Remember Robert Lucas everytime expectations confound us
His was an extreme theory but what
people rationally expect is often seen to impair policy efficacy
Economic doctrines pursued today are dominated by two theories:
Monetarism and Keynesian. The former is used to justify monetary policy action
that according to Milton Friedman is effective in inflation contol. The fiscal
aspect of growth is explained well by the theory of Keynes. But both these
theories could be exceptions that work at times and not always be effective.
This may sound odd, given that most countries espouse these tenets for policy.
But the factual at times does prove this supposition because regardless of what
authorities do, the desired results aren’t always attained.
The clue to this conclusion lies in the realm of the theory of Rational
Expectations, which gained fame in the 1970s. Robert Lucas, who won the Nobel
Prize in Economics in 1995 for his role in this school, had a different take
that remains relevant. Today, we often say that even though interest rates were
kept low post the financial crisis or as covid relief to secure growth, there
was no discernible impact on it. A Keynesian would argue that growth is better
engineered by an expansionary fiscal policy. But even uncontrolled expansion of
the deficit by giving cash handouts did not restore growth, though it made
living easier. In fact, both central bank and government actions contributed to
inflation rather than growth. Clearly, neither theory helped much.
Robert Lucas worked with Thomas Sargent on a theory based on the
principle of ‘rationality’. Micro-economics assumes that all economic agents
are rational and take decisions based on available information and
expectations. Therefore, the same assumption must feed macroeconomic analysis.
To take decisions, for example, people need to know the policy environment and
other conditions as revealed by data, so that they can formulate expectations
that guide actions. When expectations were negative during covid, investment
did not take place even though authorities did everything possible.
If interest rates are kept stable and the government spends prudently,
all affected sectors will take decisions on investment and employment based on
this information. This will lead to an optimal growth rate. People do not
borrow money only because it’s cheap. This is why lower rates rarely promote
growth. Note that India experienced higher growth in the earlier part of the
last decade, when interest rates were high. This is where demand comes into the
frame. If the Centre is conservative and the private sector hesitant to invest,
then monetary action achieves little.
Similarly, as visible today, it is not possible to control inflation by
letting unemployment rise, which is what the conventional Phillips Curve spoke
of. Theory said that as joblessness rises, it can bring down prices as demand
drops. But this is not happening. Unemployment has gone up in India and
inflation remains high. Cheaper loans did little to create jobs as the future
expectations of enterprises did not lead them to do so.
In short, the theory says that all monetary and fiscal policy
announcements will get discounted by the market. If the Centre is expected to
enhance capex or RBI to slash rates, business decisions will been made assuming
this. Therefore, expected measures have only a muted effect on macro parameters
such as investment or employment rates. One often hears after a credit policy
that the action had already been buffered in by the bond market, say, and so
yields did not move. Ideally, our policymakers should state their stance at the
beginning of a year and let things be.
Rational Expectations further argues that beyond a point, the only way a
government make policy work is by ‘fooling the public’. This means that a
stance is taken and then changed through shocks which in turn can create an
impact. But here too, it is argued that the effect is temporary, as once people
get to know of the temporary nature of a shock or policy, they would re-adapt
to this new environment. If the market expects a 25 basis points repo-rate hike
but RBI goes in for 40-50 basis points, it works. But this is only for few
days. Things revert to normal and growth remains unaffected.
Embarking on reforms sends a strong set of messages to investors, which
then forms expectations and brings about investment, employment and growth.
However, sudden shifts in stance and policy changes in the form of, say, additional
customs duties on steel, can disrupt expectations. But again, this will be only
for a short duration, after which the news gets absorbed. The imposition of
such duties by earlier Indian budgets did not really have a significant impact
on the steel industry.
Rational expectations is surely an extreme view. It urges policymakers to be transparent with their stance and let market forces play out. The assumption here resembles one made by classical economists that all economies would reach an equilibrium which may not always go with full employment. There would be a ‘natural rate of unemployment’ that cannot be eschewed. Growth, employment and investment would all be guided by rational decisions taken by economic agents and hence the government should provide a medium-term perspective with few deviations to maximize certainty. That, in essence, would be what Lucas would have reiterated.
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