Business News/ Opinion / Views/  Remember Robert Lucas everytime expectations confound us

Economic doctrines pursued today are dominated by two theories: Monetarism and Keynesian. The former is used to justify monetary policy action that according to Milton Friedman is effective in inflation contol. The fiscal aspect of growth is explained well by the theory of Keynes. But both these theories could be exceptions that work at times and not always be effective. This may sound odd, given that most countries espouse these tenets for policy. But the factual at times does prove this supposition because regardless of what authorities do, the desired results aren’t always attained.

The clue to this conclusion lies in the realm of the theory of Rational Expectations, which gained fame in the 1970s. Robert Lucas, who won the Nobel Prize in Economics in 1995 for his role in this school, had a different take that remains relevant. Today, we often say that even though interest rates were kept low post the financial crisis or as covid relief to secure growth, there was no discernible impact on it. A Keynesian would argue that growth is better engineered by an expansionary fiscal policy. But even uncontrolled expansion of the deficit by giving cash handouts did not restore growth, though it made living easier. In fact, both central bank and government actions contributed to inflation rather than growth. Clearly, neither theory helped much.

Robert Lucas worked with Thomas Sargent on a theory based on the principle of ‘rationality’. Micro-economics assumes that all economic agents are rational and take decisions based on available information and expectations. Therefore, the same assumption must feed macroeconomic analysis. To take decisions, for example, people need to know the policy environment and other conditions as revealed by data, so that they can formulate expectations that guide actions. When expectations were negative during covid, investment did not take place even though authorities did everything possible.

If interest rates are kept stable and the government spends prudently, all affected sectors will take decisions on investment and employment based on this information. This will lead to an optimal growth rate. People do not borrow money only because it’s cheap. This is why lower rates rarely promote growth. Note that India experienced higher growth in the earlier part of the last decade, when interest rates were high. This is where demand comes into the frame. If the Centre is conservative and the private sector hesitant to invest, then monetary action achieves little.

Similarly, as visible today, it is not possible to control inflation by letting unemployment rise, which is what the conventional Phillips Curve spoke of. Theory said that as joblessness rises, it can bring down prices as demand drops. But this is not happening. Unemployment has gone up in India and inflation remains high. Cheaper loans did little to create jobs as the future expectations of enterprises did not lead them to do so.

In short, the theory says that all monetary and fiscal policy announcements will get discounted by the market. If the Centre is expected to enhance capex or RBI to slash rates, business decisions will been made assuming this. Therefore, expected measures have only a muted effect on macro parameters such as investment or employment rates. One often hears after a credit policy that the action had already been buffered in by the bond market, say, and so yields did not move. Ideally, our policymakers should state their stance at the beginning of a year and let things be.

Rational Expectations further argues that beyond a point, the only way a government make policy work is by ‘fooling the public’. This means that a stance is taken and then changed through shocks which in turn can create an impact. But here too, it is argued that the effect is temporary, as once people get to know of the temporary nature of a shock or policy, they would re-adapt to this new environment. If the market expects a 25 basis points repo-rate hike but RBI goes in for 40-50 basis points, it works. But this is only for few days. Things revert to normal and growth remains unaffected.

Embarking on reforms sends a strong set of messages to investors, which then forms expectations and brings about investment, employment and growth. However, sudden shifts in stance and policy changes in the form of, say, additional customs duties on steel, can disrupt expectations. But again, this will be only for a short duration, after which the news gets absorbed. The imposition of such duties by earlier Indian budgets did not really have a significant impact on the steel industry.

Rational expectations is surely an extreme view. It urges policymakers to be transparent with their stance and let market forces play out. The assumption here resembles one made by classical economists that all economies would reach an equilibrium which may not always go with full employment. There would be a ‘natural rate of unemployment’ that cannot be eschewed. Growth, employment and investment would all be guided by rational decisions taken by economic agents and hence the government should provide a medium-term perspective with few deviations to maximize certainty. That, in essence, would be what Lucas would have reiterated.

Madan Sabnavis is chief economist, Bank of Baroda, and author of Banking Trends and Controversies. These are the author’s personal views.

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Updated: 24 May 2023, 11:28 PM IST
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