In the foreword to Imperfect Knowledge Economics, by Roman Frydman and Michael D. Goldberg, 2007 Nobel laureate Edmund S. Phelps writes,

The authors argue that if we aspire to build models that apply to modern economies–economies whose central functioning is the manufacture of change through their innovative activity and their adoption and mastery of the innovations made available–it is contradictory to adopt the rational expectations postulate that whatever change takes place in the future is already knowable and known in the present…

Keynes saw the rate of return as quite unknown and the demand for investment funds as driven by enterpreneurs’ “animal spirits.” Hayek saw that every participant has little or no knowledge of how the economy works as a whole, contrary to rational expectations; that a participant is apt to ahve only some highly specialized knowledge…such knowledge may permit creative person to conceive some new business strategy or new business product that is not in the air, not already known by all…Keynes and Hayek were right but did not carry the day.

Unfortunately, once I moved from Phelps’ foreword to the actual book, I could not understand it, because of all the fancy equations that are not accompanied by sufficient intuitive explanations (for me). So I cannot really write an informed review. The book jacket has endorsements from Jean-Paul Fitoussi, Ken Rogoff, Kenneth Arrow (another Nobel laureate), and Alan Blinder, any one of whom could understand the book if they were motivated to do so.I have a hard time believing Blinder was motivated to really delve into the guts of the book. Rogoff probably was, because the authors focus a lot on the empirical performance of exchange rate models, where Rogoff did some of the most important research.

Exchange rate markets differ from most markets in that currencies are traded in central locations, so that anyone with any sort of opinion or exposure can participate on pretty much equal terms. So the uncertainty is going to consist of different models of the world. I thought that this sort of situation had been explored by Mordecai Kurz, but I do not see Kurz listed in the list of citations.

Because participants in financial markets cannot be certain which model of the world prevails, I have always thought that the sorts of variance bounds tests pioneered by Shiller are silly. Those are tests that compare the observed variation of fundamentals (dividends in the case of stocks) to the variation in market prices. It seems to me that if you make a small change to your dividend growth forecast, you can get a big change in a stock price. Back in the day, people pooh-poohed my criticism. They said I was just worrying about nonstationarity. I did not understand what they were saying, and I was never convinced that they understood what I was trying to say.

In any event, my view of the world now is that financial intermediaries, including ordinary corporations that raise funds in the capital markets, are not perfectly transparent (contra Modigliani-Miller). So investors have to guess what sorts of risks they are taking. Risk premiums move around as innovations occur and as investors revise their ways of making guesses about the intermediaries. The subprime mortgage kerfluffle is an example of this sort of movement.

So I agree broadly that it is a shame that Keynes’ and Hayek’s notions of uncertainty and imperfect knowledge got trampled under the steamroller of rational expectations. However, the “new” mathematical approach of Imperfect Knowledge Economics does not speak to me.