Rational Expectations and the Fallibility of Keynesian Fine-Tuning

Two Americans were recently awarded the Nobel prize for economics. The awards were a much needed endorsement of using data and common sense to analyze and solve problems.

The winners essentially confirm data based common sense decision making. Among other things, they have observed that when government officials make policy without fully taking into account what the reaction of ordinary Americans is likely to be, the politicians' moves are often frustrated. People take into account what the politicians are doing when deciding what to do themselves.

In other words, people aren't fooled by the attempted manipulations or forecasts of politicians and other policy makers. We the people are able to figure out the 'rest of the story' and that there is no free lunch, no matter what we are told.

The Return of Rational Expectations describes the rational expectations concept of Nobel Prize winner Thomas Sargent this way:

"As Mr. Sargent, who teaches at New York University and is a fellow at the Hoover Institution, has put it: "The concept of rational expectations asserts that outcomes do not differ systemically (i.e., regularly or predictably) from what people expected them to be. The concept is motivated by the same thinking that led Abraham Lincoln to assert, 'You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time.' . . . [Rational expectations] does not deny that people often make forecasting errors, but it does suggest that errors will not persistently occur on one side or the other."

This means it is hard for politicians to manipulate people into behaving in ways that don't make economic sense. One implication is that loose monetary policy cannot permanently lower unemployment because people will anticipate higher future inflation and demand higher wages and interest rates in compensation. Likewise, temporary fiscal stimulus won't change consumer spending permanently because it doesn't change underlying wealth or income."

A Nobel for Non-Keynesians describes Sargent's views on the effects of extending unemployment compensation payments to 99 weeks in this manner:

"Although the Nobel committee did not cite his work on unemployment insurance, Mr. Sargent, with Swedish economist Lars Ljungqvist, found that high, long-lasting unemployment benefits in Europe have caused many European workers who lose their jobs to stay unemployed for years and, thereby, erode their "human capital." This makes them less employable in the long run. The fact that the U.S. government has extended unemployment benefits in many U.S. states to 99 weeks, said Mr. Sargent in a 2010 interview with the Federal Reserve Bank of Minneapolis, "fills me with dread."

The discrediting of Keynesianism continues:

"If, for example, people get used to the Federal Reserve increasing the money supply when unemployment rises, they will expect higher inflation and will adjust their wage demands higher also. The result: The lower unemployment rate that the Fed was trying to achieve with looser monetary policy won't happen.

This conclusion was at odds with the Keynesian model, which dominated economic thinking from the late 1930s to the early 1970s. The Keynesian model posited a stable trade-off between inflation and unemployment. In 1970, major U.S. econometric models, built on Keynesian assumptions, predicted that the government could get the unemployment rate down to 4% if it accepted an increase in inflation to 4%. In a 1977 article titled "Is Keynesian Economics a Dead End?" Mr. Sargent wrote, "[I]nstead of 4-4, in the mid-1970s we got 9-9, a very improbable occurrence if econometric models of 1969 had been correct.""

In other words, people are free to choose and free to react to what politicians and policy makers are doing. As such people will make good decisions in their own best interests based on what policies are being proposed or implemented at the political level.This is especially true when policy makers want to create a certain outcome and don't give people enough credit for knowing what's going on.

Stated another way, the Nobel winners believe that people aren't stupid and won't easily be fooled, even when our elected officials believe and act otherwise.

Let's expand this point further by asking why politicians seeking elected office aren't speaking the plain truth. Instead we get negative campaigning and thirty second sound bites. Nobody tells us what they will do but only why the other guy can't be trusted. That's too bad.

So why can't office seekers just say what they believe and then let the chips fall where they may? If it's because of concern about their political job security, that's a shame.

Governance is far too important to be viewed solely as an employment scheme for politicians, along with a favor seeking forum for special interest groups.

It's rational for citizens to expect and demand more from the political process, so let's proceed accordingly.

Thanks. Bob.