Robert Lucas: Lower Your Expectations

Don’t you hate it when you hit rush hour traffic? How about when you end up going to lunch at your favorite chicken spot and the line is out the door? Me too.

I’m never surprised by the rush hour or the long lines. Sometimes, I get frustrated with myself before I get caught in these situations simply because I’m expecting them. I look at the clock and I’m upset that I didn’t wake up earlier or eat a heartier breakfast so I could wait another hour before eating lunch.

Ahhhhhh!

Can you relate? Maybe the mere thought of sitting in traffic is frustrating enough that you actually wake up when your alarm goes off. Others just adapt to the traffic by listening to the news radio, music, or inevitably showing up late because…traffic.

In any case, we have certain expectations about how the world works around us, and we usually act accordingly.

This unremarkable insight has some very important economic implications. Just like we expect long lines at Peruvian chicken at noon, in the same way we anticipate certain actions taken by the government and central banks and act according to our anticipations.

“That’s Mrs. Silver Fox to you bucko.”

The Silver Fox, Lord of the Federal Reserve, Janet Yellen, mentioned that the Fed was still cautious toward raising the Fed funds rate. The news of slow rising interest rates means businesses, investors, and consumers, can still enjoy the perks of easy money, hence the perky stock market the day after.

The stock market rally shows how we adapt to the expectations, rationally. In economics, Nobel laureate Robert Lucas called this the “rational expectations theory.”. He won the Nobel prize in 1995 for developing and applying this theory to economic models in a way that completely transformed how economists do macroeconomics, in general, and how we should think about economic and fiscal policy.

“Lemme tell you how how the world really works.”

Before his formal treatment of incorporating people’s rational expectations, economic models essentially produced results with the assumption that humans had irrational expectations. Lucas states in his Nobel lecture, “that if one assumed rational expectations these tests settled nothing.” The statistical way of looking at the economy proposed by Nobel laureates before Lucas, such as Frisch, Tinbergen and Samuelson, did not take into account that the supposed levers policymakers pull to direct the economy will not have the desired effect if people in the economy are already expecting it.

For example, if I’m walking behind someone and we’re coming up on a door, I can expect that the person will hold the door for me, considering this scenario happens quite frequently. The reason we get so upset when the person doesn’t hold the door is because we have usually sped up so that the person does not have to hold the door for too long. The systematic expectation of the “holding the door” has us reacting preemptively.

So, if Janet Yellen tells us that we are experiencing high unemployment and low inflation, businesses expect that the Fed will likely lower the Fed funds rate to help alleviate this. However, the news alone will get businesses to speed toward the door, by increasing investments and market activity, to the point that the Fed doesn’t even have to “hold the door” at all. The economy just adjusts quietly.

But what about unanticipated events — such as finding out a huge bank defrauded millions of people, the unraveling of toxic mortgages that catches virtually everyone off-guard, or suddenly winning the lottery? These are the cases where there is a real impact, but the impact is only temporary.

The theme park used for his illustration of how the economy can be manipulated

Lucas provides his own illustration of distinguishing between anticipated and unanticipated events in a short, but entertaining article explaining the effects in a controlled economy of a theme park. By unexpectedly increasing the price of the park tickets, or as Lucas thinks of it, the currency used for rides, the park managers can engineer an economic depression in the park. People would respond by cutting back on the amount of tickets they purchase. More people would watch ducks swim instead of getting on the roller coaster. Ride operators would respond by sending workers home and maybe reevaluating the scream ride of death. Gloomy-ness would ensue.

If the opposite happened, people would be pleasantly surprised and purchase a whole bunch of tickets when they find out that they could get more tickets for the same amount of money they expected to spend. However, it would be crazy to think that making the ticket prices cheaper would have any long-term effect. People would wise up, the park would staff up, and everyone would still make roughly the same amount of money, especially if the cost of running the park didn’t change.

Lucas incorporated this unremarkable, yet mind-blowing insight, into macroeconomic models. Sure, it complicated them more, but it also made them slightly more accurate, and knocked some reality into how we think about policymaking. The “Lucas critique” which is based off this theory, shows that there’s no point expecting policies to achieve any kind of long term effect. Because of rational expectations, politicians and policymakers constantly pass new laws and regulations — the old ones lose their effect.

Rational expectations tell us a lot about how our reactions to anticipated events, but not much about events we can’t anticipate. Though it was initially applied to monetary policy, it helps answer why banks “too big to fail” make risky bets, why stock markets rally when the President says the administration is going to cut corporate taxes, or why the value of gold increases when people are expecting a recession.

Unfortunately, it doesn’t tell us much about how we came to have these expectations about the world. Our beliefs and subjective perceptions are formed by our world. We constantly adapt to changes, acquiring new information that adjusts our expectations so we can react differently. Understanding this narrows the scope of what economists and politicians can control to achieve long-term benefit, which to me, is pretty relieving. Giving someone so much control is a scary thought.

However, I’m still upset at the long lunch lines at the best chicken restaurant in town.

Doesn’t look like much…but lemme tell you.

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