The Trouble With Expectations

Late Freddie Mercury, who fronted for British rock band Queen, once crooned “crazy little thing called love”. That song has found a secure spot among the alltime favourites of pop/rock history, but its claims to an enduring place in the list of crazy and strange things may have to confront some occasional challenges. One of the peculiar things that demands immediate enlistment is the indefinable, indeterminate and intangible concept called “expectations”. It’s playing havoc with the economy and all the strategies conjured up by planners. It is time to get hold of this slippery creature.

The government has announced three well-publicised stimulus plans so far. These include duty cuts on manufactured products, tax relaxation for services provided and a host of other measures designed to spur people into spending more and companies into investing money for building new production capacities. Unfortunately, none of these seem to be working — consumers are not buying and companies are resisting new investments. Planners are perplexed (despite their brave public visage and statements), commentators foxed and politicians scared by this inexplicable systemic obstinacy. What they don’t realise is that, unseen and unheard, a phenomenon called “expectations” is at work below the surface.

So, what is this strange thing? The answer might be available in contemporary macroeconomics. It is a technique called the theory of rational expectations and is a device used in building models that try to predict a series of future decisions likely to be taken by consumers, investors or companies. This theory was first proposed by John Muth, a professor with Indiana University in the US, in the early 1960s. In the words of New York University professor Thomas Sargent, Mr Muth used the concept to “describe the many economic situations in which the outcome depends partly on what people expect to happen. The price of an agricultural commodity, for example, depends on how many acres farmers plant, which in turn depends on the price farmers expect to realise when they harvest and sell their crops. As another example, the value of a currency and its rate of depreciation depend partly on what people expect that rate of depreciation to be. That is because people rush to desert a currency that they expect to lose value, thereby contributing to its loss in value. Similarly, the price of a stock, or bond, depends partly on what prospective buyers and sellers believe it will be in the future.”

The theory also posits that future outcomes do not tend to vary greatly with the general expectations of the people. This means that some people will always get their forecasts wrong, but generally the majority’s assumptions of the future tend to be right. If that is so, this understanding might hold some keys to sorting out the clogged economic arteries. People are probably not spending because of expectations that things might get worse in the next few months, and that their uncertainties about job losses might, unfortunately, come true. Therefore, they feel it is better to save today, rather than indulge in discretionary spending, in case the climate gets cloudier tomorrow.

But what might be interesting to note are two related theories that are based on the theory of rational expectations or contribute to its development. The first one is the “permanent income” theory of consumption formulated by Milton Friedman. The Chicago-based economist used this theory to strengthen John Maynard Keynes’ consumption function that showed a positive relationship between people’s consumption levels and their income. This might sound a bit like stating the obvious, but this was a necessary development in the realm of theoretical economics to understand what drove people to consume and to formulate policy around it. Mr Friedman said that people consume based not only their present income but also on their perception of what their future income is likely to be. Hence, expectations.

The second hypothesis built around the expectation theory — and which seems important from the economy’s standpoint — was the “policy ineffectiveness proposition”, which said that if policy-makers attempt to manipulate the economy by encouraging people to have false expectations, they are unlikely to succeed. This derivative theory — first articulated by Robert Lucas — argues that if people have rational expectations, it will be difficult for policy-makers to improve the economy’s performance by inducing false expectations. These two important theories lead to two inferences. One, the government needs to start working on those building blocks of the economy that create jobs, capacities and thus future incomes. A start could be the infrastructure sector, which is still under invested and tangled up in bureaucratic knots. Second, the excise duty cuts and the service-tax reductions are like the false promises described above. They try to induce false expectations and, therefore, do not lead to an improvement in the economy.

It may be instructive here to notice that the dismal third quarter GDP numbers — which showed that the economy had grown by only 5.3% — has one silver lining. While agriculture and allied activities contracted by 2.2%, and manufacturing grew by only 2.37%, services growth at 9.85% seems to have saved the day. As part of services, social sector spending grew by 17.3% reflecting the impact of the sixth-pay commission and the national rural employment guarantee scheme. There might be some clues here.

(Courtesy: The Economic Times)