That is, that we know the range of outcomes that might happen and how the economy works and, insofar as is possible, given uncertainty, that we correctly analyse the available information to weight the probability of those. A famous corollary of this is the efficient markets hypothesis – that it is not possible to systematically ‘beat the market’. The stronger form of the hypothesis posits that market prices fully reflect all available information – that the price reflects the likely future revenue streams. But even if the price does deviate from that fundamental level, it may be rational for investors to remain in the market – as Chuck Prince famously put it, to keep dancing so long as the music is playing. The rewards of the game may be worth the risk of being stuck without a proverbial chair at the end. And even if they are not, sitting on the sidelines may not be a winning career move if promotions and funding flow to those with a reputation for high returns. It may be rational to stay with the herd, as Keynes said “it is better for reputation to fail conventionally”.11 Rational expectations do not mean that the future matches expectations and corrections are avoided – when new information arises, agents react to that. If the information is material for a financial asset, for example a change in Roman property ownership laws in AD 33, the adjustment can be large.
The economic model they have developed – of ‘diagnostic’ expectations – is appealing because it starts from research on how humans form beliefs about the future, and how they act on those. The way in which investors and markets form expectations of the future is clearly an area that merits further research. As I will go on to discuss, it is important to those of us responsible for financial stability to understand what is driving the expectations of the future that underlie risk-taking And what drivers kick in when those expectations meet the future and have to be adjusted. Macroprudential Policy As I said at the outset, I expect the next ‘crisis’ to involve some form of over-valuation of assets, over-extension of credit and losses when this corrects. While infrequent, significant adjustments seem to be a feature of the system. The more important question, in my mind, is whether those adjustments destabilise the financial system and lead to very disruptive economic impacts. Will adjustments lead to ‘great financial crises’ as they did 10 years ago or will the system be able to absorb the adjustment and perhaps even dampen its impact? In the first instance, it does not matter whether expectations are rational and are then significantly adjusted because of ‘news’ or whether they are irrational and extrapolative and get adjusted because reality has caught up. Either way, the costs of financial crises can be minimised and perhaps avoided if the system is resilient to shocks that are possible even though they are very unlikely.