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Commentary: Dashed expectations hurt the economy

This article first appeared in the St. Louis Beacon, June 20, 2012 - Expectations play a significant though little understood role in economics. In most introductory economic courses, for instance, the main drivers of, say, demand, are factors such as your income and the price of other goods. When your income rises you tend to buy more. When the price of beef rises you tend to switch to a relatively cheap meat, such as pork.

Suppose your expectation changes: You believe your income will rise, or that the price of beef will increase relative to pork. We can predict those effects, but are less certain on the actual outcomes. Why? Because we do not know whether your expectation is correct until after the fact. And having one’s expectations dashed is a key reason for the current malaise in economic policy.

Consider two examples, one at the individual level and another at the macro level.

For many years prospective college students were told that getting a degree opens job doors and guarantees higher incomes. Generally this is true: individuals with a college degree are less likely to be unemployed and more likely to earn higher incomes over their lifetimes. So, quite sensibly, families and students borrowed to pay tuition against the expectation of this expected outcome. The problem is that those expectations have not been met. This has helped create the current student loan debacle that many believe will necessitate some governmental intervention.

Were these students wrong to borrow? In some cases, yes. Some degrees simply have never had the incomes that could service a six-figure debt right out of school. Did these students (and their parents) think things would change in four years?

Who ramped up these false expectations? Some blame universities for being less than candid about student aid. Shouldn’t borrowers shoulder as much of the blame? I find it difficult that rational borrowers (perhaps too strong an assumption) would allow themselves to be fooled for four or more years into thinking that a degree in art history from NYU would generate the income necessary to pay off $250,000 in student loans.

Government loans at extremely low teaser rates helped increase educational attainment, but also altered expectations about responsibility. How many 30-plus year olds do you know that are still paying off student loans, not because they are so large but because the amortization schedule was so favorable to delaying payment?

On the macro side, turbulent expectations have left policy in disarray. The results of the recent Greek election briefly buoyed stock markets one day as the outcome suggested a government more receptive to the changes needed to hold the euro together. But the elation was short-lived: markets quickly turned their attention to future problems arising in Spain. On the eve of the Fed meeting, where expectations are that they will step in once again, stocks soared. One set of expectations was met, another looms.

Fiscal policy is in a shambles and roils expectations. With the Presidential and Congressional elections looming on November, one knows what to expect. The approaching “fiscal cliff” paralyzes business and markets because no one knows what to expect. Will the proposed tax and spending proposals be enforced, even though some predict that doing so would push the fragile economy into recession? Or will the Bush tax cuts be extended and the proposed spending cuts be scaled back? Weakly held expectations of any solution reflect this lack of leadership.

Tyler Cowen recently wrote in the New York Times that “the reason we are not getting more expansionary macro policy is fundamental: lack of trust.”

I argue that this lack of trust stems from policies that have skewed expectations. Perhaps we do not trust policy makers because they promised more than they could deliver. Fool me once…

Rik Hafer is a distinguished research professor in the Department of Economics and Finance at Southern Illinois University Edwardsville and a scholar at the Show-Me Institute.