Wednesday, June 3, 2015

Expectation and Reality

I was outside mowing the lawn, thinking about the way JMK laid out supply and demand. I summarized it the other day:
Effective demand occurs at the intersection of supply and demand, where supply is

the expectation of proceeds which will just make it worth the while of the entrepreneurs to give that employment

and demand is

the proceeds entrepreneurs expect to receive from the employment of N men

I also remembered what he said about expectations:
It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. It is reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty. For this reason the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change.

In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention — though it does not, of course, work out quite so simply — lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.

I hopped off the mower, ran into the garage, grabbed a pad and pen, and wrote:

Expectations are the reason things don't go bad until they go bad suddenly, and, when that finally happens, expectations are the reason things get far worse than the situation merits.

Expectations only look like the reason it is so difficult to recover from a financial crisis. The true reason is that we don't reduce private debt quickly and sufficiently -- we don't solve the problem -- so there is no real improvement. With no real improvement, discouraged expectations are altogether appropriate. But they are a result, not the cause, of the lethargy.

Expectations are the source of lag; they explain why lags are "long and variable". But expectations arise from realities. Realities drive expectations. You cannot fix the economy by changing expectations, but only by changing realities.

You can only fix the economy by actually fixing the economy.

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