The Apprentice Economist

by Filip Palda

  How then do investors determine the payout of a company? Or more generally, how do they form expectations about the equivalent concept of future company revenues? This may seem like a respectable but anodyne question of interest only to horn-rimmed academics, yet it has become a triumph of the analysis of uncertainty in economics and shapes government policy as perhaps no other idea does.

  An early attempt to understand the formation of expectations is due to Alfred Marshall, better known as the 19th century popularizer of the demand and supply diagram. In Book V, Chapter V of his celebrated Principles of Economics, he considered the case of a cloth manufacturer who must anticipate the price of wool in order to know how much to invest today in the machinery needed to provide future cloth. Marshall spoke somewhat vaguely of something he called the “normal price” of wool. What he may have meant was what today we would call the anticipated, or expected price. He argued (1895, 443-444) that, “in estimating the normal supply price of wool, he [the cloth manufacturer] would probably take the average of past years, making an allowance however for any probable change in the causes likely to affect the supply in the immediate future”.

  Marshall was saying that to form expectations, you need to know something about how prices have evolved in the past, but you cannot simply be backward looking. The cloth manufacturer would also try to understand how supply conditions in the future would influence price (that is, how the market works) and would try to form some notion about how random events would change supply. Marshall went on to suggest that market players do not need to delve into the psychology of workers or others involved in production. All they need to do is understand whether some regular pattern is at work. Here were the seeds, which were to lay long dormant, of a school of economics that came to be known as Rational Expectations, or simply, RE. Marshall’s thinking was ahead of its time by about sixty years. Economists in those years took little notice of this aspect of Marshall’s research and did not attempt to integrate people’s expectations of the future into the economic view of how people should behave.

  It was only in the late 1950s that Marc Nerlove tried to redress this omission in economic thinking by arguing that people formed expectations about the future by looking to the past. His thinking was the foundation for oscillatory models of supply and demand that came to be known as cobweb models.

  Suppose you are a student thinking of investing in education and you see everyone who graduated in the last few years making good money. You then invest in education. But so do many others, thinking as you do. When you all arrive on the job market there is a glut of skilled workers and wages fall. The low wages then discourage people from investing in education and in a few years there is a shortage of skilled workers. This cycle may repeat itself over many years and may even increase in amplitude. The oscillations are due to mistaken anticipations. When people overestimate the need for educated labor in the future they will over-invest in education. This means that the needs of the labor market and the abilities of workers are being mismatched, which is a waste of resources.

  While Nerlove’s work rekindled interest in expectations, some economists started to question his view that people formed expectations just by looking back. Nerlove’s heart was in the right place but his approach seemed misdirected. The protracted waste of resources arising from oscillatory market conditions predicted by adaptive expectations raised the question of whether there was a more “rational” way of dealing with uncertainty. One such way was for buyers and sellers to form some idea of how markets worked, rather than to act as retrospective simpletons. If you know something about markets, the way Marshall described in his passage on cloth producers, then you look to the past only to form an impression of how chance irrupts into the regular affairs of business. These affairs are normally regulated by the laws of supply and demand. They are upset by what economists call “random shocks”, or by what Shakespeare called the “slings and arrows of outrageous fortune”. So, basically, it helps to know how the world works normally, but also to take into account upsets to the regular course of things. This regular course is determined by forces that conform to economic models of supply and demand.

  In the early 1960s, economist Richard Muth provided a simple but seminal view of how economic equilibrium could arise if people acted as if they were making forecasts of the future based on the best statistical techniques and some idea of underlying economic structures. As original as Muth’s work was, the response to it in academic circles was muted.

  Then came Milton Friedman’s address to the American Economic Association in 1968 in which he challenged the Keynesian intellectual justification for government intervention. Friedman’s theme was that Keynesian prescriptions for government intervention were based on ad hoc (meaning tacked together) assertions that had nothing to do with rigorous economic thinking.

  The example he latched onto was the Keynesian belief that increasing inflation could reduce unemployment in a consistent and lasting manner. Friedman argued that economic analysis only allowed such an outcome if government tricked people, and that such tricks ultimately would prove detrimental to societal interests.

  So huge were the implications for economic policy of Friedman’s thinking that even as listeners left the auditorium some of them set about sharpening the outlines of the argument he had sketched. The challenge was to clarify how expectations based on some knowledge of the economy could be brought into the fold of classical economic thinking about equilibrium between supply and demand. This would rectify decades of lassitude in which otherwise-occupied economists had neglected expectations to the detriment and even shame of their science. Friedman had provided the intuition and a primer. Now it remained for the formalists to hammer out precisely what his vision meant and whether it was logically consistent with fundamental economic thinking.

  Money illusion

  FRIEDMAN EXPLAINED THAT indeed government could increase employment by increasing the money supply and pumping up inflation. But at the heart of such a mechanism lay trickery. His story was formalized in 1972 by Nobellist Robert E. Lucas Jr., who developed something called the “islands” model of inflationary trickery. The story that emerged is as follows. When the money supply goes up, but nothing else changes in the economy, all prices also tend to go up, in a case of more dollars chasing the same number of goods, a concept embedded in what is called the “quantity theory of money”. The problem employers face is that they cannot be quite certain of whether the rising price they immediately observe for their good, well before they have information on the average of all prices, is really just for their good, or whether all prices in the economy have risen. In this sense employers feel they are living on small islands, isolated from other firms, and having to form impressions on what is happening on the entire economic archipelago from local price movements and a knowledge of the past history of the entire system.

  If the price rise is unique to the good the employer produces, then he or she has an incentive to produce more because what gets sold will bring in extra revenues capable of buying other goods. In other words, the extra revenues will be “real” in the sense of materially being able to improve the life of the employer. If, however, the rise in price is just part of a larger number of price increases in the economy, then the extra money earned on a unit of good produced will not allow the employer to buy more of other goods, because their prices have also increased. In technical economic language, when all prices increase, no production or consumption should change because of the “zero-degree homogeneity” of demand and supply functions.

  Through experience and some knowledge of how the economy works, people quickly learn how to break down visible price increase in to real and inflationary components in a process of “signal extraction”. They become inured to rises in the general price level as they hone their anticipations of the government trick and their ability to separate real and inflationary price increases improves. What results is that government monetary policy risks becoming �
�neutral”, that is, impotent. Only by trying to fool the people about what it is doing with the money supply can government stimulate production. In other words, for monetary policy to have real effects it has to be unpredictable.

  Rising monetary unpredictability adds “noise” to the signal extraction problem employers seek to solve in order to separate real from general price increases, and thus cater to real needs in the economy. The result is that monetary policy can end up being worse than neutral. It can actually be a fog in which firms blunder, making costly mistakes about how much they should be producing. To avoid these risks propagated by government trickery, people rationally blind themselves to true opportunities signaled by the market. The economy then stalls.

  Self-fulfilling equilibria

  WHILE LUCAS BLAZED the trail towards an understanding of rational expectations, the clearest exponent of what rational expectations equilibrium meant was Sanford Grossman, a twenty-two year old economic prodigy putting the final touches on his Ph.D. dissertation at the University of Chicago in the early 1970s. He helped to clarify how expectations and the classical structure of economic equilibrium meshed.

  Grossman’s exposition began by putting a new twist on an old story. In any group interaction, economists seek to understand the equilibrium that will result. That is, they look for some steady pattern of exchange between people that will need no further adjustments in prices. In a certain world equilibrium can be characterized by a price such that the quantity producers offer is the quantity demanders request. This may sound fairly mundane, but it has as its basis something called “Nash equilibrium”. This is a state in which no participant in some group activity finds profit in changing his or her plan of action given the strategies of all other participants. In market equilibrium people somehow come to a point at which no one feels the need to change his or her consumption or production in the face of what everyone else is consuming and producing. That was the traditional story of economic equilibrium under certainty. But what happened when the world was uncertain?

  Grossman suggested that in an uncertain world equilibrium is a state in which the expectations of buyers and sellers about the future price of some product have very specific features. For businesses, their expectations induce no further present adjustments in preparations to produce in the future. For consumers, expectations induce no extra savings in anticipation of getting “deals” from future buying possibilities. Expectations and reality converge because economic actors have some idea of the structure of the economy in which they are working and act upon these ideas in such a way that, in an average sense, the future is the result of a self-fulfilling prophecy.

  Take the case of farming where the seeding decisions taken today influence the crop to be harvested, but in an uncertain manner. Some general idea, or “central tendency”, or expectation of a crop can be arrived at, but due to quirks of the weather and the varied depredations of weeds and other parasites no certain number can ever be attached to the future crop. Only some idea of the expected crop and a spread of possibilities around that expectation are possible. A farmer deciding today how much to plant does not simply look at the past price, as in Nerlove’s adaptive expectations model. The farmer has some idea of the structure of supply and demand. By taking into account how others who have a similar knowledge will behave he plants a crop in unison with similarly minded farmers such that the future possible spread of prices currently anticipated induces no further change in seeding activity.

  Here again Nash equilibrium pops up, but in an unexpected, challenging manner. The future anticipated statistical distribution of prices is consistent with present production and consumption decisions in the sense that people, knowing the effect mass action today will have on the future range of possibilities, feel no further need to react to these future anticipations. What is truly mind-bending about this analysis is that by anticipating these distributions, they realize them. It means that, in a certain sense, our expectations about the future make us prepare for that future in such a way that these expectations become self-fulfilling prophecies. This self-fulfillment is based upon people’s anticipations of how they should react to other people’s anticipations about the future.

  If we think the price of gasoline will rise, then we had better stock up now. Producers anticipating my anticipation will raise the present price and curb our stocking up. We start converging to an equilibrium today based on our views of the future. At the equilibrium, the consumer’s expectations are such that when plugged into the data sheets of companies, they see no reason to expand or contract their anticipated production.

  Grossman thus explained that rational expectations is an equilibrium concept, not a concept based on the predictive power of those involved. Peoples’ forecasts were based on a notion of how the world works, reinforced by memories of mistakes and successes in past forecasts. These forecasts do not stand alone but rather shape equilibrium price, which in turn shapes the forecasts, and so on. The predictive power of these forecasts could be quite weak. What is important is that people interact in such a manner that no matter what their predictive abilities, some stable consensus on the future emerges, and over the years the way the future turns out tends to validate the way people make their decisions. In an understated way Markowitz and Sharpe had anticipated such a process in the portfolio allocation model.

  Despite the self-assured modelizing of high-flying economic intellects, the self-fulfilling aspect of rational expectations is an intellectual lump hard to digest. Yet, as weird and disembodied from intuition as this concept may seem it is at present the best means by which economists may make sense of the interplay of mutually reinforcing expectations that arrive at some stable economic outcome. It is unbelievable, weird, and probably right on the money. Only time will tell.

  Chance and the individual

  OUR EXCURSION INTO the economic analysis of chance has taken us in a straight line from the basic principles of choice under uncertainty, to pricing insurance, then pricing stock market shares, and finally understanding how expectations of the future are formed. Yet in our haste to cover this modern ground we may have forgotten that chance and the human response to it have always been with us. And that we have always struggled to tame risks for most of history through repressive social norms, and then, with the development of “risk management technology”, through insurance and stock markets. These modern developments have not only protected us from risk but have liberated us from age old cultural constraints.

  For most of history, tradition, unchanging custom, and even taboo and superstition governed our investments, be these the sowing of a new field, the humble purchase of a plough, or the acquisition of a deed to an alehouse in Elizabethan England. Superstition and custom are mechanisms for either consciously or subconsciously restricting behavior so as to avoid unseen dangers. The dangers were unseen because information on prices was unavailable, or sparse. It is upon such information that today’s purveyors of financial products can tout a combination of stocks as a portfolio that removes needless risk from the anticipated returns of investors. At a simpler level, it is upon information about individual lifespan that life insurance can be sold. These modern techniques of taming risk have liberated people from having to obey cultural bonds that had a purpose but were extremely restrictive. The person living in a modern society need not conform to the expectations of the community nor of his or her ancestors.

  The contrast with existing primitive societies is stark. In a primitive society, or one which is “otherwise-civilized”, the individual is a secondary concept. Its members possess a herd mentality—with good reason. Otherwise-civilized people live at the margin of survival and any deviation of the individual from his or her time-tested roles imposes risks that might weaken the whole community. The modern concept of the individual, which is widely taken for granted in developed countries, has its origins in the development of humanism during the Italian Renaissance. The Italians of that period generated the wealth that
allowed some of them the luxury of indulging individual deviation.

  Opening gates up to the individual allowed human stars to shine. Giotto and Fibonacci are but of few the famous names we now associate with this period. The experiment in Italian humanism was short-lived, but was taken up again, haltingly at first by Montaigne, and then with vigor at the start of the industrial revolution with the philosophical writings of Hume, Smith, and Kant. Though history labels them as philosophers, they were really psychologists, delving into the meaning of individuality, that is, the things that matter to, and motivate, the individual. Their insights might have remained unexpressed in an earlier age where people were tuned out of the notion of individualism. As Mircea Eliade explains in his essay, “The Myth of the Eternal Return”, society has lived in a timeless state since its beginnings. So entrenched was the conservative mind-set that people were caught, or perhaps it is better to say they sought refuge, in a loop of production, procreation, and fixed social hierarchies.

  Though it would be difficult to prove, one might trace the rise of individual consciousness to developments in economic techniques, and possibly even to economic thoughts, that have helped to shield people from risk. It is under such a shield that individuals have learned to stop living in perpetual fear of rebuke by the community and have begun to explore the possibilities inherent in each one of them. Such is the meaning of civilization. The concept of the individual facing an unlimited vista of possibilities which are his or hers to explore and perhaps even to create, is what distinguishes modern, developed peoples from the otherwise-civilized where a herd mentality prevails and where deviation from social norms are subject to swift and savage repression.