Traditional economic principles have focused on quantifiable, rational, and policy-based analyses of the economy. However, recent bubbles and busts have shown that these are only part of the equation – the other component lies in the uncertain field of human behavior.
But how much do psychological forces actually affect economic growth?
Expecting The Unexpected
Studies show that expectations and consumer perception greatly influence market outcomes of monetary and fiscal policies, sometimes even to the point of completely countering their intended effects. History has shown that positive expectations lead to output expansion, while pessimistic expectations lead to low or even negative output growth. Take the example of Ireland.
The Luck of The Irish
In 1981, the Irish were buried in debt. With a budget deficit of 13 percent of GDP, and government debt at 77 percent of GDP, the government set out to slash the deficit with a tax hike. The results were dismal. Three years later, Ireland had negative output growth, a dismally high unemployment rate and only a slightly lower budget deficit. In 1987, the government decided to tackle the beast once again, this time with a cut in government spending, a reduction in the role of government and a widening of the tax base. The results were markedly better this time around – strong growth, a reduction in the unemployment rate and a significant decline in the deficit.
Many economists have cited the differential reaction of expectations as the cause of the polar outcomes of the two Irish deficit reduction programs.
They argue that in the second attempt to reduce the deficit, people had more favorable expectations since they believed the government would pursue a longer term solution rather than just putting a band-aid on its mis-finances by increasing taxes.
Though the Irish example is only one case wherein different expectations resulted in varying economic conditions, behavioral economists have developed a few theories that explain the crucial role expectations play in the economy.
Before the 1970’s, there were generally only two schools of thought that dealt with how people develop expectations. John Maynard Keynes, a British economist, coined the term animal spirits to describe human behavior. His theory highlighted the fact that expectations were important, although very unpredictable and therefore enigmatic. On the other hand, Milton Friedman claimed in his article, “The Role of Monetary Policy” that people have static expectations and base their perceptions of the future on what has happened in the past.
Modern Fortune Tellers
Today, rational expectations are frequently used by macroeconomists for policy analyses. Developed by Robert Lucas and Thomas Sargent, this theory states that people make rational decisions about the future based on all the information available to them, including news reports, historical events, statements from the Fed, and the implications of government policies. Although assuming all humans are perfectly rational actors might be misrepresentative, this is currently the most accurate benchmark for evaluating economic activity. In other words, what people think will happen in the future will actually partially affect subsequent economic conditions. So, be careful what you expect, because it just might come true!