Macroeconomic Experiences and Expectations: A Perspective on the Great Recession∗

Life-time experiences shape macroeconomic expectations. Young people, endowed a small experience set, are particularly prone to rely on very recent data when forming expectations. I illustrate these patterns with micro survey data on inflation, stock return, and house price appreciation expectations. In the case of asset return expectations, the tendency to extrapolate from recent data makes asset return expectations pro-cyclical. This pro-cyclicality supported the house price boom leading up to the Great Recession and it reinforced the subsequent bust. The optimistic expectations during the boom help understand the rise in household leverage, the buildup of excess stocks of durables and housing during those years, and hence the fragility that set the stage for the ensuing household balance sheet recession. I also discuss the outlook for households’ asset return expectations given their experiences with the Great Recession and the subsequent slump until the end of 2011. ∗Paper prepared for Academic Consultants meeting of the Board of Governors of the Federal Reserve System, May 14, 2012. †Graduate School of Business, Stanford University, 655 Knight Way, Stanford, CA 94305 Consumer decisions to purchase a house, to take on debt, or to invest in the stock market reflect expectations about future personal circumstances and about the macroeconomy many years into the future. As in other realms of human decision-making, past experiences may exert a profound influence on these economic expectations. Macroeconomic events may shape the expectations of generations that live through these events. Discussing the persistent increase in the demand for money following the onset of the Great Depression in 1929, Friedman and Schwartz (1963) suggest that “The contraction after 1929 shattered beliefs in a ‘new era’ [...]. The contraction instilled instead an exaggerated fear of continued economic instability, of the danger of stagnation, of the possibility of recurrent unemployment.” (p.673) In line with Friedman and Schwartz’ hypothesis, experience of macroeconomic events might have an excessive influence on individuals’ expectations—excessive relative to the fiction of an agent armed with rational expectations and knowledge of the parameters of the processes driving the economy. In this paper, I present empirical evidence from microdata on how macroeconomic experiences shape expectations, and I discuss channels through which these experience effects may have contributed to the dynamics of household spending before, during, and after the Great Recession 2007-09. I focus my discussion on subjective expectations of macroeconomic variables. This is not to say that preferences (for risk taking, for consumption smoothing) might not also be influenced by experiences of macroeconomic events. However, microdata over long time spans is required to separate the effects of life-time experiences from other factors. The availability of clean measures of preferences is more limited in this regard than the availability of expectations data. The set of macroeconomic variables that could play an important role in household spending decisions is vast. I focus on a few for which we either have a long history of survey data