Endogenous Expectations Present a Compelling Alternative to Exogenous Theories of Expectations

There would be no business cycle without government artificially expanding credit. Although it may be true that distorted signals were created through government involvement, the critics say, to pin everything on government intervention implies a type of perfect markets theory where there are never any bubbles or systemically inaccurate expectations. But what about the hundreds of bubbles across countries and throughout history (Kindleberger and Aliber 2011)? Surely government intervention did not cause all of them. And if some bubbles occur without government intervention, why not all of them? These critics claim that business cycles are driven by market excesses, not by government intervention (Keynes 2006 [1936], Krugman 2000; Shiller 2006; Minsky and Kaufman 2008; Akerlof and Shiller 2010; Kindleberger and Aliber 2011).

Incorporating endogenous expectations into ABCT [Austrian Business Cycle Theory] answers these critics. By recognizing why people engage in speculation, make seemingly foolish, unrealizable plans, and how markets usually restrain this behavior, Austrian theorists can better explain exactly how government policies contribute to naturally occurring asset bubbles. Understanding how people form expectations highlights how governments often replace limited self-correcting asset bubbles with large bubbles by distorting entrepreneurs’ and consumers’ expectations. We need to understand how people interpret relative price changes, particularly with respect to their expectations of future prices. Unfortunately the mechanisms for how and why expectations change are largely ignored.

This paper sketches a theory, in the tradition of Menger, Mises, and Hayek, that expectations are endogenous to market processes and institutions. Endogenous expectations present a compelling alternative to exogenous theories of expectations, particularly rational expectations. It also forms the basis for an Austrian response to the “irrational exuberance” and “animal spirits” theories advanced by Shiller (2006) and Akerlof and Shiller (2010). Although many Austrians understand the importance of expectations (Mises 2009 [1912], 1949; Lachmann 1943; Wagner 1999; Garrison 2001; Carilli and Dempster 2001; Evans and Baxendale 2008), an analytical theory of expectations remains largely absent from their theorizing. Surveying recent Austrian treatments of the 2008 financial crisis reveals little interest or awareness of the role played by individuals’ interpretive frameworks or expectations.

—Paul D. Mueller, “An Austrian View of Expectations and Business Cycles,” Review of Austrian Economics 27, no. 2 (June 2014): 200.