Big Players and the Economic Theory of Expectations

This post originally appeared on cobdencentre.org.

Via FT.com / US / Economy & Fed – Fed signals pullback in liquidity supports, we learn:

The Federal Reserve on Wednesday upgraded its assessment of the US economy and highlighted its intention to shut down most of its crisis-fighting liquidity facilities in early 2010.

And consequently:

Stocks eased slightly after the Fed statement, while the yield curve in the bond market steepened.

Which brings us on to Roger Koppl’s Big Players and the Economic Theory of Expectations.

I am indebted to Cobden Centre Supporter Bruno Prior for introducing me to Koppl’s work which extends the tradition of Ludwig von Mises, Friedrich Hayek and others, unusually, applying empirical methods to demonstrate the application of the theory.

Koppl demonstrates, with extensive reference to other scholars, that investment and all other economic actions depend on “subjective” expectations. He then presents a theory of expectations which assumes people interpret their situations in unpredictable ways. This theory includes a theory of “Big Players”:

Big Players are privileged actors who disrupt markets. A Big Player has three defining characteristics. He is big in the sense that his actions influence the market under study. He is insensitive to the discipline of profit and loss. He is arbitrary in the sense that his actions depend on discretion rather than any set of rules. Big Players have power and use it.

We learn that Big Players reduce the reliability of expectations, thereby disrupting markets. They encourage herding and produce perverse effects on entrepreneurship: traders must pay attention to the Big Player and not the fundamentals.

And so we find today, for example, the markets moving in response to the Fed not the realities of the economy…