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The Internet, the Economics and Expectations

“Life is, largely, a matter of expectation..” — Horace

How many times have you changed your opinion in the past couple of weeks? How many articles, YouTube videos, Facebook posts or Instagram pictures have you seen that presented plausible counter arguments to your opinion? In the ‘.com’ era, opinions change as fast as weather forecasts, and what one day is your absolute truth, could become your next theme for protest on a Facebook post. This constant paradigm shift offered to us by the Internet—small note, I believe it is time to consider the Internet an institution, and as such, capital letters are required—is what makes it so special, unique and progressive.

However, in this humble student’s opinion, at least economically, the Internet could be causing us some problems. You see, since the dawn of times, economists have been trying to equate expectations in our models. Rational expectations, adaptive expectations, expected inflation and so on. These are just a few of the many types of expectations described by famous economists, such as Keynes and Fisher.

All in all, they were able to describe and create models which comprised these expectations in economic theory. And with those models they were able to predict economic outcomes. But take note dear reader, predict in economics doesn’t mean explain. Actually, the two terms couldn’t be more apart from each other. As another great economist of our time, Milton Friedman, said once: ‘Economic models should be judged by their predictability, not by their explanatory power’.

Lack of explanation is the turning wheel that made us hit two trees in less than 20 years: the .com crisis and the 2008 crisis. The lack of understanding and the oversimplification made us think that the Internet wouldn’t change the economic models we had, and if it would, it would be for the best. It would be to finally create perfect market conditions, to lower transaction and transportation costs, to produce more efficiently and effectively, to, finally, give explanation without assumptions created to failproof economic theories.

While we were in this .com dream, we forgot to consider that the internet could generate negative outcomes, and amongst social and cultural problems, there is the economic expectations problem. Let’s consider the two economists previously cited, Fisher and Keynes. Both of them theorized about expectations, and I believe their work is fairly useful on this subject. Fisher’s theory is quite simple:

i = r + π

This equation says that the nominal interest rate is composed by the real interest rate (r) and the expected inflation (π). The nominal interest rate is the one seen all the time in newspapers and so on, and it’s usually defined by the Central Bank of any country.

The real interest rate is an exogenous variable, resulted by the subtraction of the nominal interest rate and the expected inflation. Last, but not least, the expected inflation will depend both on the monetary policy of a country, which is also controlled by the CB, and the other economic agents.

Let’s start by defining this last term. Economic agents are all the individuals that compose the economy of a country: households, firms and banks are generally the ones used as example.

Before telling you that the expectations of these economic agents are being affected by the internet and changing the economic models we have used so far, I have to protect myself by showing you how powerful these same economic agents are. Ironically, or not, the perfect example of how expectations can affect the economy, happened right here in the Netherlands. 1630. TulipMania. Tulips become a craze in the Netherlands—more than ever.

One new type of tulip starts being produced. Expectations of getting the Semper Augustus, the special tulip, increase exponentially, and speculation over the flower starts to grow up until the point where: “It was enough to feed, clothe and house a whole Dutch family for half a lifetime, or sufficient to purchase one of the grandest homes on the most fashionable canal in Amsterdam for cash, complete with a coach house and an 80-ft (25-m) garden – and this at a time when homes in that city were as expensive as property anywhere in the world.” (BBC One, The Tulipmania)

Of course, speculation was the main reason of the crisis. But what you don’t know, is that the Semper Augustus was a type of tulip generated because of a virus. Which means that while everyone expected to have more or the same quantity of flowers in the marketplace, there wouldn’t be any of those tulips anymore. Their expectations were completely mismatched with reality, and this pretence caused the first speculation crisis ever registered in history.

Keynes also talked about expectations, and, as the great economist that he is, he admitted that the optimism/pessimism of consumers could directly affect the economy. He just couldn’t quantify how. Moreover, in his theory, he added variables which represented this state of mind of the economic agents.

With the start point of the macroeconomic identity, Keynes would define the term ‘propensity to …’, for all the variables on the equation. Propensity to consume, invest, save, export and import would all be affected by this state of mind. Now, if the state of mind of economic agents is unstable, and this takes part on building the components of a country’s national identity equation,  what can we expect from our economy?

If we add Keynes and Fisher’s theory, the Internet and a little bit of chaos theory, this is the outcome: our economic models weren’t ready for the volatility of expectations generated by the internet.

We can see the lack of explanation and the economic oversimplification as the utensils we use; the economic models as the dish we eat; and the realization that the internet actually affects our economic models as the realization you don’t have to use utensils to eat a dish of chicken wings.

It’s true, this is all theoretical. I’m indeed putting my neck out there, questioning great economists and all the other scholars which interpreted their works. But hey, because of this article, I might have just changed your mind or even just put small question mark on your head, and that would reinforce my theory even more, wouldn’t it?


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