In a free market economy, individuals’ expectations will tend to move in tandem with reality, and this contrasts with…
by Frank Shostak via Mises
In order to gain insight into the future state of the economy, some analysts utilize consumer and business surveys. Randomly selected consumers and businesspersons are asked to provide their views about where the economy is heading.
If a survey shows that, most of those surveyed express optimism it is regarded as good news for the economy. Conversely, if the majority of those surveyed are pessimistic it is taken as a bad omen for future economic activity.
It appears that the information regarding future economic conditions is dispersed. Hence, the chances of any particular individual having an accurate picture of the state of the economy are low. Hence, it would appear that a large number of individuals selected randomly has a high likelihood of securing an accurate picture of future economic conditions than one individual.
It is quite possible that a group of individuals will have more information than any given individual. However, more information does not necessarily mean a more accurate knowledge of the future.
To ascertain the facts of reality the information must be processed by means of a theoretical framework. Whether a forecast “makes sense” is determined not only by the amount of information available but also whether a theory, or a thinking process, is in tune with the facts of reality. As long as the individuals surveyed have not disclosed the theories behind their views, there is no compelling reason to regard various confidence or sentiment surveys as the basis for the assessment of the future state of the economy.
Also, note that various consumer and business surveys are considered useful because these surveys could establish likely changes in the demand for goods and services. Thus, a strengthening in the consumer and business confidence indexes can be associated with a strengthening in the demand for goods and services. Conversely, a weakening in the indexes raises the likelihood that the demand for goods and services is going to weaken. Given the view that demand creates supply it seems that by establishing the likely strength of the confidence indexes one can ascertain the likely future course of the economy.
However, following the Say’s law we know that increases in supply generate increases in demand, not the other way around. Consequently, we can suggest that the knowledge of the state of the confidence among consumers and businesses is going to have limited value in ascertaining the future state of the economy. What is required for economic growth is a suitable infrastructure, and the lack of such infrastructure will prevent the eventuation of economic growth.
Importance of Past Knowledge to Ascertain Future Knowledge
Contrary to the rational expectations hypothesis (REH), the past knowledge of individuals, which was instrumental in determining their past actions, shapes and constrains individuals’ future values and knowledge, thereby influencing future actions. If it were otherwise and the past had no effect on the future, a world of chaos would exist in which the accumulation of knowledge would not be undertaken, and economic advancement couldn’t take place. If the future is not related to the past, then knowledge today will be regarded as useless tomorrow.
According to Ludwig von Mises knowledge of the future can only be qualitative:
Economics can predict the effects to be expected from resorting to definite measures of economic policies. It can answer the question whether a definite policy is able to attain the ends aimed at and, if the answer is in the negative, what its real effects will be. But, of course, this prediction can be only “qualitative”. It cannot be “quantitative” as there are no constant relations between the factors and effects concerned.
Can Positive Thinking Prevent a Decline in Economic Activity?
Given the view that expectations are the key driving force of the economy, some commentators hold that “positive” thinking and large dosages of “good” news can prevent the development of pessimistic expectations and in turn bad economic conditions. Thus, individuals are depicted as driven by a psychology susceptible to wild swings.
It logically follows, therefore, that to keep the economy prosperous, people must be guided to think positive thoughts. Hence, whenever commentators discuss the state of the economy, they try to portray the bright aspect of it. Even when the economy falls into a recession, various influential commentators are very guarded in their speech. On this Murray N. Rothbard wrote:
After the disaster of 1929, economists and politicians resolved that this must never happen again. The easiest way of succeeding at this resolve was, simply to define “depression” out of existence. From that point on, America was to suffer no further depressions. For when the next sharp depression came along, in 1937–38, the economists simply refused to use the dread name, and came up with a new, much softer-sounding word: “recession”. From that point on, we have been through quite a few recessions, but not a single depression. But pretty soon the word “recession” also became too harsh for the delicate sensibilities of the American public. It now seems that we had our last recession in 1957-58. For since then, we have only “downturns”, or, even better, “slowdowns”, or “sideways movements”. So be of good cheer, from now on, depressions and even recessions have been outlawed by the semantic fiat of economists; from now on, the worst that can possibly happen to us are “slowdowns”. Such are the wonders of the “New Economics”.
Again, the main reason for this gentle talk is a view that soft language will not upset individual’s confidence. Therefore, if an individual’s confidence is kept stable then stable economic activity will follow. Believing that stable expectations imply economic stability, many economists believe that government and central bank policies must be transparent, for if policies are made known in advance, we can avoid surprises and reduce volatility.
What really matters is that individuals’ expectations correspond to reality and not whether these expectations are stable because expectations of stability cannot undo the damage caused by loose monetary and fiscal policies. Moreover, irrespective of whether individuals are successful in identifying reality, these facts will assert themselves anyway.
Thus, if we have identified that individuals’ real incomes are declining, then this is a fact of reality. Regardless of individuals’ confidence, this fact that will force the decline in consumer outlays.
Expectations in Free versus Hampered Markets
Expectations emerge in response of the individual’s evaluation of reality. In a free market economy, whenever individuals form expectations that run contrary to the facts, incentives for a renewed evaluation and different actions are created.
For example, an incorrect evaluation might wrongly direct capital investment in the production of product A instead of investing in the making of product B. The effect of the malinvestment in the production of A is to depress profits, because the excessive quantity of A can only be sold at prices that are low in relation to costs.
The effect of underinvestment in the production of B will lift its price in relation to cost, and will raise its profit. It is likely that we will have a withdrawal of capital from A and a channeling of it toward B, implying that if investment goes too far in one direction, and not far enough in another counteracting forces of correction will be set in motion. In a free market, the facts of reality will assert their dominance quickly through individuals’ evaluation and therefore their actions.
However, this is not so in a distorted market economy. By enforcing their policies, governments and central banks can set a platform for a prolonged deviation of expectations from the facts of reality.
Conclusion
In a free market economy, individuals’ expectations will tend to move in tandem with reality. This contrasts with a hampered economy in which government and central bank policies give rise to expectations that are uncoordinated with reality. Simply expressing an opinion regarding future economic conditions does not make it more accurate than anyone else’s view.
Author:
Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.
