Are markets rational? an interview with Roman Frydman, whose book with Michael D. Goldberg, Imperfect Knowledge Economics: Exchange Rates and Risk, was recently published by Princeton University Press.

• Position: Interview

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TIE: Your book leads an assault against the rational expectations school of economics. What is wrong with rational expectations?

Frydman: To put it simply, despite its name, Rational Expectations Hypothesis (REH) has nothing to do with rational forecasting.

The basic problem with REH models can be traced back to the widespread belief among contemporary economists that economic models can't be considered scientific unless, except for a purely random error term, they generate exact predictions of outcomes. Obviously, forecasts of asset prices drive outcomes in financial markets. But if we acknowledge this, and yet insist on exact predictions, we must come up with an exact model of how market participants think about the future. That's a tall order. And REH goes even further. It supposes that market participants forecast according to the exact model that economist themselves create.

This is even odder than it sounds. After all, economists' bread and butter is the search for alternative models. But if a particular economist's model were to capture rational forecasting, the use of other models would be irrational,

Interestingly, John Muth, who proposed REH in the early 1960s, was well aware of the danger that the term "rational expectations" might suggest some notion of individual rationality. But, despite his warning, REH is commonly viewed as the way to model rational forecasting. As such, REH is not just of academic interest. It is widely used as the centerpiece of sophisticated models to price derivative products and risk in financial markets.

TIE: So is not the failure of sophisticated finance models the telltale that RICH is seriously flawed?

Frydman: Spot on. We should have expected REH models to fail in financial markets. After all, outcomes in these markets are primarily driven by forecasts, and REH is a particularly poor forecasting model. Many of our colleagues cite REH models' failures as evidence that markets are populated by irrational traders. In fact, rational individuals in real-world markets do not follow pre-existing rules and procedures, let alone exact forecasting rules implied by economists' models. So the failures of REH models do not prove that markets are irrational. They simply show that economists have a wrong model of rationality. Neither REH models nor, for that matter, any other quantitative model, can capture exactly how profit-seeking market participants forecast the future.

TIE: You argue...