Foresight, Perfect

BIBLIOGRAPHY

A term of everyday use, foresight, when qualified by perfect, is elevated to a concept of signal importance, certainly for modern economic theory with its proclivity to fixed points, but perhaps also for social sciences more generally. This entry attempts a brief overview.

In his analysis of investment decisions in chapter 12 of The General Theory of Employment, Interest, and Money (1936), John Maynard Keynes (1883–1946) draws attention partly to “existing facts, known more or less for certain” and partly to “future events, forecasted with more or less confidence” (Keynes 1936, p. 147).

The state of long-term expectation does not solely depend on the most probable forecast that we can make. It also depends on the confidence with which we make this forecast—on how highly we rate the likelihood of our best forecast turning out quite wrong.… The state of confidence … is a matter to which practical men always pay the closest and most anxious attention. (p. 148)

Keynes (p. 152) emphasizes that our projections into the future, as well as our assumption that the “existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts” are based on a convention whose essence lies in the assumption of stationarity.

In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention. But it is not surprising that a convention, in an absolute view of things so arbitrary, should have its weak points. (p. 152)

These points are collected under four headings, but with the proviso that “philosophically speaking, [market evaluations] cannot be uniquely correct since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation” (p. 152).

Undoubtedly familiar with the writings of French mathematician and economist Antoine Augustin Cournot (1801–1877), Keynes does not formulate or work with the notions of rational expectations equilibrium or self-fulfilling expectations. (See Merton [1936, 1948] for his historical take on the idea encapsulated in these phrases.) In a Cournot-Nash equilibrium, each individual action, taken on the basis of a judgment about the facts of the situation, a judgment that not only takes the actions and judgments of others into account in ascertaining the facts of the situation as they find and judge it, but also allows their judgments, and consequent potential actions, to incorporate all that it itself takes into account, ends up by generating precisely the shape of the situation it initially took into account. In Keynes’s General Theory, the word foresight is used nine times, perfect appears four times, and imperfect five times, but the two adjectives are never used to qualify the noun. Keynes refers to a correct state of expectation and correct foresight, the latter twice, but in as much a negative, possibly ironic, light as in a positive one. Hindsight, perfect or imperfect, is never employed to subdue and discipline history, as the assumption of perfect foresight is now sometimes used to discipline data and neutralize the future in theoretical thinking current in macroeconomics and associated with Brock (1972, 1974), Lucas, Lucas and Prescott (1971) and their followers. (For issues relating to perception and individual observability, see Chakrabarti and Khan, 1991.)

Nevertheless, Keynes’s chapter 12 is impressive in how it draws on and anticipates the vernacular of modern game theory and finance. (For epistemological concerns stemming from Nash (1951), see Aumann and Brandenburger (1995) and Khan (1990, section 2.)) Referring to investment as a “battle of wits,” and using metaphors for games that are played with “zest and enjoyment” even though the players know what they entail and their sorry end, Keynes introduces game-players and player-types: uninformed versus informed investors “as gulls among the public to feed the maws of the professionals” (Keynes 1936, p. 155), and speculators versus enterprisers. He emphasizes “animal spirits—a spontaneous urge to action rather than inaction [as opposed to an] outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities” (p. 161), a maximization of von Neumann-Morgenstern expected utilities, and flatly denies that the “basis for making such calculations” exists. Anticipating David Lewis (1969) and Robert Aumann (1976), but stopping short of them and of infinite regress (see Parikh and Krasucki (1990) and their references to the work of Geanakoplos-Polemarchakis, Cave and Bacaharach), Keynes writes:

We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some I believe who practice the fourth, fifth and higher degrees. (1936, p. 156)

Once the investment decision is reviewed as part of an anonymous multiplicity of decentralized decisions taken by producers and consumers, independent of each other except for their dependence on the price system, as in the Arrow-Debreu-McKenzie theory, the facts of the situation refer only to the price system. (Debreu (1959), Nikaido (1968), Arrow and Hahn (1971) and McKenzie (2002) represent the loci classicus of a theory to which many others have made fundamental contributions. See Khan (2004) for a reading of Debreu through the eyes of Keynes and his Cambridge predecessors and successors, including Frank Hahn.) If however, there are facts that are not, perhaps cannot be, “priced out,” and agents have differential informational access to these facts but not to each other, then the price system can be used by each to gauge the information and beliefs of the others, and to refine their decisions accordingly. (Hayek (1948) is now a classic reference on differential information.) Such a context is particularly amenable to attempts at equilibrium theorizing. James Jordan and Roy Radner refer to agents’ individual models, endow these models with a measure of rationality, and introduce the 1982 Journal of Economic Theory symposium with these words:

In a market for commodities whose future utility is uncertain, the equilibrium prices will reflect the information and beliefs that the traders bring to the market, as well as their tastes and endowments. The term rational expectations equilibrium is applied to a model of market equilibrium that takes account of this potential informational feedback. (Jordan and Radner 1982, p. 201)

A situation in which agents have identical information regarding an uncertain environment, Keynes’s convention becomes the theoretical reality, and an equilibrium that features a “correct” price-expectation function can be formulated. Under the heading of a perfect foresight approach, Radner (1982) refers to this as Muth’s (1961) idea of rational expectations, and distinguishes it from the one originally formulated, in 1967 and subsequently, to deal with differential information (see also Jordan and Radner 1982, para. 6, and Sent 1998).

Margaret Bray (1987) focuses on the perfect foresight hypothesis in what Radner describes as Muth’s sense. In addition to following Radner in designating John Hicks (1939) as another precursor, Bray also discusses the early work of Nicholas Kaldor (1934). Her conclusion that “there is little to be gained in realism by exchanging the myth of complete markets for the fantasy of perfect foresight” (Bray 1987, p. 834) surely stands twenty years later; I leave it to the reader, and to a more detailed subsequent investigation, to determine how much the hypothesis has gained for the theory and for the understanding of competitive markets, themselves nothing if not intertemporal. (See Aumann (1998) and his references for issues centered on temporality.)

SEE ALSO Arrow-Debreu Model; Beauty Contest Metaphor; Competition, Perfect; Expectations; Expectations, Implicit; Expectations, Rational; Game Theory; Hicks, John R.; Nash Equilibrium

BIBLIOGRAPHY

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Sent, Esther-Mirjam. 1998. The Evolving Rationality of Rational Expectations. Cambridge, U. K.: Cambridge University Press.

M. Ali Khan