The Bank of Sweden Prize in the economic sciences for 2011 to Thomas Sargent and Christopher Sims is an affirmation of an old, but remarkably controversial, idea: that individuals are rational and capable of making informed choices. Economists have squabbled on it for long.
Formally, their theory is mathematically complicated,?but in essence, its ideas are simple. In any economy, policymakers want to reduce unemployment, increase output and raise purchasing power. This is done on the basis of an appropriate mix of monetary and fiscal policies. If employment is to be raised, interest rates are brought down and taxes lowered. There can be other combinations as well. Policies are usually framed by observing past data—weeks, months and years. This is the traditional view of policymaking.
In a famous 1975 paper with Neil Wallace, Sargent showed this quest to be illusory. For one, economic agents—individuals and firms—are not silent “takers” of policies. They anticipate them and modify their behaviour accordingly. They do this on the basis of future expectations and not past observation. If agents expect inflation to rise by 10% in the year ahead, they will demand wages that are higher than this rate. Similarly consumers would be willing to borrow money at 12% interest to purchase durable items if they expect future inflation to be, say, 7%. If there were no inflation, they would reconsider. This was the basis of the famous policy ineffectiveness theorem.
The travails of the Union government in recent years in creating employment and its inability to control inflation are a good example of these theories. The assumption that there was a simple unemployment vs inflation trade-off has backfired. Even a cursory look at the inflationary expectation surveys by the Reserve Bank of India shows that individuals have anticipated these effects very well. They bury claims that individuals have limited rationality, preventing them from anticipating changes in policy variables.
Rational expectations is now a half-century old idea that began with a paper by John Muth in 1961. Since then, evidence to support the theory has been, frankly, mixed. As always, it will take another better theory to defeat it. The timing of the prize should not be misinterpreted as motivated by an effort to drum up support for “Wall Street” or something equally absurd. In 1974, when Friedrich Hayek was awarded the prize, his theories —especially his monetary theory of the business cycle—had been dismissed 33 years earlier. Yet, in the end, the Nobel committee gave him the prize for his insights into the working of the modern economy. So is with Sargent and Sims.
In the end, the question is not about the wisdom of a few well-meaning policymakers, but that of the rationality of the many.
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