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FOCUS - 1 of 1 DOCUMENT Business Week November 8, 1976, Industrial Edition

How expectations defeat economic policy


A controversial new theory called rational expectations is sweeping through the economics profession. It says that economic policy is impotent. Systematic policy changes can do little to increase employment and output, because the public -- individuals and institutions -- takes actions that offset the changes. Therefore, the most appropriate policy, maintain its proponents, is steady money growth and balanced budgets. Stabilization policy has had its skeptics since the 1950s, to be sure, led by Nobel laureate Milton Friedman.But Friedman's critique of economic policy rested on the assertion that policymakers are unable to forecast the economy accurately and therefore cannot properly time their policy response to either inflation or recession. Now the work of ivory-towered economists Robert E. Lucas Jr. of the University of Chicago and Neil Wallace and Thomas J. Sargent of the University of Minnesota is giving Friedman's assertion something it lacked for two decades -- a solid theoretical base.Indeed, the implications of rational expectations theory go well beyond what even Friedman would claim. The rationalists are saying that no systematic economic policy can be devised that is capable of affecting anything other than the inflation rate. This radical conclusion rests on an analysis of how individuals form their expectations affect their responses to government policy moves. There are two key theoretical findings about the interaction between policy and economic behavior. the first is that any policy move that is widely expected will have no impact at the time it is taken, since it has already been discounted by the public -- much as the price of a stock already reflects all known information about the future earnings of a company. And second is the corollary that only policy moves that people do not expect will cause changes in current behavior, just as the only thing that moves a stock's price is some new information that has not been previously anticipated. Rational expectations is causing excitement and controversy the likes of which the economics profession has not seen in years. It helps explain why economists and policymakers have done such a poor job in forecasting. It is a theorists' delight, since no one has ever seen, touched, or tasted an expectation. Why policymakers fail. Policymakers go wrong, the rationalists hold, because they make decisions that fail to incorporate the fact that the public has already formed expectations about what the policy is going to be and have already acted on these expectations. The first time a policy is introduced it may work because it comes as a surprise. Lucas uses the example of an on-again, off-again investment tax credit. The economy begins to flag, and policymakers for the first time institute an investment tax credit. Companies respond by vigorously increasing capital investment, as they indeed did respond to the Kennedy Administration credit of 1962, and the economy picks up. It may work a second time. But as businessmen learn that a sputtering economy means a tax cut, a perverse reaction sets in. Business now expects the tax cut, so they postpone investment in the current period. This turns an economic sputter into an economic slide. The cut takes effect and investment moves up sharply, more so than economists expected based on their models of what occurred when taxes were cut in priorl periods. The economy recovers. Looking at the results, economists and policymakers pat each other on the back. But, in fact, the expectations of businessmen turned a countercyclical policy into a procyclical policy. Instead of stabilizing economic activity, the policy actually accelerated both the downturn and upturn. Arguing money growth. But it is in monetary policy that the rationalists are making major theoretical breakthroughs. They are showing that a systematic countercyclical monetary policy -- in which the Federal Reserve Board tightens money when the economy speeds up, and loosens money when it slows down -- is much less effective than a fixed money-growth rule. (The rationalists assume that money is what economists call neutral, in the sense that increases in the money supply affect only the price levle, at least in the long run.) A countercyclical monetary response that is triggered by an economic slowdown is anticipated by the public and has already been factored into inflationary expectations, much as the investment tax credit was factored into the expectations of businessmen.

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There are thus only two ways in which monetary policy can have any impact on output and employment, say the rationalists. Either the public systematically makes mistakes in forecasting the policy and its impact, or the moves that the government actually makes come as a complete surprise. But the rationalists flatly reject the idea that people are so foolish that they consistently make those mistakes. For Fed policy to work, therefore, it must come from out of the blue. For example, if the public expects the money supply to increase by 5% next year, companies and unions will strike bargains based on those expectations. But if the Fed instead suddenly increases the money supply by 10%, then changes in real output and employment will indeed occur. Companies will hike prices, but wages will respond more slowly, so profits willrise and employment will increase. Says Lucas: "To affect real output, the monetary authorities must resort to trickery, and how long can you keep pulling that off?" And Wallace adds: "For countercyclical policy to work, it must surprise people, and that's not a policy, that's throwing dice." An economic dampers. Throwing dice is a dangerous game. The public soon learns that the Fed is randomly changing course, and this increases uncertainty. Uncertainty damps economic activity. Businessmen and consumers alike get nervous, and spending falls. Sargent makes an even more telling argument.Says he: "Given the current state of the art, the Federal Reserve simply does not know what the public's current expectations are. Therefore, the Fed has no real handle on whether a policy will come as a surprise and affect real output or whether it has been discounted and has already affected the price level." Although it might appear that rational expectations is yet another nail in the coffin of Keynesian countercyclical policy -- it indeed has come under serious attack from Keynesians -- monetarists should be no less unhappy.For rational expectations undermines the claim that the monetarists, notably Milton Frieman, hve labored for decades to establish: that an increase real output and only then, after a lag, hype prices. But monetarists have never been able to explain why this is so, nor why the time lags vary widely. Explains Lucas: "The sloppy effect we observe between money supply on the one hand and prices and real output on the other is the reflection of changes in the state of expectations held by the public as to what monetary policy will be." Since no one can be sure at any time what the public's expectations are, the monetarists have no way of predicting the effect of a monetary stimulus to the economy. The matter of time. Almost all economists agree tha the rationalists have made a major contribution by alerting both forecasters and policymakers to the inadequacies of policy that does not consider expectations. Says Benjamin M. Friedman of Harvard University, "They have uncovered a serious flaw in our models." but Benjamin Friedman and the majority of economists part company with the rationalists on how rapidly the public adjusts its expectations. Even Milton Friedman, who is clearly impressed by the theoretical work the rationalists have so far produced, has serious doubts about this crucial part of their argument. "You may be able to fool people for a very long time," he says. "I cant't accept the idea that inflation premiums are incorporated into interest rates and wages instantaneously." To admirer and critic Robert E. Hall of the Massachusetts Institute of Technology, the rationalists' strict monetarist model results in a major fallacy in their argument. "They believe," he says, "that a monetary expansion is quickly translated into actual inflation premiums right away." But HAll maintains that an increase in the money supply lowers interest rates, which leads to an increase in capital investment and thus in industrial capacity. "I accept rational expectations in the sense that the public uses all available information," says Hall. "But monetary expansions do not cause inflation, because capital investment increases capacity," he says. "According to my model of the way the economy works, a hike in the monetary growth rate need not lead to an increase in the rational expectation of inflation." Even if increases in the money supply trigger inflationary expectations, it takes time for prices and wages to adjust. Keynesian Franco Modigliani says that rational expectations views all markets as auction markets -- where prices adjust instantaneously. But in the real world there are such things as fixed contracts that induce rigidity in wages and prices. Minnesota's Sargent and Wallace remain unconvinced. They maintain that time lags in the system are a thin reed on which to hang the success of stabilization policy. "The length of time of a labor contract is not written in the Bible," notes Sargent. "It itself depends on the rate of inflation." And Wallace notes that since more and more contracts are being indexed to inflation, time lags are getting shorter and the impact of short-run policy on real output is vitiated. Clearly, the rationalists have raised serious questions about the effectiveness of stabilization policy. But as monetarist Allan H. Meltzer, who does not favor countercyclical policy, nevertheless says, "WE need a lot more empirical evidence before we can know that rational expectations cripple stabilization policy." URL: LANGUAGE: ENGLISH GRAPHIC: Pictures 1 through 3, Academic theorists Lucas, Wallace, and Sargent launched a devastating attack on monetary and fiscal policy. Dale Wittner

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Copyright 1976 McGraw-Hill, Inc.

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