Irrational Expectations

It is a nice question whether Britain’s economic institutions or the attempts of economists to explain why they do not tick are in a greater mess. Every now and then, albeit with decreasing regularity, a government minister will tell us, as the Chief Secretary of the Treasury does in the collection of essays on The 1982 Budget, that there is a new dawn over the hill, that, before our very eyes, ‘things are improving’ – only to be contradicted by some even more authoritative voice, although it hardly needs the CBI to remind us of the frailty of political positive thinking. Yet the present administration has at least made Britain’s economic sickness superficially more accessible to reason by specifying both the disease and its putative cure in radically simple terms.

For three years now we have been living with a political economy which acknowledges only one basic problem (rising prices) and only one possible solution (monetary restraint). When the Labour Government of 1974-79 abandoned Keynesian demand management as the centrepiece of its policy, it was sufficiently conservative not to allow a new preoccupation with money and credit to obliterate a vestigial concern with such traditional economic problems as the level of unemployment or the balance of trade. It remained for Mrs Thatcher to stake her all on a single objective and a single instrument – even though the principal focus of the latter seems to have shifted from the control of the money supply to the reduction of the public sector borrowing requirement (PSBR). If these magnitudes can be brought to heel, we are cajoled, then all else will follow.

How far this laser-like vision of reality comprehends a coherent body of economic theory is not immediately obvious. Certainly, it is replete with incantations which suggest an unusual correspondence between political policies and economic models. And the constituent elements of at least some versions of recently fashionable monetarist theory can be discerned: the presumed difficulty – even impossibility – of a government acting successfully as well as directly to determine the performance of the ‘real’ economy; the monetary essence of inflation; the importance of ‘rational expectations’ on the part of economic agents, and the consequent need to ensure absolute consistency and predictability in government financial and monetary policy; the intangible, conceivably empty, conceptual meaning of ‘involuntary’ unemployment. And for their part, many academic monetarists find much to applaud in the Government’s economic posture. Clearly, a symbiotic thread runs between the new economics and the new Conservatism.

It would be good to be able to report that The 1982 Budget offers a useful introduction to the current debate about economic policies. Intended as a survey, from various theoretical perspectives, of our annual ritualistic grope with economic reality, it certainly should fill that role. In fact, however, it is an unsatisfactory guide: partly because its authors are talking, if not to the converted, then at least to the initiated, but principally because what they actually offer is a rather loose collection of attenuated, episodic comments, many written in a staccato and allusive style. Moreover, the book lacks what would, to the innocent, appear to be indispensable: a systematic description of what the Budget was actually about in the context in which it was formulated.

The main lesson that emerges (for those, at least, who do not yet subscribe to the monetarist view of the economy) is the disconcerting flabbiness that lies at the heart of the new economic policy. For the Ark of the Covenant contains (or has, over time, contained) two concepts which are, to use an alternative fashionable jargon, ‘problematic’ in the extreme: a specific measure of the money supply, M3, and the PSBR. On these two targets, specified with impressive precision, policy sights have been firmly set; success is identified with their attainment, and will ultimately ensue. For, in their direct consequences and through their perception by economic agents with rational expectations, they can move the world. Now it is fairly obvious that no economist worth his salt has ever denied the significance of the supply of money or of government borrowing. What is very difficult to accept, however, is, on the one hand, that their precise role in the working of the economy is very satisfactorily understood; and, on the other, that either concept is unambiguous, or susceptible to useful and accurate measurement, let alone prediction. Erecting an economic policy solely on the basis of official concepts of the money supply or of future public borrowing is like building a house on ectoplasm.

Thus Marcus Miller, by no means unsympathetic to monetarist economics, goes so far as to describe M3 as a ‘relatively meaningless monetary aggregate’. And, lest proponents of pecuniary discipline shake off that comment by observing the more recent significance of the fine tuning of public borrowing, Nick Morris (much more decisively in the Keynesian tradition) reminds us that the PSBR is, after all, only a residual between two big and unpredictable numbers. (A sympathetic echo is struck in Controlling Public Industries, where Redwood and Hatch, while accepting that the concept of the PSBR may function as a crude check on official profligacy in an imperfect world, go so far as to admit that in an ideal world ‘the PSBR, as currently defined, is a theoretical nonsense.’) In any event, the future magnitude of an entity that can be neither predicted nor managed with any great precision is a curious, as well as dangerous, plank for policy. Nor does the problem stop there: just as Miller points out in The 1982 Budget that the absolute and relative sizes of the borrowing requirement are transformed by measurements which allow for price changes, so Morris and David Savage, in the same book, make the even more telling observation that public expenditure and income are not dependent solely on government policy. They vary with fluctuations in the economy, since these fluctuations will change the expenditure needs (for example, unemployment or social security benefits), the yield of taxes, and the profitability of nationalised industries. Hence any useful measure of PSBR – or of fiscal policy generally – should adjust for cyclical variations, and any estimate of the consequences of changes in public expenditure should take account of its effects on public income. Life is, after all, very complicated.

Things look different, of course, on the other side of the theoretical divide. In his comments on the Budget, Patrick Minford, the most determined monetarist around, argues that the Government’s financial and monetary policy is absolutely right. Yet in justifying these comments, and in his discussion of the nature of unemployment, Minford leads us onto the more treacherous ground of theoretical fundamentals. These involve the relationship between ‘rules’ (usually derived from government guidelines for monetary and fiscal variables) and ‘expectations’, which work within rules and can adapt decisively to a decisive (and stable) change in them. Hence the monetarist argument against counter-cyclical meddling with demand management: it sends out confusing signals which frustrate rational expectations, or generate alarm, and disorientate the economy. Hence, too, according to Minford, the danger of maintaining unemployment and social security benefits so high in relation to wages: sooner or later the labour force will learn about these rules and their permanence, and act accordingly (i.e. choose to be unemployed). This sort of argument is interesting, and expectations and incentives are clearly important aspects of the workings of any economy. But to attribute so much importance to them, and to such political perversities as the neglect of huge fluctuations in the economy, itself verges on the perversely simplistic.

Simplification – as that term is understood by the layman – is not an accusation that can be levelled against Frank Hahn’s published lectures on Money and Inflation. For, in spite of the book’s relaxed and even reassuring title, it is primarily a rigorous essay in abstract theory, and incidentally a sustained assault on the new monetarism. At a general level, it provides a salutary reminder of the problem posed by the mere existence of money for the satisfactory construction of economic models, and of the complexity thereby introduced into their operations. More critically, however, Hahn picks away at the foundations of some recent economic analysis: he points to the absence of any acceptable theory of expectations; to the disturbing fact that even with certainty, and with correct predictions built into the model, shocks to the economic system can still result; to the difficulties and contradictions inherent in the idea of the ‘neutrality’ of money with respect to ‘real’ variables; and, most scathingly of all, to the extraordinary character of the monetarist claim that involuntary unemployment not only does not exist but has no useful meaning.

These summaries do less than justice to the subtlety and specificity of argument involved, or to the book’s engaging, if occasionally slightly tiresome, mixture of vigour, cleverness and elliptical egocentricity. Above all, they neglect the distinctive way in which, starting at the most abstruse level of theorising, Hahn can arrive at a useful reality, while retaining his deep scepticism about how much economists can know for certain. Surprisingly, however, a note of false naivety enters towards the end when he claims not to be able to grasp ‘the outstanding problem in inflation theory: Why do people seem to hate it? Why does it drive politicians to destructive frenzy?’ In his view, this is because inflation is seen as ‘a moral evil in itself’, and that ‘is a belief for the anthropologist and psychologist to unravel; economists cannot help.’ In fact, the existence of inflation is a central feature of the economic environment, as are attitudes to it. No more purely moral than attitudes towards contracts, thrift, individual aggrandisement, wage bargaining, rising material living standards, and the like, these attitudes determine responses to economic stimuli and government policy, and therefore economic performance itself; they are part of the rational and irrational expectations that keep the economic show on, or off, the road.

Indeed, the existence, but intangibility, of expectations exemplify the central problem of current policy-making, and theorising. Why should we expect these expectations to be unchanging, or, once changed, to stay changed? Suppose Mrs Thatcher is right, and that when we are all persuaded that she means what she says about money and public borrowing and prices, we shall act accordingly when it comes to wages and productivity and enterprise. Will the continuance of such a state of grace then become independent of the ‘rules’ the government sets? Or will all governments have to be like Mrs Thatcher’s in perpetuity, for our expectations and behaviour to remain worthy of the monetarist heritage?

These problems, of course, derive from a vital general issue in economics: the dependence of economic modelling on assumptions about the way people and institutions work and relate to each other. To some cynics, this establishes an indissoluble link between economics and ideology, and justifies a contempt for any aspiration to objectivity or scientific method in economic analysis. But we need not descend to this level of vulgarity to accept the obvious fact that institutions and politics determine how economies operate. Power and politics, social organisation and social psychology, income distribution and the structure of trade unions, do indeed influence economic performance and outcomes. Such issues are currently most dramatically exemplified in matters of inflation and unemployment. But they also concern equally fundamental questions of economic and social structure – especially the situation of those 20th-century behemoths, the nationalised industries.

Roughly speaking, Britain’s nationalised industries account for 8 per cent of national employment, 10 per cent of output and 20 per cent of investment. Moreover, they dominate some commanding sectoral heights of the economy – notably energy, communications, transport, and iron and steel. And it is astonishing to recall, as John Redwood does in Public Enterprise in Crisis, the bright hopes that attended their births. They were to advance social and economic equity, enhance efficiency and actually prevent waste, guard against the abuse of monopoly power, eliminate workers’ resentment towards management, and improve industrial relations. When did we last hear such arguments from any disinterested person? The reality of a nationalised industry is, alas, not something that Sidney Webb or Herbert Morrison ever contemplated. It is immensely grieving to say so, but most public enterprise has turned out to be just what all those selfish and heavy-handed capitalists predicted: inefficient, wasteful, monopolistic, unresponsive to the needs of consumers, and excessively tender of the interests of those on the public payroll. The distinctive power and expectations of those employed (at all levels) in nationalised industries produce a different, and worse, economic performance from that of their counterparts in the private sector. The combination of monopoly (for unions as well as management), an absence of personal as well as commercial incentives, and government involvement and political sensitivity, has proved irresistible in attracting subsidies and/or bolstering inefficiency.

Public Enterprise in Crisis and Controlling Public Industries both address themselves to these problems and to possible remedies. And the overlap of approach as well as content is not surprising since John Redwood is the sole author of the first (published in 1980 and now reissued in paperback) and joint author of the second. One, however, consists primarily of a case-by-case examination of the various nationalised industries, and the other of an analysis of the different ways in which public enterprise can be made more responsive to public needs. They share a sense of proportion and a persuasively reasonable approach. Neither could have originated in any great admiration for nationalised concerns, but they are scrupulously fair and painstaking in their discussion of the activities and problems of these industries, balanced in their recommendations, and no more than reasonable in concluding that most of the nationalised industries perform very badly and, like any other institution, are obliged to justify themselves to the society which sustains them.

Certainly Redwood’s case-studies expose a sorry state of affairs (with rare exceptions such as the electricity supply industry): the Post Office’s inefficient use of manpower, poor decision-taking, and looming pension-fund deficiency; the commercial errors of British Gas, its white-collar overmanning, and the grim record of its appliance sales and service; British Steel’s inefficiency and losses, as well as its subjection to arbitrary government intervention – the sad story seems almost endless. Nor has the situation been helped by the vicissitudes of government policy towards the setting and attainment of goals. By the late 1970s the official framework involved dangerously broad and vague aims, and gave precedence to ad hoc decisions to protect employment over any attempt to create an effective and viable industrial structure.

Yet it is a salutary characteristic of both books that their perception of the gravity of the problems does not lead them to offer extreme and unrealistic solutions. Admittedly, Redwood and Hatch favour privatisation (especially where it results in a number of competing units), but they grant that it may only be feasible and politically practical in a limited number of cases. They also see a role for external financial limits, primarily because of the poor quality of public investment decisions in the past, even though such constraints on the borrowing powers of nationalised industries are more properly part of monetary policy. The devising of market proxies and performance indicators, to monitor the quality of consumer services and management skills, they judge to be possible and desirable, but difficult conceptually and in any case dependent on the particular circumstances of each industry. Altogether, they are driven to acknowledge the deficiencies in the inherited panoply of control devices. And they therefore advocate, not merely ‘a whole range of published physical performance targets covering both effectiveness and efficiency’, but also ‘value for money audits’ to improve management information and control systems.

Compared with the problems they are designed to solve, such proposals may appear unadventurous and even bland. They certainly do not satisfy the yearning for some panacea which will transform the sickly giants of the public sector into the lean and virile contributors to social welfare envisaged by their progenitors. But such recommendations – the results of careful exploration and well-argued elaboration – have the enormous merit of starting with the world as it is, and of not assuming that it is as it ought to be. We are, after all, dealing with history as well as economic models: the reality of the economy, and of the problems of improving its efficiency and our welfare, includes the existence of huge vested interests and institutional power bases. This precludes dramatic and sweeping solutions, although it does not rule out incremental radicalism or even theoretical arguments about alternatives. But since the problem exists at various levels, a variety of solutions must be tried – possibly simultaneously. Since we cannot start again we must be content to reform the system we have inherited. And if we wish to understand how that operates, we must take account of the distribution of power within it, and of the range of expectations, selfish as well as altruistic, irrational as well as rational, which shape social and economic action.