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Sudden and Violent Changes in Long-Term Expectations: Keynes and Reality

This study takes up Keynes’ ideas concerning long-term expectations, particularly his notion that expectations are subject to sudden changes with strong effects on economic activity. We start by detailing Keynes’ views regarding the nature of expectations and their role in the business cycle. I first argue that it is wrong to judge long-term expectations as being unstable and unpredictable based on the experience of the variability of stock prices. The link between the expectations that underlie investment decisions and stock prices is too weak. Hence, in order to check Keynes intuition I suggest assessing survey data on expectations and newer contributions from the side of behavioral economics. Whereas survey data do not offer much support for Keynes, the recently introduced concept of pattern-based expectations does. These expectations are built up from data elicited in the laboratory and describe how people actually form forecasts and how they assess uncertainty. I show that before and during the great recession of recent years expectations were very likely to be a driver of the cycle.