aggregated expectations paper at Econometrics Paris 1998

A new approach to macro-economic theory, 'The Hypothesis of Aggregated Expectations', is based upon the most important contributor - expectations - to the individual decisions which aggregate to create final macro-economic -outcomes. It offers a viable basis for examining likely future (economic) outcomes and developing new tools for influencing some of those outcomes. In essence, the future outcome of an economic issue will be largely determined by the expectations of those, in the population affected, whose aggregated individual decisions will shape that outcome.

In recent years, managers of organisations dependent upon the macro-environment - larger organisations and, most notably, national governments - have often been unsuccessful in their attempts to control the impact of that macro-environment on their activities. One reason has been the increasing uncertainty which has pervaded the external environment in general, resulting in their inability to predict the likely outcomes; with the consequence that intervention has been poorly executed. Here, we describe a new hypothesis which allows such managers to make relatively meaningful predictions, even in an otherwise uncertain macro-environment, and hence to permit the possibility of successful intervention[2].

A number of existing hypotheses already refer to ‘expectations’ of future outcomes. Perhaps the most important of these, and the most directly related to the new hypothesis in the specific field of macro-economics, is that of rational expectations. Although this also deals with a form of aggregated expectations, it is more specific, and is normally justified in terms of the rational (economic) actors in the 'market' (usually a financial market) immediately recognising, and discounting, the expected effects of any outside intervention in that market; so that - apart from a role for short-run stabilisation policies (see Friedmann, 1968) - any such intervention, by government in particular, is bound to be ineffective.

On the other hand, the new ‘general hypothesis of aggregated expectations’ does not assume a rational actor and, where rational expectations is based upon the actions of the informed actors (who are usually quite limited in number) most directly influencing macro-economic outcomes, the new hypothesis typically looks to the very much larger number of uninformed, though not necessarily irrational, participants throughout the whole population.

The new hypothesis has is origin in management practice, which has recently addressed uncertainty by looking to alternative forecasts, typically using the scenario planning processes; which derive from ‘soft’ practical judgements about the future (usually on the basis of experience) rather than the ‘hard’ theoretical equations favoured by many economists. Such scenario planning techniques have been most extensively developed by Shell Oil (see Wack, 1985, and Schwartz , 1991) with whom we worked - to develop the basic research techniques which are necessary to put the hypothesis into practical use.

The future outcome of a (macro) issue - economic or political - will be largely determined by the expectations of those, in the population affected, whose aggregated individual decisions will shape that outcome.

The corollary is that changing the expectations of this population will change the (macro) outcome.

The outcome will be decided by many individual decisions, such that no one such single decision will unduly affect the overall aggregate decision.

The outcome will not be unduly constrained by any resource scarcity, or bottle-neck.

The separate individual decisions, and hence the overall aggregated outcome, will on average be swayed by the individual expectations of this population, as well as specifically by individual needs and/or wants; and the latter can be assumed to be random in nature, cancelling out when aggregated.

It has proved possible to adopt some of the techniques now employed in marketing to deploy the Aggregated Expectations Hypothesis in practice; and to test some of its underlying assumptions. Most notably, it is possible to adopt the marketing research philosophy that, if you cannot realistically model individuals' behaviour from first principles, you can 'ask' them what their expectations are - on any given issue. In particular, the critical ‘dimensions’ of the key issues (as seen by the population as a whole) can be derived, and subsequently quantified, by the new research techniques we have developed (see Mercer, 1995, 1996 and 1997) and, by use of repeat surveys, changes in these can be tracked over time. The new research techniques used are described, in outline, in Appendix B.

The evidence is that the assumptions underlying the hypothesis are met in many circumstances. In particular, the evidence is that resource constraints no longer dominate outcomes in developed countries; though, even so, bottlenecks and in particular uneven distribution of these resources mean that not all issues, in all markets, are susceptible to this form of resolution. Never-the-less, for the majority of issues across the spectrum - not least those applying globally - real resource constraints, as opposed to perceived constraints (which affect expectations), can no longer be seen as the major factor determining overall outcomes. This is especially true where developed economies are rapidly moving from a predominance of physical goods to one of intangible services which make relatively fewer demands on resources.

In terms of the aggregation of individual decisions, few important issues are now decided by a relatively small number of individuals. Over recent years it has become apparent that even national governments cannot control many of the events within their boundaries, and in almost all fields the important trends are now set by the aggregate of individual actions - from brand shares through to inflationary pressures.

Even so, the one factor which sways the overall 'votes' is not individuals’ wishes but their expectations. In part this is because, to a degree, individual wishes cancel each other out. More important, individuals - who are more capable and better informed than many politicians would allow for - recognise that the world will not necessarily change to give them just what they want. They do, however, assume that it will change, in line with their expectations. It is for this reason that their expectations are such a powerful predictor of the future, and can be used - for instance - to allow the development of more effective economic models; as described in Appendix A.

In terms of general practice, practical use of the hypothesis involves three stages:

1. observation/measurement of existing expectations - the starting point must be an understanding of what the population's existing expectations are; and, hence, what will happen if no intervention occurs. Without knowing where you are, and in what direction you are currently going, it is impossible to steer a course to the destination you want. The new quantitative research techniques - outlined in Appendix B - allow this information to be obtained.

2. decision on the possibility of intervention - the next, key, step is to decide whether any intervention - to change the outcomes - might be feasible. This formalises the recent recognition that governments are not all powerful, but may only be successful in certain classes of action. The new (mass) qualitative techniques - which use relatively large numbers of participants - are the key to this aspect of implementation. The basic decision, whether or not to act, leads naturally to two types of subsequent activity. At one extreme, therefore, the expectations may be so firmly held, or the tools for changing them so weak, that it would be unrealistic to expect the outcomes to change. In this case the third step, where intervention simply is not possible, becomes:

3a actions to ameliorate the outcomes - actions are then taken not to change the outcomes, but to alleviate - or intensify (if positive) - the symptoms arising from the inevitable outcomes. Damage limitation may then offer the most practical route.

On the other hand, if it appears possible to modify the expectations, such that more beneficial outcomes will be achieved:

3b modification of expectations - the various tools, including those of marketing but also those of persuasive modelling, can then be deployed to steer expectations in the desired direction. Conviction marketing techniques (see Mercer, 1996) are then likely to become the methods of choice.

The process is best seen in an example where the elements are simplified. Let us, therefore, take the example of a contract for the supply of a repeat purchase good. It is arguable that the analogue of a 'market price' should enter into any equation - which might be used to describe the relationships involved - in the shape of the expectations of the supplier, and of the purchaser, as to what will be - on the date of future supply - the generally prevailing price which they will be required to meet. As this is a repeat-purchased good, as indeed are most consumer goods, the price can therefore be assumed to be based upon the currently applying price modified by an allowance for the expected inflation over the period in question.

Where P_f= Future Price, P_c = Current Price, I_e = Average Expected Inflation, and

The last term allows for the fact that the individual’s information is bounded, and their interpretation of it may not be as rational as many economists’ would wish. If, however, we aggregate a sufficient number of such individual decisions the resulting new aggregate price is:

As suggested earlier, it may then be reasonably assumed that the individual deviations are effectively random and will sum to zero - indeed that is, by definition, the case for the average price[4]. The resulting new ‘market price’ average (Pa) therefore will be:

It is, thus, possible to focus on the overall, average, expectations (of the total population) as to what inflation will be - and this becomes a self-fulfilling (prophetic) expectation.

Using new research techniques, the Aggregated Expectations Hypothesis offers a viable means of examining likely future outcomes, by observing the most important contributor - expectations - to the individual decisions which aggregate to create the final macro-outcomes. By determining the current expectations of the population involved, and plotting the optimal path - if any - to the desired outcomes, it also offers the more powerful actors, especially governments, a new tool for influencing some of those future outcomes.

In a number of fields, most notably in that of economics, frequent attempts have been made to model behaviour of key variables. Indeed, it has even been claimed that the individual economic agent must possess a formal model in order to generate his or her expectations (see Hahn, 1973). In view of the prevailing uncertainty, it is not surprising that many of these models, especially econometric attempts to model the macro-economy but even the less complex ones which are used in rational expectations work, have been doomed to ultimate failure. Even reference to elements of chaos theory (for example see Dopfer, 1991) is unlikely to unlock the solution to this problem. In the context of expectations theory, this failure should primarily be seen as that of trying to accurately predict (mathematically) the dynamic outcomes of essentially non-rational processes, which are based on the aggregation of individual decisions, by the use of (typically static) rational models ,which are based upon discrete macro-variables.

The Aggregated Expectations Hypothesis would posit, however, that these models do still have an important, albeit different, role - as potentially powerful elements of the communication process. Some models, in this context, can offer a very potent means of influencing expectations; as is now recognised by those governments which use interest rates to communicate (signal) their own expectations of future changes in inflation. Paradoxically, one of the best examples was to be seen in the influence of the Chicago School of economists in general, and of Friedmann (see 1968) in particular; arising from their promotion of the simple model(s) behind monetarism. Their theories were eventually accepted by the majority of decision-makers; and built into their own expectations - in the terminology of our hypothesis - of future developments. Under those circumstances, monetarist theory was able to predict outcomes, for the relatively short time that these expectations were shared by the wider world, and enabled governments to influence those outcomes.

The nature of the model, as a communication device, becomes most apparent when we compare the success of this (monetarist) model with the equal success of that of the previous period - covering several decades - when the very different theories previously put forward by Keynes (see 1936) were just as well accepted. In their time, they as powerfully influenced expectations, with an even better track record in terms of predictability and of government use.

The change from Keynesianism to Monetarism also illustrated another feature applying to the hypothesis of aggregated expectations:

When there is a general shift in expectations from a basis in one model to that in another - paralleling Kuhn's (see 1970) paradigm shift - relative stability (in terms of predictability, at least) is replaced by a period of uncertainty; as the proportion of the population supporting the two competing models progressively shifts from one to the other (and the strength of their individual belief in the new model grows, as that of the old one wanes).

This may, thus, be seen as one contributor to the uncertainty which has been a characteristic of the macro-environment in recent decades. It has been compounded by the need for 'monetarists' to regularly modify their earlier, over-simplistic, theories to allow for discrepancies in the observed outcomes. The shifting nature of this recent (‘monetarist’) theory has possibly been one contributor to the on-going dissonance. In the context of stable, and predictable, expectations it is even arguable that it is better for a government to be consistently wrong - as in retrospect the Thatcher governments were - than to be inconsistently right - as John Major's governments have sometimes been subsequently.

This (expectations) communications aspect of modelling imposes rather different requirements. Previously, models were deemed most academically worthwhile - and supposedly more effectively productive - if they were reducible to exact mathematical equations - as, for the benefit of my fellow academics, my own work at the beginning of this paper has been. Indeed, they were sometimes thought to be even more worthwhile if such equations were so complex ('mirroring the complexity of nature') that only the most erudite elite could understand them.

In the new context, of communicating expectations, such mathematical complexity should be seen to work against many models - not least those developed by econometricians. Instead, in line with the parallel requirements in the commercial sector for 'conviction marketing' (see Mercer, 1996), the key parameters for a persuasive model - one which most effectively influences expectations - are:

simplicity and clarity - the concepts have to be easily grasped by the population at large. The very simple message of monetarism, that of the devaluation caused by governments 'printing money', was easy to understand at a superficial level - even if it did not attempt to fully describe the complex issues involved.

distinctive, rich identity - the ideas have to be clearly differentiated from competitive offerings, as was monetarism, but ideally should also tap into a much richer 'value system', as was monetarism supported by the panoply of the (Chicago School) free-market debate.

believability, especially of the champions - the model must ultimately be believed by the majority of the population. This typically occurs because the promoter is believable, as was Friedmann on behalf of monetarism - where his 'opponent', Keynes, was dead.

strength of opponents - indeed, the comparison with the old paradigm, and especially with its supporters, is a key element in the battle for hearts and minds. The Keynesians were handicapped not just by the fact that their leader was no longer there to defend his theories, but - even worse - by the fact that they had foolishly also espoused the Phillips J Curve as a core element of their expanded theory (even though Keynes himself had written his theories, and died, before Phillips had propounded his). They were, therefore, highly vulnerable when Friedmann proved this particular theory to be false!

match to 'consumer' needs - finally, the concept(s) have to resonate with the population on which they are targeted. The main target of monetarism was the business community, and the economists who aspired to mediate between it and government, both of whom found the notion of the free-market emotionally, and practically, satisfying at a time when it was increasingly claimed that there was too much government intervention.

In addition, if such a model is to survive the ravages of time, it needs to incorporate:

ambiguity - such that it can be progressively reinterpreted to meet changing circumstances. This has happened to an extent with monetarist theory - and rational expectations itself can be viewed as one such reinterpretation. Most notably, though, it has also happened to the longest lived models of all; religious texts - such as the bible - which have been interpreted very differently by different sects at different times in history.

In terms of practical use of Aggregated Expectations Hypothesis, four stages of research/analysis are employed:

This was the most important stage of the overall project, and involved the development of two new sets of qualitative research techniques. The first of these, ‘simpler scenarios’, allows this approach to be used as a framework for more general research. In the context of our 'simpler scenarios', as initially developed for use by smaller organisations (see Mercer, 1995 and 1996) this process comprises five main steps - all to be followed sequentially by those wishing to investigate the future of their organisations:

In the new form of qualitative global research, specifically used in our work on expectations, only the first two steps were undertaken exclusively by our participants and the last two were undertaken exclusively by ourselves. In the case of step 3 there was an overlap.

The second technique, ‘self-documenting focus groups’ used to put the scenario building into practice, requires the seven or eight participants in each of these groups to use Post-It Notes - placed on a suitable (conference-room) wall - to identify the drivers for change in the global environment; and then to analyse the relationships between these. This enables a large number of dimensions, key factors or drivers for change, to be generated; as input to the second, quantitative research.

This uses postal questionnaires based on well-tried techniques (semantic differentials) to establish, for each of the 160+ events (dimensions), its importance, its probability of occurring, and the most likely date it will occur. It quantifies the current position held by individuals - influenced by the culture (the environment) in which they are immersed - and this provides the starting point for future plans.

Unusually, the next step is to return to the ‘qualitative’ work to determine how it might be possible to influence the current position of the participants. The first aspect of this extended process is to determine ‘whether’ desired changes might be possible. The second is estimation of the ‘effort’ required to achieve such changes. The rationale for using the ‘qualitative’ approach is that this is undertaken in groups; and, as members of the groups interact, these provide a dependable indication of how positions may be shifted. The only caveat is that the work should be undertaken on such a scale, with upwards of ten (8 person) groups, that the results approach a degree of statistical validity.

The main limitation, of even the qualitative work, is that the participants tend to be culturally blind to the underlying structures. Accordingly, their final output often focuses upon symptoms rather than the causes. It is, therefore, passed - as the final stage - to expert analysts who use their own expertise (and that of the reports from other experts onto which the output is mapped) to synthesise the material into the most meaningful patterns.
REFERENCES

Dopfer, K. (1991), ‘The Complexity of Economic Phenomena’, Journal of Economic Issues, Vol. 25 (March)

Friedmann, M. (1968), ‘The Role of Monetary Policy’, American Economic Review, vol. 58, pp. 23-41

Gerrard, Bill. (1994), ‘Beyond Rational Expectations: A Constructive Interpretation of Keynes’s Analysis of Behaviour Under Uncertainty’, The Economic Journal, Vol. 104 (March), pp. 327-337

Hahn, F. (1973), Money and Inflation, Mitsui Lectures in Economics, Blackwell, Oxford

Keynes, John Maynard. (1936), The General Theory of Employment, Interest and Money, Macmillan, London

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Mercer, D. ‘A New Qualitative Technique for Exploring the Future’, Marketing Education Group (MEG), Warwick (August, 1996)

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Mercer, D. (1997), A General Hypothesis of Aggregated Expectations, Technological Forecasting and Social Change

Mercer, D. (1997), Determining Aggregated Expectations of the Future, Technological Forecasting and Social Change

Wack, Pierre. (1985), ‘Scenarios: Uncharted Waters Ahead’, Harvard Business Review, Sep/Oct 1985, pp. 39-150

Wack, Pierre. (1985), ‘Scenarios:Shooting the Rapids’, Harvard Business Review, Nov/Dec 1985, pp. 139-150

Telephone: 044(0)1908 655878 Fax: 044(0)1908 655898 Email: d.s.mercer@open.ac.uk

A new approach to macro-economic theory, ‘The Aggregated Expectations ‘, is based upon the most important contributor - expectations - to the individual decisions which aggregate to create final macro-economic -outcomes. It offers a viable basis for examining likely future (economic) outcomes and developing new tools for influencing some of those outcomes. In essence, the future outcome of an economic issue will be largely determined by the expectations of those, in the population affected, whose aggregated individual decisions will shape that outcome.

[1] Open University Business School, Walton Hall, Milton Keynes, MK7 6AA, United Kingdom

Telephone: 044(0)1908 655878 Fax: 044(0)1908 655898 Email: d.s.mercer@open.ac.uk

[2] It is based upon observations made, as part of the Open University’s ‘Millennium Project’, working with more than a thousand large organisations and government departments. This project (run in conjunction with the Strategic Planning Society and the American Council of the United Nations University) was designed to improve the practical accuracy of long-range forecasting by using research techniques (see Mercer, 1995, 1996, and 1997) derived from a combination of scenario-planning and focus-groups. It is described in more detail in Appendix B.

[3] This compares, for instance, with the rather more complex form of even the ‘simple’ representation of the rational expectations hypothesis given by Gerrard (see 1994):

_t-1 X^e_t=E(X_t|O_t-1)

where _t-1 X^e_tis the rational expectation formed in period t-1 of the variable, X, in period t and E(X_t|O_t-1) is the mathematical expectation of X_t conditional on the information set O_t-1 available in period t-1 (where the whole is characterised by unbiasedness and orthogonality)

[4] This is a key feature of the generalised hypothesis, as it is for the rational expectations hypothesis, hence the emphasis on aggregation