Rational expectations, Keynesianism, and Austrian Theory

The eventful happenings of last year or so have not only unleashed a crisis on the world economy, but also unveiled what is probably an even greater problem – a crisis within economics itself! In the two decades or so before 2007, the primary proponent of anti-Keynesianism within the mainstream tradition was the Rational Expectations School (RES). Lucas, Prescott, Sargent et al, were the “best” macroeconomists, and their work is the staple diet of masters and PhD programs.

The basic idea behind RES is that “perfectly rational individuals” with “complete information” will react to government policies by adjusting their own behaviour, thus nullifying its impact. So for instance, if government increases its expenditure (fiscal stimulus), people will figure that taxes will go up in future since government is incurring a deficit which will have to be reduced later, so the net effect is 0.

There are of course various ways to contest the broad idea. But at the moment, policy makers have ignored the rational expectations guys on the simple grounds that their assumptions are entirely “unrealistic”. And this brings us to the bigger issue of what was the point of spending so much time and energy in deriving the results of RES, of teaching it around the world, if it is of no use when the we get an economic crisis. A compass is useful because it points to the north! Check out what RES has to say now here.

The Austrians have of course been doing much better. Within the Austrian Business Cycle Theory the present crisis originates from the low interest rate policy followed by Fed in the post dot com bust scenario. Natural rate of interest is the rate at which two individual will voluntarily be willing to lend and borrow from each other.

There is no such thing as “the” natural rate of interest, but many such rates. But let us for analytical ease assume there is one such rate, and its 5%. When a central bank (RBI did this too) fixes the rate at say 3%, we get two problems.

1. How to produce?

Entrepreneurs begin to investment in more long term production facilities, since the same quantity of monetary resources can now fund longer term projects. So I can begin building a factory which will take 10 years to complete and 10,000 tons of steel at 3% interest, but would have had to build a factory which takes 6 years to complete and uses 70,000 tons of steel at 5% interest. In other words, the time structure of production is artificially skewed.

2. What to produce?

Many goods which would have been unprofitable to produce at 5% interest, become profitable at 3%. In the very short term, low interest lowers cost of production but prices of final output remain the same. So we get goods which would not have been produced under natural conditions. At 3% households are saving less than at 5%, entrepreneurs are borrowing and investing more than at 5%. Less savings mean more consumption. More consumption and more investments pull the economy in opposing directions, we get inflation, central bankers panic, interest rates are hiked (remember the last months of the Y V Reddy regime), many projects become unfeasible because of rising cost, recession!

Note that since the cause of the crisis is misallocation of resources, we would like economy wide churning. Firms must readjust production processes, some firms will have to reduce employee count, these people will then be employed elsewhere (the time lag between the two registers a high rate of unemployment), some firms will have to shut down, other firms will have to produce new products (less luxury villas, more apartments for instance), and so on. And soon enough we will be back to a rather normal state of affairs.

Not understanding this process is the root cause of many dangerous proposals floating around in the press. Take A. K. Arun’s Economic Times article for instance, he says,“What is rational for individual enterprises could spell gross irrationality at the level of the economy. Job cuts at a large number of companies in the wake of the slowdown, is a good example of this phenomenon. As individual companies try to cut costs and reduce the impact on their bottom lines by laying off workers, the cumulative result is to depress demand for what all companies produce in the aggregate. This accelerates the slowdown, and releases further pressure to cut costs. There must be intervention at the macro level to stop this vicious cycle.”

Any government intervention will only further delay the process of economy wide churning which is the only way to recover with or without a fiscal stimulus. Arun proposes “a tax break for companies that do not lay off staff”, and says the tax break itself maybe a certain percentage of a firms “wage bill”. So we have an economy where there is been gross misallocation of resources, plenty of capital is been destroyed (10 year factories will have to be torn down, 6 year ones build), and instead of encouraging firms to become more efficient, employ least cost methods of producing goods so that there are more resources available for economy wide reconstruction, we encourage firm to increase wage bill, i.e. increase cost!

In fact what we really need is more savings, and it’s a good thing that household reduce consumption and increase savings during recessions, we need more resources to restructure production. But its not just Arun’s article really, the problem is with the whole of Keynesianism which is pretty much just the 20th century name for mercantilism!

2 comments to Rational expectations, Keynesianism, and Austrian Theory

  • Dirk

    Nice article. The RSE and Austrians both underestimate the power of the Fed to create global financial crisis. If the bottom line goal is to create and distribute goods and services as widely (if not equally) as possible, these gyrations do not help. They destroy confidence, and when you’re trying to get more people to come out and participate and create, confidence is important.

    Hopefully, Obama and friends won’t destroy confidence in markets and rule of law before the Fed undoes its damage, and next time the Fed and those who talked down our economy in 2004-2007 will have learned their lesson.

    And when a China engineer has to work 3 years to buy the same car a US engineer can afford in 6 months, something’s gonna give- namely, the US dollar.

  • I think you mean the “RSE and Keynesians”, not “RSE and Austrians”

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