How do expectations impact the economy?

Several years ago when the economy was doing rather well by nearly all measures I noticed an unusual article in the New York Times.  The article gave little information about the actual economy but instead focused on a poll they conducted that suggested people were of the opinion that the economy was doing poorly.  The absence of factual information coupled with the focus on opinion suggests (via our Logic tools) that the article was meant to sway opinion rather than to provide factual information – a.k.a. news.  The technical term for that is propaganda.  The media focused on opinion over fact when covering the economy twice in recent decades.  Once when the post Iraq war popular George H.W. Bush was up for re-election and at the end of George W. Bush’s second term.  Both times the economy was covered this way it went into a recession.  Media set up the expectations of poor economic conditions which people reacted to by changing their spending habits which then brought on a recession.  The media was not the sole cause but they played a significant part – all through the art of affecting expectations.

Chronic Inflation

Chronic inflation is driven by expectations.  People expect inflation so they ask for wage increases large enough to keep up with inflation.  The cost of the product they make or service they perform has to go up to maintain a profit margin.  As prices increase people ask for wage increases to keep up with inflation.  And round and round it goes.  The expectations are the fuel for the inflation.

The only antidote for chronic inflation is to change the expectations of people.  This is why Ronald Reagan squeezed the money supply and created a recession.  When people have lost their job, are worried about losing their job, or are working a lower level job than they had previously their expectations for wage increases drastically change.  Their spending habits also change.  After unemployment was around long enough to wring all the inflation out of the economy Reagan cut taxes and increased domestic spending on the military.  The result was new local jobs and more money in peoples wallets with which to spend, invest, and save.  The economy roared back and tight monetary policy has kept inflation at bay ever since.

Most presidents prior to Reagan knew that unemployment would check inflation and several started down that road only to retreat when unemployment began to rise.  Many economists at the time thought that Reagan’s move was an economic necessity but political suicide.  Few expected the economy to improve as rapidly as it did and of course Reagan won re-election in a landslide.