seems reasonable to suppose the two typically fit together. Atheory of dispositional expectations without a correlated theory ofpsychological expectations is tenuous. We may wonder if anyplausible psychological expectations could correlate with theposited dispositions. Rational expectations, for example, are anassumption about dispositional expectations. Traders act as if theyhad, on average, the true model in mind. The assumption isreasonable under some circumstances. But rational expectations arenot reasonable assumptions when the implied psychologicalexpectations entail, say, superhuman powers of calculation.A theory of psychological expectations without a correlatedtheory of dispositional expectations is also dubious, and for aparallel reason. Without the latter we cannot be sure the positedpsychological expectations would really come to prevail.Expectations are, as Lachmann insisted, endogenous to the marketprocess. If we do not correlate our understanding of psychologicalexpectations with a story of the emergence of dispositionalexpectations, we have to doubt that the imagined psychologicalexpectations would really survive the test of market competition.An example may clarify some of these issues. Consider theoperation of a modern asset market. Traders must anticipate futurevalues at least passably well if they are not to be forced out of thegame by losses. Profits will encourage those with unusually goodforesight to keep at it. An evolutionary selection mechanism worksto keep anticipation more or less in line with underlying values asrevealed by future returns. If the market filter of profits and lossworks well, prices will reflect fundamental values. If the filter worksbadly, prices may wander freely from fundamental values. Whetherthe filter works well or not is an empirical question.Efficient market theories predict that market prices will reflect allavailable information. An important implication of such theories(together with a few subsidiary assumptions) is that the pastchanges in an asset’s return give no evidence about future changes.In consequence the expected value of an asset’s return in any periodis simply its return in the previous period. This property of thereturn series defines a ‘martingale’. (A random walk is a special case75