October 2011 Archives

Rational Expectations?

This article came out in the Deseret News on Tuesday, October 18th.

Last Monday the Nobel prize in economics was awarded to Tom Sargent and Chris Sims.  Both are well-known macroeconomists and both have worked on economic issues relevant to the 2008 recession and recovery.

Forecasting the future of the economy is tricky business.  For one thing it is very complicated, with millions of goods and services changing hands.  Another reason is that it is subject to changes in the economic environment that are not economic in nature; weather and politics being two good examples.  Forecasting how the economy will behave requires simplifying models that capture most of its features without adding too much complexity.  Over the years, economists have developed increasingly sophisticated ways of doing this.

By way of analogy consider the portion of U.S. Highway 6 that runs between Spanish Fork and Price.  I drive this stretch of road on occasion on my way to the San Rafael Swell.  The road goes up Spanish Fork Canyon, over Soldier Summit, and down Price Canyon.  It is necessarily winding and steep in many places.  Suppose you were tasked with forecasting the fate of a convoy of vehicles traveling over this road.

A simple first stab at the problem might involve using elementary physics.  The vehicles have given weights, they travel at certain speeds over different portions of the road, the road's gradient and curvature are known.  Based on this information you could, with some effort, derive a forecast for the progress of the convoy.

However, to improve your forecast, you might also consider the weather.  Unfortunately, the weather is changeable.  You have a general idea of conditions, but the specifics at each point on the road are not known.  Furthermore, these conditions can change unexpectedly.  You need to make a best guess and factor this into your forecast.  You will also need to update it as the convoy progresses and available information changes.  The same principle applies to other factors like the mechanical condition of the vehicles, and the mental condition of the drivers.

When you make your forecast you realize that it is only a best guess.  It is subject to change due to factors that are difficult to predict.

If you had some control over the highway or the vehicles you might be able to reduce the chances of a serious slowdown or pileup.  Suppose you had a radio controller that could uniformly boost or reduce the amount of fuel all the vehicles consume.  If conditions looked dangerous you could dial down consumption of gas, slow the convoy down, and reduce the chances of something bad happening. 


This type of forecasting and policy recommendation corresponds roughly to state-of-the-art economic forecasting prior to the introduction of Rational Expectations theory thirty to forty years ago.  Tom Sargent was an important contributor to that literature.  Chris Sims' contribution was to develop statistical techniques that identify how economic variables influence each other as time progresses.

When you cut back gas consumption you assumed this would make the cars go slower.  However, drivers are not automatons and they adjust their driving behavior based on the conditions they observe.  They do this by gathering all the relevant information they can: direct observation of the road through the windows, listening to the radio, talking with other drivers on cell phones, etc.  When things look dangerous, they slow down on their own.  If you dial down the gasoline flow, drivers will simply push harder on the accelerator to compensate and will maintain the speed they think is best.  .  Ignoring the responses of the drivers (decision makers) in the convoy (economy) to your manipulation of the gas flow (economic policy) gives bad forecasts.  Good forecasts will incorporate these rational responses.

The 2008 financial crisis and recession have been held up by some people as evidence that Rational Expectations is incorrect.  If decision makers are gathering information and processing it effectively, how could they have missed the subprime meltdown?  Why did they ignore the warnings of those who were warning against just such a meltdown at the time?

Go back to the convoy.  Suppose you have a fellow forecaster who believes the brakes on a large semi-truck are about to fail.  As the convoy makes each turn along the route he announces over the radio to all concerned that the semi is about to run out of control, tip over, and cause a massive pileup.  However, for the first several turns the brakes hold and the convoy continues on unharmed.  Eventually, everyone discounts his predictions of doom.  If the brakes finally do fail, it comes as big surprise to almost everyone.  Why did drivers not foresee the crash?  Why did they ignore the voice on the radio?  Because the problem was small, subtle, not readily apparent to anyone but an expert, and the exact moment of failure was largely random.

The problem is not that the forecasting methodology is wrong.  Rather, it is that unexpected or difficult to predict events can in some circumstances have huge consequences.  They are easy to see in hindsight, but not so easy to see before they happen.  One message the Nobel committee sent was that rational expectations is still an important piece of economic theory.

Is another recession on the horizon?

This article appeared in the Deseret News on Tuesday, October 4th.

According to the National Bureau of Economic Research (NBER) our most recent U.S. recession began in December 2007 and ended 18 months later in June 2009.  There are no precise criteria for deciding when recessions begin and end.  Instead, the NBER uses a variety of economic data to reach a consensus on the dates.  The general idea is to look for turning points in economic activity.  A peak, when economic activity begins a sustained fall is the beginning of a recession.  A trough, when the economy stops shrinking and begins to expand again is the end.  One commonly used rule of thumb is that a recession is at least two quarters of falling inflation-adjusted gross domestic product (GDP), while a recovery is two quarters of rising GDP.

Not all recessions and recoveries are equal, however.  A downturn can be mild as the one from July 1990 to March 1991 was, when GDP fell by 1.3%.  Or it can be severe like the most recent one where GDP fell by 5.1% from peak to trough.  In addition, recoveries can be anemic or robust.  For example GDP grew almost 14% in the two years following the 1981-82 recession, while it has only grown 5% in the two years since the end of the last recession.

What exactly causes a recession is a matter of intense debate amongst macroeconomists.  It is likely that there are many causes.

Keynesian theories focus on the role that consumer confidence plays in recessions.  When consumers begin to feel pessimistic about the future, they will save more and spend less.  This leads to a decrease in demand for goods and services.  If the prices of goods are slow to adjust, this will, in turn, lead to a surplus of production and firms will begin to lay off workers.

New classical economic theories point to the role of technology.  When there is a drop in productivity, firms will be unable to produce as many goods as they could previously.  The drop in worker productivity leads firms to lay off workers and leads to a recession.  It also causes capital to be less productive and this leads to large drops in purchases of investment goods.  New classical economists realize that technology rarely decreases, but they point out that energy price increases and increases in taxes are often identical in terms of their effects on firms.

Financial crises can also cause recession if they have a major impact on the banking sector.  When banks are in financial trouble they are reluctant to lend to businesses, and many sectors of the economy rely on bank lending to cover up front costs.  Residential construction and shipbuilding are two good examples.  A loss of lending forces these firms to lay off workers since they cannot borrow the money to pay their wages.

Our most recent recession was caused primarily by the subprime mortgage financial crisis.  The resulting drop in consumer confidence was likely an important contributing factor.  The anemic recovery, however, is likely due to other causes.  One facet of recent recoveries has been the slow rebound in employment.  This is especially true of the past two years.  A great deal of this is due to government policy.  Increases in personal and corporate income taxes are very similar to drops in technology from the point of view of firms hiring workers.  It makes no difference to the firm if revenue is lost because the firm is less efficient than before or because the government takes more in taxes.  Expectations of increased taxes act as a powerful disincentive to businesses.  Since most business operators dislike dealing with uncertainty concerning the future business environment, even uncertainty about whether taxes will go up or not, can act as a drag on the economy.  The expectation of increased government regulation can also mimic a productivity drop.  When particular methods of production are banned or made more costly, this forces firms to adopt different production techniques that are likely less efficient (else the firm would already be using them).

Are we headed toward another recession soon?  It is difficult or impossible to say for certain.  Unpredictable future events will have bigger effects than anything foreseeable right now.  The unfolding sovereign debt crisis in Europe has the potential to stress the banking sector.  But a banking meltdown is not a foregone conclusion.  Increased taxes are a possibility, particularly with the increased attention the public and policymakers are placing on reigning in government deficits.  However, budgets can be balanced by cutting spending rather as well, so it is entirely possible that tax rates will not be raised.  The implementation of Obamacare has the potential to impose costly regulation on firms that would lead to a drop in productivity.

One thing that is certain is that there will be another recession sometime.  It may begin this year or we may be lucky enough to go a decade or more without one.  When making financial plans for the future it is always a good idea to remember that recessions are a recurring feature of the economy.

This article was published in the Deseret News on Tuesday, September 20th.

The Greek financial system is in big trouble right now.  The fundamental problem is that the Greek government has been on a bit of spending bender over the past few years and has borrowed a lot of money to pay for this, all of it denominated in euros.  It has become frighteningly clear that this level of debt is unsustainable and the Greek government needs truly radical fiscal reform to avoid defaulting on its outstanding debt.  Much of that debt is held in the form of Greek government bonds by Greek banks, but a large amount is also held by various financial institutions outside of Greece.

By itself this is not really a very interesting or important situation.  There are a large number of countries in the world and inevitably, some of them get into fiscal trouble.  Some sort of financial crisis of this sort happens on a fairly regular basis.  Greece is, however, a member of a monetary union.  And its financial health could have an effect on the financial health of other members of that union.

The euro is a unique currency because it is issued by a collection of sovereign states, rather than by a single country as is usually the case.  The currency was formally introduced into circulation in 2002 and replaced the national currencies of the participating countries.  Control of the euro money was given to the European Central  Bank (ECB), which was created with the sole purpose of managing the euro.   When the euro was created it was very clear that all member countries would be using a single currency and would therefore be unified monetarily.  It was not clear, however, how unified these countries would be in fiscal terms, however.  There is no governmental equivalent to the ECB.  There is a European parliament, but there is no central government with authority to tax and spend for the European Union as a whole.  Fiscal matters are, in theory, left entirely to the individual member countries. This means there is no natural central source of funds to "bail out" the Greek government.  The two bailout packages worked out so far have been hammered out via complex negotiations between Greece, the ECB, and other European governments.

Suppose Greece decides it is going to default on its government bonds.  Does this necessarily mean that the euro as a currency is in trouble?  Not necessarily.  In fact, if there is no expectation that Europe is a fiscally united, then there should be no issue at all.  Greek bonds, though denominated in the same currency as German bond, already pay higher interest rates due to their higher probability of default.  If the Greek government decides to default, things could get really bad for Greece, but it need not affect other European countries.  The fact that German and other European banks hold Greek government bonds could lead to increased stress on the banking sectors in those countries, but it need not lead to dissolution of the euro as a currency.

However, a problem does arise with one the way that Greece might choose to default on its debt.  Rather than default outright, the Greek government could choose to drop out of the euro zone and reintroduce their previous national currency, the drachma.  They could do this by initially trading all euro amounts in Greece one-for-one with drachma, for example, and legally rewriting all contracts in euro to contracts in drachma.  Then the Greek central bank could drastically increase the number of drachma in circulation and repay its nominal debt with this new money.  The result would be a devaluation of the drachma.  Greek assets would be worth less on the world market, just like a default, but a formal default would be avoided.  In effect, Greece would be solving its fiscal problems by imposing an inflation tax and at least some of the burden of that tax would fall on non-Greek holders of Greek government bonds.

Now suppose you had a time machine and knew for certain that this was going to happen on Dec. 31st 2011.  What should you do today?  You should sell any Greek assets you hold today to avoid the inevitable loss in their value when the drachma is devalued.  If you are a savvy investor you might take profits by short-selling Greek debt.  Even if you don't have the time machine and are uncertain what is going to happen, you might still find it prudent to sell.  When all or most investors do this, the result is a worsening of the financial crisis.

If investors feel that Greek devaluation is becoming more and more likely, it is only natural that they begin to look at other European countries with similar fiscal problems.  These countries include Ireland, Spain, Portugal, and perhaps even Italy & France.  If enough countries choose to withdraw and devalue their currencies - particularly if either of the latter two do - then the euro as a multinational currency will effectively be dead.

Greek fiscal problems don't automatically mean the euro is doomed, but it is very easy to see why policy makers in Europe and elsewhere are worried that events are moving in exactly that direction.


  • Richard W. Evans is an Assistant Professor of Economics at Brigham Young University

  • Jason DeBacker is an Assistant Professor of Economics at Middle Tennessee State University

  • Kerk L. Phillips is an Associate Professor of Economics at Brigham Young University