Communications, Expectations and Equilibrium Dynamics

Are expectations important for monetary policy? Arnold Kling appears "frustrated" with modern macro, and not surprisingly, some of Scott Sumner's market expectations discussion in particular. Kling writes:

In modern macro, we have everybody working in the GDP factory. And we have everybody forming expectations about the price of the output from this GDP factory, or about the total nominal value of that output. And booms and recessions are caused by changes in their expectations...

I know that almost nobody who reads Specialization and Trade buys into my view that movements in aggregate price indices mostly reflect habits and inertia, rather than central bank operations. But when you see the contortions that monetary theorists have gone through over the years, I think I have a fair case.

Granted, for Kling and others who are all too used to the inertia of our nation's capital, ingrained habits can seem as though key economic drivers. Even so, tradable sector activity doesn't have the luxury of "standing still" for societal inertia, no matter how entrenched. Tradable sectors are going to reflect whether consumers and policy makers expect a dynamic economy to continue, even if all concerned are like rusted lug nuts when it comes to non tradable sector preferences. And - with today's digital communications - societal expectations continue to shift in real time.

Why should expectations matter? Why can't Kling's "GDP factory" exist as a mostly objective, "real economy" phenomenon? Tradable sector activity - in spite of it's primary position for wealth creation - is always affected by the subjective dynamics of non tradable sector activity. For instance: While time based services are often uninterrupted as they "wait" for budget reconciliation during economic downturns, tradable sectors lack that option. Other equilibrium dynamics for tradable/non tradable sector activity affect nominal income as well; and consequently, the marketplace structure which is maintained in any given time period.

Indeed, this is hardly the first era, that expectations proved important for economic activity and its associated monetary representation. When communications time between nations was shortened by the first transatlantic telegraph cable, marketplace expectations doubtless became more prominent, in the first globalization which lasted from approximately 1870 to 1914.

Prior to modern communications, it was a simpler matter to anchor tradable sector activity via a gold standard, especially since non tradable sector activity mostly consisted of informal norms which didn't make extensive claims on equilibrium territory. However, once non tradable sector activity grew in complexity and formality, it began to impose both time and political constraints on other sectors, which affected overall output and wealth formation. Even though today's non tradable service structure is still dependent on tradable sector revenue and redistribution, the fact the latter remains the starting point of wealth creation, is hidden by the general equilibrium effects of non tradable sector activity.

Services have always generated important macroeconomic effects, even though they aren't sufficiently emphasized in the literature. For instance, Carlo M. Cipolla noted that economists don't always give services their due. In the quote below: What I describe as primary market activity, Carlo M. Cipolla identifies as primary and secondary market activity. Likewise, he describes as tertiary activity, some of the activities which are included among my secondary market designations, in "Before the Industrial Revolution":

The primary sector normally includes agricultural activities and forestry. Sometimes fishing and mining are also included. The secondary sector consists of manufacturing. The tertiary sector includes the "remainder". Like all residual categories, this one is a source of ambiguity and confusion. In industrialized societies, the tertiary sector is mainly represented by the production of services such as transport, banking, insurance, the liberal professions, advertising and the like. Some years ago, an Australian economist, Colin Clark, put forward the theory of a highly positive correlation between the general level of development of an economy and the relative size of the tertiary sector. But other economists with firsthand knowledge of certain primitive societies have shown that in a preindustrial society, the tertiary, or "residual" group, is also fairly large, with the difference that, instead of including bankers and insurance agents, it includes a picturesque variety of people with trades ranging from dealers in stolen goods to gatherers of used items.

What has changed since the Industrial Revolution? Again, much of what once took place on informal terms (particularly service coordination and home building), was increasingly formalized. Also, as bankers and insurance came to dominate, they did so in ways which lent further confusion, given the interdependence of primary and secondary marketplace activity which defines fiat monetary policy.

The expectations of non tradable sector equilibrium circumstance, often weigh heavily on tradable sector formation. Yet in the 20th century, fiat money made it possible to expand the use of knowledge, beyond what might otherwise have occurred in a tradable sector dominant economy. The challenge now, is to make service formation and knowledge use less equilibrium dependent, so that state and national budgets can be reduced without extensive deflation. These misplaced fiscal policy expectations, will also need nominal stabilizers in the meantime. As Ben Bernanke noted in a recent speech:

Since 1977, real output in the United States has expanded by a cumulative 80 percent, and yet during that time, median weekly earnings of full-time workers have grown by only about 7 percent in real terms.

Marketplace expectations will only become increasingly important in the years ahead. Even though some degree of fiscal policy "bailout" might become necessary, it is vitally important to maintain nominal stability. Short term, such bailouts would place further strains on national budgets. The sooner that time based services can contribute to equilibrium dynamics via less equilibrium dependence, the better.