A few months ago, Daron Acemoglu and James Robinson commented on current events in Egypt by using Turkey as a foil. The first half of the post introduces us with a brief political history of Turkey, starting with the Democratic Party’s (DP) 1960 election victory. Sometime after coming to power, however, the DP turned to authoritarianism. The military responded by toppling the DP in a coup, and they would launch three more in the years to come. Acemoglu and Robinson then give an interesting answer to a good question,

What would have happened without the military coup? Nobody knows. Perhaps. Menderes and other DP elites would irreparably damage the economy or somehow cow into a total submission before the next election to effectively set up their own dictatorship. Possible. But unlikely. Rather, they would have probably been kicked out of power in the next election, cementing Turkish democracy’s credentials (ed. emphasis mine).

This and other parts of the post reminded me of Bryan Caplan’s argument that “every social system requires favorable expectations to survive.” Speaking of democracy, he makes the point, for example, that peaceful transfer of power will only occur if people expect them to. The argument sounds a lot like a belief in self-fulfilling expectations. Caplan’s discussion of communism seems to confirm my interpretation. His essentially asks whether self-fulfilling expectations can save communism, but concludes that they can’t because the incentive to shirk is too strong.

The self-fulfilling expectations argument has parallels in economics. One example is NGDP targeting. One of the main transmission mechanisms is expectations. If a central bank buys assets on a large-scale and people come to expect NGDP to rise the demand for money will fall, as people exchange cash for assets, goods, and services. The increase in purchases, in turn, causes an actual increase in the NGDP, and it continues in a cycle (with diminishing returns, I assume).

But, I’ve always thought that the “expectations channel” is a weak theory. Yes, expectations in economics are very important, and yes expectations of the future inform present decisions, but sometimes the thing people are supposedly expecting is so broad that the theory starts to lose persuasive power. Firm owners do consider expectations of future demand and revenue to plan their production processes, individuals do think about their expectations of future income when making spending decisions, but how many non-economists even know what NGDP is? How many people can you think of that make daily decisions based on where they think NGDP will be x-time into the future?

For people to care about NGDP, it has to be an indirect channel. Monetary policy has to affect revenue streams, which means that there has to be some transmission mechanism that influences expectations. In other words, there is something that prompts the person to revise their expectations. I don’t think central bank monetary policy is enough, because the fact is that most people consider many other variables, if they consider monetary policy at all. There are people who do include expectations of monetary policy in their decision-making, but to rely on these people to actually cause a significant rise in NGDP is a bit desperate, in my opinion.

The expectations channel explanation makes even less sense once you consider that in the real world expectations are heterogeneous, and oftentimes people outright disagree with each other. The economics profession itself can’t agree as to whether there will be inflation, deflation, stagnation, a double-dip, or a straight-forward recovery. The safest assumption is that the range of opinion is even broader outside of the economics profession, since the average non-economist is not very likely to have the educational background to even know much about what they supposedly expect. Finally, most people find that they have to correct their beliefs over time (i.e. their expectations are falsified). This reinforces my belief that changes in expectations need to be prompted, and the method of communication can be indirect — e.g. a child learns to not touch fire not because she expects some intricate chemical reaction that will damage her hand’s tissue, but because she expects that touching the fire will hurt (and she knows this out of experience).

My sentiment is the same when it comes to the use of the expectations channel theory in political science (it’s probably not coincidental that the people cited here invoking it are all economists). Is his discussion of communism, Caplan implicitly says as much. He argues that the incentive to shirk is too strong for expectations to self-fulfill in communism. But, the incentive to shirk is a product of that social system’s institutions: there is no constraint that disincentivizes shirking. (Not too mention that we know that the strongest argument against communism doesn’t have anything to do with expectations, but about the lack of institutions that allow for an efficient allocation of inputs.)

Similarly, a precondition of successful democracy isn’t a democratic expectational equilibrium, but of the right institutions (e.g. rules of the game). I agree that people come to expect peaceful transitions of power, and that the expectation of such outcomes is important (otherwise there is an incentive to resist), but I’d argue that these expectations form over time, as people see peaceful transitions occur. This is how I interpret what I excerpt above out of Acemoglu and Robinson’s piece. The event has to occur so that people have a reason to expect it to occur again in the future. Sometimes this reason is a completely random event; other times, expectations form slowly, over time, and reflect gradual changes in institutions. It would be difficult to substantiate an argument that the expectation of peaceful democracy came suddenly, rather than develop over time as institutions of governance changed and incentivized these expectations to form. For example, people trace American democracy too the English magna carta.

Calling “expectations!” strikes me almost as hand-waving. Theories of change need transmission mechanisms to explain the relationship between variables, especially when they’re forward-looking (remember, expectations are heterogeneous). In the 1930s, Mises and Hayek argued that economists’ emphasis on changes in the price level hid them from the consequences in changes in relative prices, including the business cycle. This may not be so drastic, but it really does seem that the more broad and aggregated the expectations channel is the higher the probability that the theory is wrong.