Professor's New Book Offers Fresh Way to Think About Markets
By Lori Wright, Media Relations
October 31, 2007
Michael Goldberg, associate professor of economics at WSBE, has co-authored
a new book that offers a fresh way to think about markets and represents a
potential turning point in economics.
Posing a major challenge to economic orthodoxy, “Imperfect Knowledge
Economics” asserts that exact models of purposeful human behavior are
beyond the reach of economic analysis. Goldberg and co-author Roman Frydman,
professor of economics at New York University, argue that the longstanding
empirical failures of conventional economic models stem from their futile efforts
to make exact predictions about the consequences of rational, self-interested
behavior. Such predictions disregard the importance of individual creativity
and unforeseeable sociopolitical change, thus usually failing to predict how
“Economists mistakenly believe that they have found the way to specify
how ‘rational’ individuals are supposed to behave. As a result,
the failure of their models to explain fluctuations in asset markets leads
them to conclude that participants in these markets are ‘irrational’ and
that fundamentals such as interest rates and income growth, do not matter.
But Roman and I argue in our book that there is a much more plausible interpretation:
conventional economic models are just the wrong theory of how rational individuals
behave and how fundamentals matter,” Goldberg said.
Drawing attention to the inherent limits of economists' knowledge, the authors
introduce a new approach to economic analysis: Imperfect Knowledge Economics
(IKE). IKE rejects exact quantitative predictions of individual decisions and
market outcomes in favor of mathematical models that generate only qualitative
predictions of economic change. Using the foreign exchange market as a testing
ground for IKE, the book sheds new light on exchange-rate and risk-premium
movements, which have confounded conventional models for decades. Once one
abandons the mechanistic models of contemporary economics in favor of IKE models,
one begins to see that macroeconomic fundamentals do matter for exchange rate
movements, but in ways that cannot be fully foreseen.
Edmund Phelps, winner of the 2006 Nobel Prize in economics, calls the book
marvelous and says it offers "invaluable insights of the 'early modern'
theory of capitalism that were lost when the profession endorsed rational expectations
equilibrium. Happily for me and, I believe, for the profession of economics,
this deeply original and important book gives signs of bringing us back on
track -- on a road toward an economics possessing a genuine microfoundation
and at the same time a capacity to illuminate some of the many aspects of the
modern economy that the rational expectations approach cannot by its nature
Kenneth J. Arrow, Nobel Prize-winning economist, comments that “Frydman
and Goldberg open new doors by a more realistic understanding of the process
of forming expectations; by recognizing that universal rules are intrinsically
impossible, they exhibit a more creative understanding of the recent history
of foreign exchange spot and futures markets."