I am sure that Nobel Laureate Robert Lucas has done nothing to offend Minnesota farmers and commercial property managers while serving as a visiting scholar at the Minneapolis Federal Reserve in the autumns of 2000 and 2001.
Nevertheless, these farmers and managers are working like beavers to prove that his theoretical work on “rational expectations” is unsound.
Just what do hog farmers and property managers have to do with highfalutin’ economic theory? The answer is simple. Hog prices are weakening this year after the strong increases from the low levels that made headlines in the late 1990s.
Also, commercial property rental rates are in the doldrums after a period of rising rents. Management companies reportedly are cutting lease rates by as much as 40 percent.
Both developments result from behavior that is strikingly different from what many economists assume it to be when constructing their models of how economies operate.
Hog prices (and production), commercial rental rates (and construction) and aeronautical engineer’s salaries (and graduation numbers) follow cycles caused by shortsightedness or irrationality.
The hog cycle is familiar to farmers. Hog prices rise. Producers then keep young females to breed them to raise production. This further lowers the numbers sent to market, pushing prices higher. More producers respond and take steps to boost production.
But then all the gilts held for breeding give birth, and soon the countryside is awash in little pigs that grow and, in a few months, hit the market.
Prices drop. Producers get discouraged and stop holding on to females for breeding. They may cull their mature sows. This pushes more pork onto a saturated market. Many months later the glut is gone, numbers are low, prices rise and the cycle begins all over.
In the commercial property sector, rents rise. Developers see rising rents and make plans to build new buildings. A sow is pregnant for the proverbial three months, three weeks and three days, but it takes a year or more to develop a suburban warehouse, strip mall or commercial project and three years or more for a large downtown office tower.
But just like hog producers, property developers may have the same expansion idea at the same time. So a building boom develops. Many new buildings come onto the market at the same time. Rental rates drop as the availability of space exceeds the quantity demanded at previous prices.
Once the buildings are built, most of the cost is a sunk cost. As long as rents pay the cost of keeping the building open and make a contribution toward the mortgage, it is better to rent. New construction grinds to a halt, often for five years or more. When business growth absorbs available footage the cycle starts all over again.
How does this relate to University of Chicago professor Lucas or to the theory of rational expectations? Rational expectations argue that overt actions to manage an economy, as advocated by John Maynard Keynes and force-fed to million of college students after 1950, were doomed to failure.
This would be because individuals would understand effects of changes in taxes, spending or the money supply and would act to protect their interests.
Such simultaneous actions by millions of households would counter whatever it was that government managers were trying to accomplish. Rational expectations believers based much of their work on some highly theoretical work by John Muth in 1961, but they had an example going all the way back to David Ricardo, perhaps the greatest economist of all time in my view, who had written in the early 1800s.
Ricardo asked what would happen if a government cut taxes and borrowed to meet its spending needs instead. Would people spend their windfall tax cut? No, he argued, because rational individuals would recognize that the new government policy would run up debt that would have to be paid sometime. They would put the money away knowing taxes would have to be raised in the future. So a tax cut would not spur private spending.
This theoretical insight is not borne out by hog producers or property companies. If individuals have the foresight to save tax reductions so as to pay off eventual government debt, why can’t hog farmers see that increasing their herds when prices are high will inevitably lead to lower prices? The hog cycle has clearly existed since before the Civil War.
Why don’t property developers see that high rents lead to a construction frenzy that usually ends only in a brutal shakeout full of bankruptcies? The cyclical nature of commercial property development is as old as the hog cycle.
If businesspeople with millions of dollars at stake don’t anticipate the implications of their actions, it is not wise to assume they will have much greater foresight in evaluating government actions.
© 2002 Edward Lotterman
Chanarambie Consulting, Inc.