It occurred to me after reading this blog entry by a BBC economics correspondant: Are we stupid?, that it offers a good counter argument to the rational expectations objection used to refute ABCT.
Evan asks why we seem to keep forgetting the past and getting caught up in bubbles again and again. Rational Expecations theory suggests the public should eventually become wise to a government’s perpetual inflationary policy and therefore not get caught up in it. Behavioural Economics offers a (psycological) explanation as to why we we do and as such offers a defence of ABCT against such criticisms.
I think rational expectations theory only comes into play with regards to those in control of the government and the FED. But even then I have my doubts. Supposing that the powers-that-be know and understand what the results of monetary manipulation must be I would not say that they are behaving “irrationally” due to some ancient biological instinct. We all know that for those in control of the system there are huge gains to be made from credit expansion. Indeed these gains may justify in their minds the eventual ill-effects imposed on the rest of society.
As for other actors, even assuming that they have a keen understanding of ABCT (also assuming that ABCT is correct, which I believe it is), does not imply that business cycles would be mitigated. In addition to the bust, the ABCT provides a theory of general price movements, and in which sectors of the economy these movements occur. What it does not provide is exact durations and times of the boom and crisis phases. Thus, an actor with an understanding of the theory may try to capitalize on the boom, but his timing may be off as far as predicting the bust. This is speculation and I don’t regard it as irrational. Only perfect knowledge, rather than perfect rationality, in the face of credit expansion can mitigate its effects.
Interesting stuff.
One question though. You say “Rational Expecations theory suggests the public should eventually become wise to a government’s perpetual inflationary policy and therefore not get caught up in it.” Am I mis-interpreting you, or are you saying that rational expectations says that if a government continues perpetually inflating the economy but the people realise, that suddenly all the negative redistributive and mal-investment effects disappear?
To me that seems like saying: If you know what’s going on, it won’t affect you. Even if the rate of inflation and where it is injected were to become perfectly predictable, the realities would not change much. There would still be those who would want to gain in the short term during the boom period. Mal-investments might decrease, but they would not disappear.
Besides, by the time the public were to “wise up” to this stealth tax, governments would no longer be able to get away with perennial inflation. Their schemes depend upon ignorance.
So, suppose you know the money supply is being inflated. It doesn’t follow that the particular project you are considering is not a good use of borrowed funds - maybe your project would be smart even if there were no inflation, and so is now even smarter at lower interest rates. You only find out which uses of borrowed capital were malinvestments after the fact.
Also, you might consider the possibility that the business cycle given by the ABCT is not random. That is, the government doesn’t randomly decide “ok, now is a good time to inflate.” Instead, they are working off of a theory - a bad theory, but a theory nonetheless. Friedman repeats this theory in the section of “Free to Choose” about the depression. The theory is that, at times of great technological innovation, inflation is needed to give the economy room to grow. Yes, it’s wrong - but also notice that the inflationary booms do come amidst times when there was, even before the boom, a lot of (real) growth going on. The 20s wasn’t all inflationary boom - there was a lot of real growth too. The tragedy is that this real growth could have made people richer in the 30s, if the government hadn’t inflated, producing a business cycle with a depression in the 30s.
The thing is, so long as the government is committed to a policy of inflation, the “malinvestments” are all perfectly rational! It is only when the government reverses its policy in order to prevent hyperinflation that a bust takes place. That government decision is a policy choice that is unpredictable by anyone on the marketplace. It is not given that the government will stop inflating.
What the business cycle is, in essence, is a temporary subsidy to the capital market. When you subsidize an activity, you get more of it. When you stop subsidizing it, you get less of it. Both the expansion and the contraction, given the known conditions in the market, are rational.