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On self-fulfilling expectations

On self-fulfilling expectations

Have we talked ourselves poorer? Economists increasingly suspect that we have, because expectations of weak growth might be a cause of such weak growth.

Simon Wren-Lewis at Oxford University says that if companies believe (whether rightly or not) that trend growth will be low, "then the need to invest to meet an expanding market largely goes away", so we'll get slow growth. "There's a self-fulfilling aspect to pessimism," says the Peterson Institute's Olivier Blanchard. Roger Farmer at UCLA has shown how declines in what Keynes called "animal spirits" can depress growth. And Christopher Gunn at Carleton University in Canada has shown how such expectations can drive not just demand but also productivity growth, because optimism about future demand can encourage companies to introduce new innovations and technology.

Such self-fulfilling expectations might be one reason why financial crises tend to depress economic growth for years afterwards. Such crises have a 'scarring' effect: the memory of them makes people scared to invest even long after they've passed.

Maybe therefore talk of secular stagnation isn't just a symptom of our problem, but also a cause of it.

This raises a question: is our era of low expectations and low growth permanent or temporary?

Professor Blanchard believes the latter. He thinks demand growth has been weak because people have adjusted spending downwards in response to expectations of lower future productivity growth, but that growth should recover once the adjustment period is over.

The recent rise in share prices to a record high in the UK and US might be evidence of this. It could be that the election of Donald Trump as president - with his promise of big infrastructure spending and tax cuts - has jolted expectations upwards. It's not just stock markets that have risen lately, so too have consumer and business confidence.

However, longer-term real interest rates aren't much above last year's lows and are still far below their pre-crisis levels. This suggests that, by historic standards, longer-term growth expectations are still depressed.

There might be a good reason for this. Maybe it's low growth and low investment that is normal and so low expectations are rational.

I say so for two reasons.

One is that our belief in a high trend rate of growth owes much to what was in fact a historical abnormality: strong growth in the post-1945 years. Between 1946 and 1973 UK real GDP per person rose by 2.7 per cent per year. But it rose only 0.9 per cent per year in the 150 years to 1939. It could be that what we're seeing now is a reversion to the long-term norm. Low expectations might be due to the fact that memories of the golden age of capitalism are fading, and to the fact that increasing numbers of business leaders never had them in the first place.

Secondly, we know - thanks to the work of William Nordhaus, Charles Lee and Salman Arif - that innovation and capital spending has often not yielded high profits. This tells us that animal spirits have in many cases been too high in the past. That they are low now (as measured by actual capital spending) might therefore be a sign that managers have learned from past mistakes.

Perhaps, therefore, depressed expectations are rational. It doesn't follow, of course, that they'll stay depressed. But this does suggest that if growth and expectations do improve, the pick-up might not be sustained.

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By Chris Dillow,
09 March 2017

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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