2013-07-15

Irrational Expectations

I.
So, to sum up, if you want a looser monetary policy you need to do three things: 
1. Increase outside inflationistas. 
2. Decrease inside inflationistas. 
3. Increase expectations of outside minus inside inflationistas by going round yelling "Everyone except the Fed knows the Fed is going to create a lot of inflation, but those crazy fools at the Fed don't get it and never will! So spend your money now, while it's still worth something!
Or, if you wanted to be boring, you might try to persuade the central bank to adopt an NGDP path target.
In short, Rowe and many other people believe that the key to economic growth is the widespread expectation that it will be so. In my mind, I am trying to determine how this jives with what my economics professors taught me about the business cycle. They said that growth happens when output exceeds expectations, while recessions occur when expectations exceed output.

This seems to suggest that in a Nick Rowe world, growth will not occur until the economy reflects the conditions of what Rational Expectations theory suggests would produce a recession. Both of these statements cannot be correct (although it's possible that neither is).

Perhaps part of my objection to NGDP targeting is that I learned the wrong kind of economics when I was in school. Nevertheless, if we think about what the Rational Expectations assumption might say about the macroeconomy, we must invariably conclude that it makes more sense to believe that recessions are a case of the world not living up to our expectations than it does to believe that we have the wrong set of expectations in the first place.

First, consider the case of the individual. When an individual suffers loss, it makes more sense to say that his income did not line up with his expected income than it does to say that he should have expected even more income than he did expect, because then he really would have gotten somewhere.

Similarly, if I place 3rd in a 5K race, but expected to place 2nd, we can definitely say that my expectations exceeded the outcome, but we would never say that I would have done better if I had originally expected to win. At least, I don't know anyone who would make that kind of claim.

If, as is often the case, a macroeconomist would reply that the macroeconomy behaves differently than a microeconomic unit, then we can still go through the same exercise. Suppose a mob gets together and decides to protest the opening of a new Wal-Mart, and the protest results in a physical altercation between the mob and the police. We can certainly say that the outcome of the event was not as the mob had hoped (assuming they really were a non-violent mob). It would be wrong to suggest that the reason the protest became violent is because the mob did not build sufficiently peaceful expectations.

II.
In my university Financial Economics course, I vividly remember on one occasion when my professor, the ingenious Kevin Huang (apparently now a professor at Vanderbilt) said to the class (this is his words as I remember them, not necessarily exactly as they were spoken).

"Why do we assume that people have Rational Expectations? Why is Rational Expectations a better theory than irrational expectations?" Here, he paused for dramatic effect. "Because, with irrational expectations, I can explain anything." He threw up his hands and smiled broadly, "It doesn't matter! It's irrational expectations!"

This colorful explanation is embedded in my mind because it drove home a crucial aspect of, not only economics, but also scientific inquiry in general. Science can only ever be as strong as its theoretical underpinnings. It is entirely possible that human beings do not behave rationally, not ever. (I am not sure how we would ever know that human beings were irrational, even assuming it were true, but leave that aside for a moment.) But that theory of human action - the theory that people have no reliable, reasonable, predictable logic governing their lives - is not so much a theory as it is a proclamation that nothing about human action can ever be known.

Even if it's true that this kind of knowledge is elusive, even if it's true that humans are irrational and unpredictable, we still possess more explanatory power under the assumption that we can possess explanatory power than we do under the assumption that nothing can ever be known about human behavior.

III.
The relationship between Nick Rowe's claims and Kevin Huang's claims are more complicated the more consideration you give the matter. On the one hand, Huang was arguing for the acceptance of the very theory that Rowe seems to be contradicting. On the other hand, there is a certain similarity between proceeding as though non-rational beings actually are rational for theoretical expedience (as Huang argues) and proceeding under the assumption that human expectations are wrong and need to be fixed through monetary policy (as Rowe seemingly argues).

Huang wants us to have rational expectations because at least in that case he is venturing a theory that can actually discussed. The alternative is that no one has any theories and nothing can be discussed. ("It doesn't matter! It's irrational expectations!") Rowe wants us to have different expectations than we actually do have, regardless of what's "rational" about them. If our expectations fully rational, then Rowe would like the Central Bank to reverse them, using the printing press.

IV.
Elsewhere on the internet, a Facebook friend of mine implores us not to expect our daughters to love being pretty and being princesses, and not to expect our sons to enjoy the color blue "and killing things" (!!!) because gender roles are nothing more than social expectations. We can change society's expectations and thereby protect our precious children from having to confront a world in which society puts pressure on them to act other than how they would like to.

Meanwhile, my boss would like me to work more overtime, my mother would like me to produce more grandchildren, the local charity would like me to give more money, and every advertiser in the entire world would like me to spend more money on the products they represent.

In other words, part of being a member of society is confronting the fact that others expect you to behave in ways that, left to your own devices, you would not otherwise behave. I never considered this kind of pressure to be unreasonable. In fact, I sort of figured it was part of the human experience. I'm a pretty eccentric guy, and I accept the fact that not everyone agrees with my views or the way I live my life. Others are entitled to disagree with me, but if they want me to actually change my behavior, they have to convince me to do it.

That's what it means to be an individual, after all. I don't automatically bow to social expectations simply because they exist. On the one hand, there is pressure everywhere to conform to society's expectations. On the other hand, I know that only in pursuing my own best interests can I ever expect to be happy. It's a balancing act, too, because part of being happy means meeting the expectations of the people I respect.

But what if I were to suggest, like my Facebook friend, that it was society's expectations that need to be changed? What if I were to suggest that the problem was society's? I'm not eccentric, I'm normal. It's everyone else that has problems.

V.
This is not an all unlike Nick Rowe's approach to economic stagnation. So far, society's economic expectations have been pretty accurate: We don't expect much, and we haven't seen much, either. Rowe would like to change that, in order to forge a world in which we behave as though tomorrow the roads will be paved with gold, so let's plan for it.

Proponents of "irrational expectations," and I am not sure if they still exist anymore, because it has been over a decade since I was in school and people were talking about it, held this point of view because they felt that, in the final analysis, people just did not behave the way economists expected them to. In a sense, they were saying that people were irrational, but in another sense, they were saying that economists were irrational for insisting on the belief that humans responded in fully predictable ways. This is not a totally fair criticism of Rational Expectations theory, but at least you can see where they were coming from.

It seems to me that the really irrational expectation people hold on to is the idea that society at large should bend to the private thoughts of a private individual - even an extremely smart individual who is also a really good person.

It is as senseless to want to change what society expects about the economy as it is to want to change what society expects about little boys and girls. Whether you go at it from the perspective that society's expectations are rational, but they require an information update, or from the perspective that society is a teeming, irrational nebula of fear and craziness matters very little. Society reflects that chaos of billions of individuals expressing the full gamut of human emotion and desire simultaneously, because that's what society is. It's everything, amalgamated!

Trying to change society is like trying to change "everything." It can't really be done. What you can do, though, is stop expecting an amorphous blog of people to conform to your wishes.