Not so Great Expectations

Economists are sticking to old ideas about our behaviour but is it time to ask them for some more?

Economics has grown in popularity as people try to make sense of the troubles in the economy.  At the same time, what is taught as economics is being challenged after economics provided little help in predicting the global financial crisis or dealing with its aftermath.  Your Neighbourhood Economist has a particular issue with the common view among economists about how people think about changes in prices and interest rates.  This way of thinking has pushed monetary policy in the wrong direction as economists rely on theory which is increasingly being shown to be detached from reality.

The above position is based on the concept of rational expectations where people’s predictions of the future are built into economics models.  This first came to prominence during the 1970s where persistent inflation was a problem - high inflation had resulted in demands for higher wages which pushed up the costs of businesses and thereby led to businesses charging even higher prices.  The notion of expectations enabled economists to explain the reasons behind rising wages.  Since then, inflation has been tamed through new policies which make price stability the main focus of central banks under the rationale that people will not expect inflation to get out of hand if the central banks are on the case.

Central banks have been successful in handling inflation but other problems such as reigning in financial crises and dealing with the aftermaths of such have proved harder to manage.  Economists have been using the same tools through forward guidance which aims to boost lending by instilling expectations that interest rates will stay low for an extended period of time.  At the same time, measures to restore the economy have been restricted by concerns about the possibility of triggering a surge of inflation if central banks are seen to be less vigilant.  Surveys of people’s perceptions of inflation are now commonplace and followed by inflation-fearing economists almost as anxiously as politicians track polls on their popularity.

Yet times have changed.  Inflation is no longer such a big deal - globalization has resulted in increased competition which keeps down prices and weaker labour unions are unable to impose the industry-wide wages hikes of the past.  The average person on the street is not overly concerned about inflation in comparison to other worries about the economy so our actions are no longer shaped much by changes to prices.  The same is true for deflation - although the faltering economy in Japan is brought out as an example of what can go wrong, it is likely that Japan is an anomaly rather than a model applicable to other countries.  The old ideas on economics have not served us well in getting the global economy up and running again suggesting that economists ought to change their thinking to help deal with the hard times.