Expectations

Great Expectations. Wikimedia commons.

One of the ways in which I tend to diverge from 'mainstream' economics is in my treatment of expectations, broadly construed. I've talked about this before (see also here and here), and I was reminded of it by commenter LAL recently.

Menzie Chinn states the mainstream view succinctly in the first half of this sentence:

In point of fact, in modern macroeconomics where expectations of the future are central, the most important variables are often not observable.

Emphasis in the original. Chinn is defending the approach of using unobservable quantities in reference to a commenter Tom, and continues: 

So when one hears a criticism like that leveled by Tom, realize that taking such a criticism to its logical conclusion means that almost no macroeconomic discussion can proceed. Everything will have to have appended to it the adjective “estimated”.

This represents one branch of opposition to expectations: market expectations are unobservable, so should be left out of economic theory. Chinn's defense is that expectations can be estimated from other variables (e.g. the TIPS spread as a measure of inflation) -- and I agree. I have no objection to the use of unobservable theoretical constructs in theories. As a physicist, I have no problem using the quantum mechanical wavefunctions (unobservable) in calculations. The properties of the wavefunction (like its phase and amplitude) can be estimated through measurements, like the probability density of electrons striking a screen in the two-slit experiment.

My issue with expectations are different and two-fold ...

Arbitrariness: While there is a Schrodinger equation to define the unobservable wavefunction, there is no universally accepted constraints on what expectations are allowed to be. As long as one can come up with a plausible sounding argument ... what Noah Smith refers to as judgment calls ... any model of human beliefs is allowed into the model.

One can incorporate the latest theory from the study of human behavior in microeconomic settings, which is interesting. But more typically, it seems that macroeconomists just make up plausible sounding assumptions, put them in the theory and see what happens. There is nothing wrong with this as long as you make a connection to empirical data. If you don't, you could end up with a chameleon model [pdf]. As Pfleiderer defines them:

A model becomes a chameleon when it is built on assumptions with dubious connections to the real world but nevertheless has conclusions that are uncritically (or not critically enough) applied to understanding our economy.

I go a bit further than Pfleiderer and say that these problematic assumptions are almost entirely ad hoc assumptions about expectations. I once made a joke about the arbitrariness of models of expectations (calling them bad ad hoc).

Rational expectations (agents have the expectations produced by the model -- i.e. model-consistent expectations) are one way to deal with the arbitrariness, but just shifts the arbitrariness from the expectations to an arbitrariness in the model. Again, this is fine if you then test the model with empirical data.

Arbitrariness can always be solved with a dose of empirical success.

Centrality: This is where I am one of Nick Rowe's so-called people of the concrete steppes. This is also where I think macroeconomics is actually wrong and it can be shown with a couple of simple thought experiments.

First thought experiment: what happens to your theory if the market doesn't believe your theory? Look at market monetarism, for example. If markets didn't believe the theory, then it's a bunch of nonsense. Equation (3) at this link would be entirely determined by the undefined systematic error term. NGDP forecasts would be independent of central bank targets. Essentially, the whole framework falls down. Now it is possible this is how the real world works -- the only functioning economies are those that believe correct or approximately correct theories of markets. But I believe markets naturally arise without the economic agents even knowing what economics is.

Second thought experiment: let's assume there exists a fundamental theory of macroeconomics -- a macroeconomic theory of everything. Call this T0. Let's say, according to T0, fiscal policy has no effect on NGDP or inflation (e.g. monetary offset is the mechanism). Now let's say we live in a world that doesn't know T0, but rather has a 'Keynesian' theory TK in its collective head where fiscal policy has a positive multiplier; fiscal expansion (government spending) leads to increased NGDP and higher inflation.

Now what happens in this thought experiment when a large stimulus package like the ARRA is announced?

Does inflation rise to the level predicted by TK, i.e. the expected value, and stay there? No. That would contradict T0.  

Does inflation only rise initially according to TK, but then fall back to a value governed by T0? In this option, expectations cause market volatility, but have no impact on the long run.

So expectations can only have a limited impact under the assumptions made in the thought experiment: T0 exists and is unknown, TK is wrong. So how does one escape from this problem? By ignoring the premise of the thought experiment:

1. Macroeconomics (or the market) is always right (T0 is known): there is no possibility of two theories T0 and TK. Markets cannot believe incorrect theories like TK. Only T0 and T0 expectations exist. This means you cannot know what the correct expectations are until you know T0 -- i.e. it assumes you already know the fundamental theory if you include expectations in your model.
2. Rational expectations (assume TK is right): expectations must be model consistent, i.e. you can only have TK expectations in theory TK and T0 expectations in theory T0. This is a weakening of option 1 where more theories than just T0 are allowed. This is sensible, but since you can build models that do anything, expectations can do anything. Additionally, there is no way to argue against any particular model except empirically.
3. Expectations are central (T0 is pure expectations, therefore TK = T0): there is no possibility of two theories TK and T0. If TK is the dominant theory, then expectations are TK and in fact the fundamental economic theory of everything is TK. T0 is then whatever the market believes, regardless of anything that is not expectations in your theory (such as measurements of the money supply). Concrete steps (like printing currency) are unnecessary. I've referred to this as model-independent expectations in the past. This implies that all you need to do is convince markets that Keynesianism is right to make Keynesianism right. Or you could convince markets that monetarism is right, which would make monetarism right. There is no reason to believe any particular theory so you can't logically suggest monetarism over Keynesianism, you can only put it forward as political preference.
4. Markets are always right and expectations are central (T0 is known and T0 is pure expectations): this is the combination of 1 and 3 and is the method of e.g. market monetarism [1]. This not only assumes you are right, but additionally that everyone knows you are right. It effectively disallows the possibility in 3 that markets could be convinced of a different economic theory. However, like 3, it also does not require concrete steps.

These are all excellent options if you are extremely confident you are correct and don't care about comparing your model to empirical data. 

Overall, I'd sum up my problem with the centrality of expectations with a question to Scott Sumner: what happens to your theory if markets don't believe market monetarism? In a sense, this question cannot be addressed by market monetarism. The "market" piece presumes markets believe the theory (i.e. market expectations are consistent with market monetarism, i.e. assuming rational expectations in market monetarism ... I called this circular reasoning before, but charitably, this could be taken that market monetarism is the only self-consistent theory of expectations as I mention in a comment at that link).

I personally like to hold on to some skepticism of theory and believe that comparing to empirical data is a necessity. Therefore, while I consider expectations to have real effects in economies, I do not think e.g expectations set by a central bank can hold inflation on a 2% path indefinitely. In particular, economies that try will eventually fail. I am uncertain if the information transfer model is T0, so there is a possibility I will be wrong. And the only thing that happens if the market were to believe the information transfer model is that there would be a minor reduction in excess volatility.

Update 7/18/2015:

[1] In a later post, I realized Sumner's view of market monetarism is actually closer to option 3 above. I think (but am not sure) Nick Rowe's view is closer to 4 still, though.