Improving Expectations Won't Improve the Reality of Economic Conditions
Given the popular view that expectations are the key driving force of an economy, many economists hold that "positive" thinking and large dosages of "good" news can prevent bad expectations from developing. This, in turn, will prevent a fall in economic activity.
This is why, when the economy falls into a recession, economists quoted by the press are often very guarded in their speech.
On this 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"1
Again, this gentle talk stems from the fear that harsh language will upset people's confidence, and thus expectations about future economic conditions. If people’s confidence is kept stable then stable economic activity will follow, so it is held.
Given that stable expectations are said to imply stable future economic conditions, many economists strongly recommend that government and central bank policies must be "transparent."
Let us assume that the government presents a plan to raise personal taxes. How can the mere fact that this plan is made known to everybody will prevent an erosion of individual's living standards and economic instability?
Even if politicians could succeed in convincing people that the tax increase is good for them, they cannot alter the fact that individuals’ after-tax incomes will be reduced, all other things being equal.
Or let’s say that the central bank makes it public knowledge that it will dramatically increase the money supply.
How can the simple publication of this information prevent capital consumption and the development of a boom-bust economic cycle?
What is to be gained if every individual has been brainwashed to believe that things are fine while in reality the economy is falling apart?
So called “stable expectations” can’t undo the damage caused by loose monetary policies or by higher taxes — opinions about facts do not change the facts themselves.
Hence, what matters is not whether government and central bank policies are transparent, but whether these policies hurt individual’s wellbeing.
Expectations in Free versus Not-Free Market Economy
Consumer expectations do not emerge in a vacuum but are part and parcel of every individual’s evaluation process, which is based on his views regarding the real world.
In a free and unhampered market economy, whenever individuals form expectations that run contrary to the facts of reality, this sets in place incentives for a renewed evaluation and different actions. The market will not permit prolonged mistaken evaluations.
Let us assume that as a result of incorrect evaluation, too much capital was invested in the production of cars, and too little invested in the production of houses.
The effect of the over-investment in the production of cars is to depress profits, because the excessive quantity of cars can only be sold at prices that are low in relationship to costs that went into making them.
The effect of under-investment in the production of houses on the other hand, will lift its price in relation to cost, and thus will raise its profit.
This process will lead to a withdrawal of capital from cars and a channeling of it toward houses, 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.2
In a free market, the facts of reality will assert their dominance quickly through peoples’ evaluation and therefore their actions.
This is, however, not so in a distorted market economy. By enforcing their policies, governments and central banks can in motion a prolonged deviation of expectations from the facts of reality.
Neither the government nor the central bank can indefinitely defy these facts, however. A classical case of this is the artificial lowering of interest rates by the central bank that results in boom-bust cycles.
We can conclude that in a free, unhampered market economy, individual’s expectations will have a tendency to change in tandem with true market conditions.