Expectations

Source: Michael Leddy

Another oddity in the annals of capacity utilization

Graph #1: Growth Rates of RGDP (blue) and Capacity Utilization (red)
(Click the graph for a bigger picture in a longer time period)

The 1982 recession was followed by an uncharacteristically large increase in RGDP growth (blue) and an unusually small increase in Capacity Utilization (red).

Hm. If capacity increased fast enough, RGDP might increase faster than we could put the new capacity to use. I wonder: Did capacity grow particularly fast after the 1982 recession?

By the standard of later years at least, it did:

Graph #2: Growth Rate of Investment

So maybe that's it: A vigorous bloom of new capacity allowed economic growth to increase faster than capacity utilization. But the vigorous bloom did not last. There followed almost immediately a great moderation of investment spending.

It looks to me as if the brief bout of vigor was brought on by great expectations, and the end of the vigor by expectations disappointed. And perhaps we know the source of that disappointment -- disappointing profits:

Graph #3: Corporate Profits relative to GDP

There is no more certain extinguisher of expectations, than reality.

What else could we reasonably do?

On expectations, from Unlearning Economics:

Any attempt at a serious discussion of transmission mechanisms is met with ‘expectations!‘ as if expectations are a magic wand and not simply a reflection of the actual behaviour of the economy.

It's awkward when a great line is buried in such a way that when you quote it, it seems something is missing and you ought to include the part that came before. But anyway what UE says is: Expectations are a reflection of the actual behavior of the economy. Expectations depend on economic conditions. If you want to improve expectations, you have to improve the economy.

I do think it can temporarily work the other way. I think the big boom we had early in the Reagan years was partly expectations-driven. People had big hopes:

Graph #1: The Red Spike Early in the Reagan Years -- A "Brief Interval of Excitement"

It didn't last. And it didn't happen again. Expectations were disappointed because the economy wasn't as good as Reagan promised it would be. As the graph shows. But a lot of economists seem to remember the one impressive aberration and base too much of their work on the presumed power of expectations.


Two paragraphs from Chapter 12 of The General Theory of Employment, Interest and Money by John Maynard Keynes, The State of Long-Term Expectation:

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.

Expectations are a reflection of the actual behavior of the economy. We assume that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.

What else could we reasonably do?

"Time doesn’t run backwards."

This is the best put-down I think I've ever seen, of "expectations" in economics. From Steve Roth:

... cause really does almost always precede effect. Time doesn’t run backwards. (Unless you believe, like many economists, that people, populations: 1. form both confident and accurate expectations about future macro variables, 2. fully understand the present implications of those expectations, and 3. act “rationally” — as a Platonic economist would — based on that understanding.)

But while I'm on the subject of expectations, I want to round up some excerpts from Maynard. From The General Theory, Chapter 5: Expectation as Determining Output and Employment:

ALL production is for the purpose of ultimately satisfying a consumer. Time usually elapses, however — and sometimes much time — between the incurring of costs by the producer (with the consumer in view) and the purchase of the output by the ultimate consumer. Meanwhile the entrepreneur (including both the producer and the investor in this description) has to form the best expectations he can as to what the consumers will be prepared to pay when he is ready to supply them (directly or indirectly) after the elapse of what may be a lengthy period; and he has no choice but to be guided by these expectations, if he is to produce at all by processes which occupy time.

... It is upon these various expectations that the amount of employment which the firms offer will depend. The actually realised results of the production and sale of output will only be relevant to employment in so far as they cause a modification of subsequent expectations...

It would be too complicated to work out the expectations de novo whenever a productive process was being started; and it would, moreover, be a waste of time since a large part of the circumstances usually continue substantially unchanged from one day to the next. Accordingly it is sensible for producers to base their expectations on the assumption that the most recently realised results will continue, except in so far as there are definite reasons for expecting a change.

So the rule is that expectations are based on existing conditions (or "recent results").

For the world's economists, everything depends on expectations. For me, expectations depend on the results we're getting now.

Which come first? Easy. Results come first. Results set the standard.

Graph #1: US Real GDP Growth Rate Since 1975

See that high spot there, that big peak just before 1985? That was expectations. That's what we got from electing Ronald Reagan. Everybody had great expectations.

But it didn't last. Look at the graph. Everything since 1985 stinks.

// update, 4:03 AM

By coincidence, Marcus yesterday showed this graph,

Graph #2, Source: Marcus Nunes

He pointed out the low spot in it, and wrote:

I wonder if the July 1932 ‘bottom’ is associated with FDR´s nomination acceptance speech on July 2, 1932.

Yes to that. I think that's how "expectations" works. You get a great surge of optimism or pessimism that cannot last long. Cannot last, because it's based on expectations rather than on economic fundamentals like cost. You get a trend anomaly and that's about it.