But instead of seeking laws capable of being falsified through testing, economics has increasingly turned itself into an axiomatic discipline consisting of assumptions and mathematical deductions – similar to Euclidean geometry.
Rational expectations theory and the efficient market hypothesis are products of this approach. Unfortunately they proved to be unsound. To be useful, the axioms must resemble reality. Euclid’s axioms meet that condition; rational expectations theory does not. It postulates that there is a correct view of the future to which the views of all the participants tend to converge. But the correct view is correct only if it is universally adopted by all the participants — an unlikely prospect. Indeed, if it is unrealistic to expect all participants to subscribe to the theory of rational expectations, it is irrational for any participant to adopt it. Anyhow, rational expectations theory was pretty conclusively falsified by the crash of 2008 which caught most participants and most regulators unawares. The crash of 2008 also falsified the Efficient Market Hypothesis because it was generated by internal developments within the financial markets, not by external shocks, as the hypothesis postulates.
