Rational Expectations Theory
Life can change pretty quickly. One day, you're the PEO of a Wall Street hedge fund, making $15 million a year. Then one bad experience with a cursed monkey paw. And poof! You're the breakdance guy on the subway busking for $90 a day in tips.
Guess you shouldn't have wished to become a better dancer. But given that you can never tell exactly what will happen in the future, how do you decide what to do day-to-day?
Economists have a model they use. It's called Rational Expectations. The theory assumes that people make economic decisions based on their reasonable assumptions about what's going to happen in the future.
Folks look at their current situation and at what’s happened in the past. From there, they make educated guesses about what’s likely to happen in the future. These expectations in turn become the basis for their decisions.
Gas prices have been low for as long as you can remember. So you don't care much about fuel efficiency when you buy a car. You go for the 10 miles-per-gallon Hummer.
Rational expectation...until militants take over Saudi Arabia's largest oil production field. Gas prices spike. Now you're paying $200 a month to fill your gas tank.
Remember: a lot of economic activity is based on what people think will happen in the future. People borrow money, planning to pay it back years in the future. They buy houses with 30-year mortgages. They choose college majors with an eye toward a 40-year career. Well, aside from philosophy majors, maybe.
People make decisions based on what they think the future will be like. Robert Lucas won the Nobel Prize in 1995 for his work on the theory of Rational Expectations.
Quick fun fact: When Lucas got divorced from his wife Rita in the late 1980s, the divorce agreement included a stipulation that she would get half of his Nobel Prize winnings if he ever won the award. However, the clause had an expiration date: October 31, 1995.
He officially won his prize on October 10, 1995. Just under the wire. Okay, so most of us don’t rationally expect our spouses to win the Nobel Prize. Most of us are just happy if they remember to put the toilet seat down. But we do make other long-term decisions based on what we think we’ll be able to make on an ongoing basis.
In your hedge fund days, you wouldn't think twice about taking on a $500,000 mortgage for a vacation place in Bermuda. However, you’d never take on that responsibility if you knew that your monkey paw wish was going to go sideways. And leave you with $18,000 in annual salary.
Your rational expectations impact your big, long-term money decisions. They also play into your smaller, day-to-day decisions. Even deciding what you're going to have for dinner relates to how much money you expect to make in the near future.
The pre-curse hedge-fund CEO version of you might get the nine-course tasting menu at Per Se, with the caviar, black Australian truffles, foie gras, and wagyu. The bill would run $610 per person. But you can afford it.
The post-curse, breakdance version of you might decide to go with the Jr. bacon cheeseburger off Wendy's value menu, which costs $1.99. All you can afford.
But the "rational" part of rational expectations assumes that your predictions will stem from past experience. Unless you've had trouble with cursed objects before, it's unlikely that you'll see the bad-wish scenario coming.
Given that you've been a 15 million-dollar-a-year hedge fund manager for 20 years now, that $500,000 vacation home mortgage seems very manageable. There's no reason to expect your job to change. The reasonable assumption is that you'll keep your fat salary for the foreseeable future.
Dinners at Per Se. Vacation spots in Bermuda. But then you wandered into that dingy curiosity shop on your last trip to Hong Kong and asked the man behind the counter if he had anything really interesting.
He started stroking his beard and, well, on the bright side, you always wanted to be able to do the worm.