American Economic Association The Investigation of Economic Expectations Author(s): Holbrook Working Source: The American Economic Review, Vol 39, No 3, Papers and Proceedings of the Sixty first Annual Meeting of the American Economic Association(May, 1949), pp. 150-166 Published by: American Economic Association StableUrl:http://www.jstororg/stable/1831740 Accessed:11/09/201303:21 Your use of the JSTOR archive indicates your acceptance of the Terms Conditions of Use, available at JStOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support(@jstor. org American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American economic revie 的d http://www.jstororg This content downloaded from 202. 115.118.13 on Wed, I I Sep 2013 03: 21: 32 AM All use subject to STOR Terms and Conditions
American Economic Association The Investigation of Economic Expectations Author(s): Holbrook Working Source: The American Economic Review, Vol. 39, No. 3, Papers and Proceedings of the Sixtyfirst Annual Meeting of the American Economic Association (May, 1949), pp. 150-166 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1831740 . Accessed: 11/09/2013 03:21 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. . American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review. http://www.jstor.org This content downloaded from 202.115.118.13 on Wed, 11 Sep 2013 03:21:32 AM All use subject to JSTOR Terms and Conditions
THE INVESTIGATION OF ECONOMIC EXPECTATIONS By HoLBROOK WORKING Food Research Institute, Stanford University Fifty years ago economists rather generally allowed themselves to ignore economic expectations by concentrating attention on the static state. Today we talk a great deal about economic expecta tions, but how much do we know about their formation and their behavior? How much can we say about them that might not have been said by Alfred Marshall or by John Stuart Mill, or even by Adam Smith, if they had chosen to discuss expectations? I. The General problem There are two broad lines of possible attack on the subject of economic expectations: the individualistic and the aggregative. In fundamentals, the problem of individual expectations may be one for psychology rather than for economics, but the economist must not hesitate to go as far as he profitably can in considering the individual a good deal of information has been collected from time to time on economic expectations of individuals. Now and then someone becomes interested in the opinions of economists and makes a survey of their expectations regarding prices. Surveys of the expectations of businessmen have been made frequently by various agencies. If these surveys had seemed to produce results of much practical or scientific value, they could and should be organized more systematically and made the business, perhaps, of the federal Department of Commerce. Thus far, at least, it seems that the information gathered falls more in the category of news of current interest than in that of significant economic information Perhaps the information has lacked scientific value because the nets of inquiry have not been cast widely enough, or in the right quarters. Or perhaps the absence of recognized scientific significance reflects inadequacy of our perception rather than absence of real signincance I have not made a search for serious anal- lyses of data on individual economic expectations, but I think it safe to say that there have been few of them There is one which comes to mind, however and the results are worth noting. Some years ago Alfred Cowles made a The annual sur er finances instituted a few years ago by the board of of the Federal Reserve System are providing some information on consumer expectations and could easily provide more if the effort should seem worth whil content down ed stroe 2 2S R e os wecoldsep2
THE INVESTIGATION OF ECONOMIC EXPECTATIONS By HOLBROOK WORKING Food Research Institute, Stanford University Fifty years ago economists rather generally allowed themselves to ignore economic expectations by concentrating attention on the "static state." Today we talk a great deal about economic expectations, but how much do we know about their formation and their behavior? How much can we say about them that might not have been said by Alfred Marshall or by John Stuart Mill, or even by Adam Smith, if they had chosen to discuss expectations? I. The General Problem There are two broad lines of possible attack on the subject of economic expectations: the individualistic and the aggregative. In its fundamentals, the problem of individual expectations may be one for psychology rather than for economics, but the economist must not hesitate to go as far as he profitably can in considering the individual. A good deal of information has been collected from time to time on economic expectations of individuals. Now and then someone becomes interested in the opinions of economists and makes a survey of their expectations regarding prices. Surveys of the expectations of businessmen have been made frequently, by various agencies. If these surveys had seemed to produce results of much practical or scientific value, they could and should be organized more systematically and made the business, perhaps, of the federal Department of Commerce.' Thus far, at least, it seems that the information gathered falls more in the category of news of current interest than in that of significant economic information. Perhaps the information has lacked scientific value because the nets of inquiry have not been cast widely enough, or in the right quarters. Or perhaps the absence of recognized scientific significance reflects inadequacy of our perception rather than absence of real significance. I have not made a search for serious analyses of data on individual economic expectations, but I think it safe to say that there have been few of them. There is one which comes to mind, however, and the results are worth noting. Some years ago Alfred Cowles made a 'The annual surveys of consumer finances instituted a few years ago by the Board of Governors of the Federal Reserve System are providing some information on consumer expectations and could easily provide more if the effort should seem worth while. This content downloaded from 202.115.118.13 on Wed, 11 Sep 2013 03:21:32 AM All use subject to JSTOR Terms and Conditions
RY AND MEASUREMENT OF PRICE EXPECTA Itical study of the economic expectations recorded by professional stock-market forecasters. The main conclusion which emerged was that these expectations had characteristics substantially identical with those of random guesses. We shall see before we finish that such an observation is not necessarily evidence of poor forecasting Anyone who contemplates analysis of existing data on individual economic expectations, and especially anyone who proposes large-scale collection of more data, should consider certain difficulties that must be faced in their interpretation. First is the question of validity of the expressions of expectation. Many people will state expectations with great confidence, but evince no confidence at all when faced with a challenge to act on their stated opinions. Second is the problem of classifying persons queried in relation to the economic significance of any expectations which they may have. Some expectations of some people carry great weight in economic affairs, yet most expectations of most people carry little weight. I do not mean these comments as deprecation of the study of indi vidual expectations, but only to suggest that any other feasible approach needs consideration also I. The aggregative Approach The aggregative approach to study of economic expectations takes for analysis some recorded economic variable which reflects a sort of consensus of expectations. Many economic quantities are strongly fluenced by expectations and some are little influenced by anything else. Prices of industrial stocks, for example, are predominantly reflec tions of economic expectations. They may be regarded as expectations capitalized at going rates of interest, and in that sense they appear to reflect both expectations and existing rates of interest-or should I say that the capitalization is at expected rates of interest? The price of a commodity future is even more clearly and specifically a composite measure of economic expectations When we undertake study of the behavior of futures prices as a means toward knowledge of economic expectations, we must consider the objection, or qualification, that a futures price is not precisely a composite measure of expectations. British writers, including such distinguished economists as Keynes, Kaldor, Hicks, and Hawtrey, have given the question a good deal of attention since Keynes advanced eory rmal backwa ardation"in 1930. They have disagreed mewhat as economists are wont to do but i think that they are Alfred Cowles, " Can Stock Market Forecasters Forecast?"Econometrica, July, 1933 J. M. Keynes, Treatise on Money (New York, 1930), Il, p. 14 content down ed stroe 2 2S R e os wecoldsep2
THEORY AND MEASUREMENT OF PRICE EXPECTATIONS 15 1 critical study of the economic expectations recorded by professional stock-market forecasters. The main conclusion which emerged was that these expectations had characteristics substantially identical with those of random guesses.2 We shall see before we finish that such an observation is not necessarily evidence of poor forecasting. Anyone who contemplates analysis of existing data on individual economic expectations, and especially anyone who proposes large-scale collection of more data, should consider certain difficulties that must be faced in their interpretation. First is the question of validity of the expressions of expectation. Many people will state expectations with great confidence, but evince no confidence at all when faced with a challenge to act on their stated opinions. Second is the problem of classifying persons queried in relation to the economic significance of any expectations which they may have. Some expectations of some people carry great weight in economic affairs, yet most expectations of most people carry little weight. I do not mean these comments as deprecation of the study of individual expectations, but only to suggest that any other feasible approach needs consideration also. II. The Aggregative Approach The aggregative approach to study of economic expectations takes for analysis some recorded economic variable which reflects a sort of consensus of expectations. Many economic quantities are strongly influenced by expectations and some are little influenced by anything else. Prices of industrial stocks, for example, are predominantly reflections of economic expectations. They may be regarded as expectations capitalized at going rates of interest, and in that sense they appear to reflect both expectations and existing rates of interest-or should I say that the capitalization is at expected rates of interest? The price of a commodity future is even more clearly and specifically a composite measure of economic expectations. When we undertake study of the behavior of futures prices as a means toward knowledge of economic expectations, we must consider the objection, or qualification, that a futures price is not precisely a composite measure of expectations. British writers, including such distinguished economists as Keynes, Kaldor, Hicks, and Hawtrey, have given the question a good deal of attention since Keynes advanced his "theory of normal backwardation" in 1930.3 They have disagreed somewhat, as economists are wont to do, but I think that they are 2Alfred Cowles, "Can Stock Market Forecasters Forecast?" Econom,etrica, July, 1933, pp. 309-324. 'J. M. Keynes, Treatise on Money (New York, 1930), II, p. 143. This content downloaded from 202.115.118.13 on Wed, 11 Sep 2013 03:21:32 AM All use subject to JSTOR Terms and Conditions
AMERICAN ECONOMIC ASSOCIATION united in the opinion that the relation of a futures price to expectations may be expressed by the equation Pt=E (1) where Pt is a futures price, E is some sort of combination of effects of individual expectations, and r is some sort of combination of (effects of?) individual risk premiums This equation serves to indicate that in studying P, we may learn facts about r rather than about E. That need not trouble us. If we find significant behavior characteristics, we shall know that they derive from corresponding characteristics in either E or r, or from ome combination of both. We shall in fact find that the main char acteristics derive from E expectations We may now profitably adopt the term "market expectation synonymous with"futures price. " Firmly established habits of thought make it difficult to think of any price as resting primarily on expecta tions. By using“ market expectation” as an alternative to“ futures price, we may keep attention focused on the predominantly expecta tional quality of such a price Because the term"market expectation has no strongly fixed connotations, it should not be difficult to reme ber that, writing Em for market expectation, its definition leads equation(1)to Em=E (2) and therefore that market expectation is not precisely equivalent to E unless r=0 Ill. Bias in Market Expectations Expectations may be defective in either or both of two respects: chey may be randomly inaccurate or they may be biased. Let us consider first the evidence under the head of bias At the outset, however, I want to mention, and to set aside, one kind of aberration in futures prices which might be treated as bias namely, the effects of corners consequences of an excessive freedom of enterprise which seems largely a thing of the past in American futures markets. The British grain trade has never permitted either corners or significant squeezes in its futures markets. Squeezes continue to occur in American futures markets, though they can and should be eliminated. Like corners hey involve gaining and exploiting a temporary monopolistic position The monopolistic element produces effects of quite a different nature gn in equation (1) because we shall usually want to use that equation in interpreting statistical evidence use a positive sign, recognizing that r may take either a positive or a negative value. to r, if r is not equal to o, is to give P,<E. On purely algebraic grounds it would be bette content down ed stroe 2 2S R e os wecoldsep2
152 AMERICAN ECONOMIC ASSOCIATION united in the opinion that the relation of a futures price to expectations may be expressed by the equation, Pf =Er. ......... (1) where Pf is a futures price, E is some sort of combination of effects of individual expectations, and r is some sort of combination of (effects of?) individual risk premiums.4 This equation serves to indicate that in studying Pf we may learn facts about r rather than about E. That need not trouble us. If we find significant behavior characteristics, we shall know that they derive from corresponding characteristics in either E or r, or from some combination of both. We shall in fact find that the main characteristics derive from E expectations. We may now profitably adopt the term "market expectation" as synonymous with "futures price." Firmly established habits of thought make it difficult to think of any price as resting primarily on expectations. By using "market expectation" as an alternative to "futures price," we may keep attention focused on the predominantly expectational quality of such a price. Because the term "market expectation" has no strongly fixed connotations, it should not be difficult to remember that, writing EM for market expectation, its definition leads, by equation (1) to EM - Er, ........ (2) and therefore that market expectation is not precisely equivalent to E unless r- 0. III. Bias in Market Expectations Expectations may be defective in either or both of two respects: they may be randomly inaccurate or they may be biased. Let us consider first the evidence under the head of bias. At the outset, however, I want to mention, and to set aside, one kind of aberration in futures prices which might be treated as bias; namely, the effects of corners and squeezes. Corners are, or were, consequences of an excessive freedom of enterprise which seems largely a thing of the past in American futures markets. The British grain trade has never permitted either corners or significant squeezes in its futures markets. Squeezes continue to occur in American futures markets, though they can and should be eliminated. Like corners, they involve gaining and exploiting a temporary monopolistic position. The monopolistic element produces effects of quite a different nature 4I give r a negative sign in equation (1) because we shall usually want to use that equation in interpreting statistical evidence arising under conditions where the effect of r, if r is not equal to 0, is to give Pf < E. On purely algebraic grounds it would be better to use a positive sign, recognizing that r may take either a positive or a negative value. This content downloaded from 202.115.118.13 on Wed, 11 Sep 2013 03:21:32 AM All use subject to JSTOR Terms and Conditions
THEORY AND MEASUREMENT OF PRICE EXPECTATIONS 153 from the others we have to consider and i choose not to try to deal Bias itself may be of several sorts. I shall use a classification involv ng four categories of bias which will be defined as we proceed. 1. The kind of bias in market expectations which has received most attention in theoretical discussion and in statistical studies is what may be called"general bias. There has been a prevalent view in agricultural circles that futures prices of a crop tend to be depressed in the period of heavy marketing soon after harvest, and thereafter to advance, perhaps tending to be highest shortly before the next harvest. Theoretical analysis, moreover, has led to the opinion that some such behavior should be expected as a reflection of risk premium Such was the argument of J. M. Keynes's"theory of normal back wardation, and similar conclusions were reached by Kaldor and other British writers who extended and improved on Keynes's theoretical analysis. Keynes himself held that the statistics of organized markets show that 10 per cent per annum is a modest estimate of the amount f this backwardation in the case of seasonal crops..., That statement is significant mainly as evidence of Keynes's opinion that an indication of the effective risk premium is obtainable from statistical calculations of general bias in futures prices. His acquaintance with the pe evidently superficial, for it is only data for short and unrepresentative periods which appear to support high al bias or“ norma backwardation"" cannot be estimated properly at over 2 or 3 per cent per annum. For Chicago corn futures, it may approach 5 per cent. nd Economic Stability, "Review of Economic Studies, on the id, 1939-40, pp 196-205 and Gerda Blau, "Some T Holbrook Working, " Theory of the Inverse n bring out some curious minor characteristics of general bias. For his, however, is probably a spurious indication of general bias, arising from the fact that Wheat Futi e1885, : month when many hedges are being transferred from that future to more distant ones. This content down ed stroe 2 2S R e os wecoldsep2
THEORY AND MEASUREMENT OF PRICE EXPECTATIONS 153 from the others we have to consider, and I choose not to try to deal with them here. Bias itself may be of several sorts. I shall use a classification involving four categories of bias which will be defined as we proceed. 1. The kind of bias in market expectations which has received most attention in theoretical discussion and in statistical studies is what may be called "general bias." There has been a prevalent view in agricultural circles that futures prices of a crop tend to be depressed in the period of heavy marketing soon after harvest, and thereafter to advance, perhaps tending to be highest shortly before the next harvest. Theoretical analysis, moreover, has led to the opinion that some such behavior should be expected as a reflection of risk premium. Such was the argument of J. M. Keynes's "theory of normal backwardation," and similar conclusions were reached by Kaldor and other British writers who extended and improved on Keynes's theoretical analysis.5 Keynes himself held that "the statistics of organized markets show that 10 per cent per annum is a modest estimate of the amount of this backwardation in the case of seasonal crops..."2 That statement is significant mainly as evidence of Keynes's opinion that an indication of the effective risk premium is obtainable from statistical calculations of general bias in futures prices. His acquaintance with the pertinent statistical studies was evidently superficial, for it is only data for short and unrepresentative periods which appear to support so high an estimate of general bias. For Chicago wheat futures, the average general bias or "normal backwardation" cannot be estimated properly at over 2 or 3 per cent per annum. For Chicago corn futures, it may approach 5 per cent.7 'Nicholas Kaldor, "Speculation and Economic Stability," Review of Economic Studies, 1939-40, pp. 1-27; J. C. R. Dow, "A Theoretical Account of Futures Markets," ibid., 1939-40, pp. 185-195; Nicholas Kaldor, J. C. R. Dow, and R. G. Hawtrey, "A Symposium on the Theory of the Futures Market," ibid., 1939-40, pp. 196-205; and Gerda Blau, "Some Aspects of the Theory of the Futures Market," ibid., 1944-45, pp. 1-30. ' Treatise on Money (New York, 1930), p. 143. 'Holbrook Working, "Theory of the Inverse Carrying Charge in Futures Markets," Journal of Farm Economics, February, 1948, pp. 8-12. (The citation in footnote 18 there should read "p. 214.") Detailed inquiry can bring out some curious minor characteristics of general bias. For example, the reference above examines an apparent general tendency for corn futures prices to rise slightly from May to August and to decline similarly from August to October. This, however, is probably a spurious indication of general bias, arising from the fact that exaggerative bias (to be considered below) operates mainly in the upward direction and occurs most often in July and August. Chicago wheat futures prices show an apparently true general tendency to decline slightly from the latter part of February to late March. ("Price Relations between May and New-Crop Wheat Futures at Chicago since 1885," Wheat Studies of the Food Research Institute, February, 1934, pp. 214-216.) There is also a quite prevalent tendency for the price of any future to rise slightly (perhaps about 1 per cent) during two or three weeks before the beginning of a delivery month, when many hedges are being transferred from that future to more distant ones. This This content downloaded from 202.115.118.13 on Wed, 11 Sep 2013 03:21:32 AM All use subject to JSTOR Terms and Conditions