Rational Expectations

New School of Economics Gives Public High Marks

by William Hoffman
University of Minnesota Update
Winter 1982

Bulletin: Thomas Sargent Wins the Nobel Prize in Economics [October 2011]

Thomas Sargent
Robert Lucas
Walter Heller
John Maynard Keynes
It is a simple matter to dismiss the public as a fool when you disagree with this or that opinion poll. But in the area of economics, the public is far wiser than the experts have allowed.

That's the view of a new school of economists, including several University faculty members, that is advancing a revolutionary theory about how the economy works. Called "rational expectations," the theory is winning adherents in academic and financial circles and represents perhaps the boldest challenge to contemporary economic thinking.

One of those economists is Twin Cities campus professor Thomas Sargent. Sargent and Robert Lucas of the University of Chicago are editors of Rational Expectations and Econometric Practice published last fall by the University of Minnesota Press. The book is the first collection of research papers on the subject--a "bandwagon" designed to provide a framework for a theory that is, at bottom, remarkably simple.

Giving people credit

Rational expectations assumes that people behave in their own best interests when they make decisions about how to spend their money. Now there's nothing new or grandiose in that notion. Indeed, it goes all the way back to Adam Smith. Yet through the 1960s and 70s, proponents argue, government economic policy depended on people failing to act in their own interests.

Next, rational expectations assumes that people make economic decisions only after having taken into account available forecasts. That is to say, they form their expectations rationally and they do not repeat their mistakes.

Rational expectations economists contend that the recent decade of economic "stagflation"--high inflation, high unemployment, and low productivity--was a result, in part, of people having learned from their mistakes of the 1960s. Those mistakes included the failure of organized labor to anticipate the consequences of government policies to expand the economy. While consumers and business firms seemed to have more money to spend-labor was locked into long-term wage contracts and suffered a decline in real wages.

Once labor began to shorten contract periods and link wages to the cost-of-living index, government expansionary policies ultimately failed.

Put simply, the idea of rational expectations is that if people see a surge in the money supply or a tax cut coming, they will act in their own best interest: Labor, expecting the demand for consumer goods to rise (people find themselves with more dollars than before), will press for higher wages. Business firms, perceiving the rise in demand, will be willing to pay them, but will also raise prices.

When the "extra money" arrives, its intended effects of boosting productivity and lowering unemployment will already have been counteracted by higher wages and prices. Instead, the economy becomes increasingly inflationary.

During the early 1960s, when the ideas of John Maynard Keynes were put into practice, government economists were able to stimulate the demand side of the economy and produce growth. By the early 1970s, Keynes's prescription had crossed political boundaries. "We're all Keynesians now," Richard Nixon remarked.

Then business people, labor leaders, workers, investors, and consumers got on to the government's game, and their expectations of an economy that was overspending and overborrowing were not so rosy. Once their expectations changed, so did the economy-for the worse.

"People recognize the truth and stop making the same mistakes," Sargent said. "When they do, they eliminate the planned effects of the policy."

Government policies based on deception or "trickery" are likely to be ineffective over the long run, Sargent said. The government cannot fool most of the people most of the time, to paraphrase Abe Lincoln.

What to do?

If Keynesian policies don't work, what policies do? Rational expectations theorists don't have a precise prescription for our current economic ills, but Sargent believes that "only stable policies familiar to most of our citizens, are likely to produce stable, beneficial results." The government should be very careful about "untried experiments."

Sargent and Neil Wallace, a University colleague and fellow adviser to the Federal Reserve Bank of Minneapolis, do not think that the world of rational expectations requires a rigid monetary theory, only that the growth of the money supply must reflect some long-term strategy familiar to the public.

In the fiscal policy, however, rational expectations theorists see nothing quite so pleasing as a balanced budget. But Ronald Reagan's preoccupation with the supply side of the economy is bringing to grief his promise of a balanced budget in 1984,

Supply-side economics, which counts on large tax cuts to stimulate investment, which in turn is supposed to boost productivity and lower inflation, "isn't trickery. It's wishful thinking," Sargent said. While it is true that taxes "distort incentives," it doesn't necessarily follow that lowering taxes will boost productivity and lower inflation, especially if tax cuts create a deficit.

In a newspaper article, Robert Lucas asked rhetorically: "Is the general principle being advanced that taxes must always be reduced, independent of the effect on the deficit, because all taxes have disincentive effects?"

According to Sargent and Wallace, there is little evidence that taxes have reached such levels that they are undermining investment and fueling inflation. "I don't think most tax rates are at the point," Wallace said. There are all kinds of incentives to invest, he said.

President Reagan's policy announcements "are not internally consistent," Sargent said. "He wants to reduce taxes, increase defense spending, and balance the budget at the same time." There goals are not compatible under the present circumstances, he said.

Gold bugs

Supply-side guru and White House consultant Arthur B. Laffer recently called for a return to the gold standard, citing Sargent's own research findings as evidence that such a move would stop inflation.

In a study of four hyperinflation following World War I, Sargent observed that German, Hungarian, Austrian, and Polish currencies, which were not on the gold standard, "stabilized" only after excessive government borrowing ceased and the budgets were brought into balance. Increases in economic output and employment followed.

Laffer suggested that a return to the gold standard, in which money is wholly or partially backed by gold, would produce similar results in the United States, which went off the gold standard completely in the 1970. But Sargent believes that a sound fiscal policy is the key to a stable currency.

"In order to make a domestic currency freely convertible into gold, or into any foreign money for that matter, it is necessary that the government run a fiscal policy capable of supporting its promise to convert its debt" Sargent wrote in a related article.

"What backs the promise is not only the valuable stocks of gold, physical assets, and private claims that the government holds, but also the intervention to set future taxes high enough relative to government expenditures."

In other words, a currency need not be based on gold to be as good as gold. Once it is good as gold, converting it is little more than a formality.

A return to the gold standard now could be chaotic. "This country couldn't go back to gold right now if it wanted to," Sargent said. Without an appropriate fiscal policy-a balanced budget-"our gold supplies would soon be exhausted and there would be a run on the dollar.

According to Sargent, there are two main sources of inflation, a "good" one and a "bad" one. The bad one is "the persistent government deficit." It is possible to eliminate the deficit by either raising revenues or cutting expenditures, "and rational expectations theory is neutral as to how it gets done," he said.

The good one, and one the government "doesn't necessarily want to change," is electronic innovation in the financial industry-electronic funds transfer and computerized bookkeeping. These innovations "have resulted in less money needed to carry on a given transaction. This leads to a reduced demand for money, which in effect increases supply," Sargent said. It is a good type of inflation " in that it makes payment mechanisms more efficient."

Models and critics

Macroeconomists, who study the operations of the nation's economy as a whole, rely on econometric models to forecast economic trends. These models are masses of mathematical equations that seek to portray all the workings of the economy.

Though the 1970s, the models performed dismally. Forecasts based on them sometimes were so wide of the mark that they were worse than useless, according to Lucas.

The kinds of theories used in forecasting "haven't been very good," Wallace said. Lucas and Sargent go further: they say that econometric models, as they are presently constructed, are of no use in guiding policymakers.

Individuals are constantly changing their expectations in response to a changing economic environment, and the current models fail to take this into account. Lucas and Sargent hope that their book will be useful for economists who are interested in constructing new econometric models.

Rational expectations is not without its critics. One of them is Walter Heller, Regents' Professor of Economics who was head of the Council of Economic Advisers under Presidents Kennedy and Johnson.

Heller engineered the 1964 tax cut that brought years of economic growth and low unemployment and narrowed the gap in the federal budget as rising national income produced more tax revenues. As a result, the prestige of Keynesian doctrine soared.

Rational expectations is a brilliant intellectual exercise by brilliant faculty, Heller said. "The fundamental question is whether people have the economic understanding and information to respond in the way that they [rational expectations theorists] suggests." It imputes a perceptiveness that people have never shown before, he said.

The theory has a long way to go before it can be translated into useful policy that "can stand up on the firing line," he said.

Sargent, Wallace, Lucas, and company might not entirely disagree with the latter remark. Economic theories do not become orthodox overnight, and rational expectations is not 10 years old. Nearly 30 years elapsed between the publication of Keynes's The General Theory of Employment, Interest, and Money and the Heller-directed economic boom of the 1960s.

William Hoffman is founder of the Minnesota Biomedical and Bioscience Network (MBBNet) and coauthor of The Stem Cell Dilemma: Beacons of Hope or Harbingers of Doom?. He wrote this article when he was editor and writer for the University of Minnesota's alumni publication Update (1978-1983).