Rational Expectations Versus Irrational Spending

This was forwarded to me by a friend. Hey, Frank, I don't text! Costs too much. But I'll never know what he means. Inside joke.

Moving along. This is a great piece by Peter Navarro talking about rational expectations:

"The theory of "rational expectations" was developed by conservative, neoclassical economists (primarily the "Chicago School") to explain why it is fruitless to engage in any kind of Keynesian fiscal or monetary policy to artificially stimulate an economy. The best way to explain theory - which is HUGELY relevant for today's financial markets - is with an example.

Suppose, then, that the US government engages in a massive fiscal stimulus to jumpstart an economy in recession. But also suppose that this massive stimulus will require equally huge budget deficit financing that over time will surely increase both interest rates and inflation. Since people are rational, they will therefore "expect" the advent of higher interest rates and inflation and behave in ways that will defeat the intent of the stimulus.

How do they "anticipate" this? How does this 'expectation" manifest itself? Is it a hunch? I say this because most people aren't macroeconomic literate. Lotsa "this" in there, I know.

In particular, consumers will save more because they know the stimulus will only eventually provoke an even deeper recession. This behavior will suppress consumption spending, thwarting recovery.

Businesses will also try to raise prices in anticipation of inflation while workers will demand higher wages -- thereby causing an inflationary shock earlier rather than later. Bond market investors will refuse to buy the bonds needed to finance the deficits because they know as interest rates rise, bond prices will fall. Stock market investors won't buy stocks because they know another bear market is coming. And foreigners won't help the US government finance its deficits because they know the dollar will become worthless -- along with their US bond holdings.

The liberal critique of rational expectations theory -- think Krugman or Reich -- is that people aren't really that smart about macroeconomics or that rational to fully anticipate all of the effects so there is a period of time during which a fiscal stimulus can actually work its magic.

I think both the right and left are guilty of under estimating people. The only difference is the left has decided the government is needed to help us along - and in some cases to "save us from ourselves".

So who's right?

Well, right now, the financial markets are a living, breathing experiment to prove -- or disprove -- the rational expectations argument. When BOTH the stock and bond markets turned bearish last week, that seemed to be a signal that the rational expectations argument may hold sway.

Of course, readers of this column will know that I've been speculating on at least a brief bullish cycle of a few months or even a year or more. However, readers should also know that I am a secular bear precisely because the Obama-Bernanke-Geithner-Summers Program contains the seeds of its own destruction -- see paragraphs above.