How well do individuals predict their future life satisfaction? Rationality and learning following a nationwide exogenous shock

Abstract

Over recent years a number of papers have used individual or household longitudinal survey data to investigate the rationality of income expectations. In this paper we provide a novel contribution to this literature by examining the ability of individuals to correctly predict their own future life satisfaction using longitudinal data for East Germans. The environment in which this analysis is based is the decade following reunification of Germany, and it is generally accepted that reunification was completely unexpected and delivered a particularly large shock to the future prospects of the inhabitants of the former East Germany. We therefore take it as a 'natural' experiment through which to study the rationality of expectations and the adjustment of expectations over a period of substantial transition. Our results show that the majority of East Germans significantly over-estimated the gains from reunification. As with the recent literature on income expectations, we find strong evidence of micro-heterogeneity with the largest prediction errors being for the young, the poorly educated and those with children. An important result, however is that expectations and realisations of life satisfaction in East Germany had essentially converged only five years after reunification, at a level considerably below that of West Germans.