Commentary

We Were All Keynesians Then

By Ike Brannon
January 9, 2006
One thing history teaches is that the person who conceives a great idea may not get the credit for it. In 1961, a little-known economist at Carnegie Tech named John Muth published a piece in the journal Econometrica demonstrating that people thoughtfully use available information to predict future prices and then make economic decisions based on those “rational expectations.” Muth’s insight seems obvious today, but it was radical in 1961, during the heyday of Keynesian economics.

Keynesian economics was built on the belief that people were slow-witted and couldn’t be trusted to make rational economic decisions. That’s why Keynesians concluded that the government needed to steer the economic ship on a steady course — they were convinced that entrepreneurs and workers were too dim to get it right on their own. Because Muth challenged the Keynesian belief by saying that that workers and entrepreneurs are at least as smart as government bureaucrats, his article received little initial attention. Discouraged at the lack of a response, Muth soon abandoned this line of research.

But in the decades that followed, rational expectations gained credence within the profession, eventually uprooting Keynesian economics and paving the way for the supply-side revolution. His article is now one of the most widely cited papers in the social sciences, and Muth’s work — especially his belief that workers and entrepreneurs do a good job making economic decisions — is an accepted part of the canon of economics.

While his idea receives broad acclaim today, the same cannot be said for John Muth himself. Muth passed away on October 25th of last year, never rising out of obscurity despite his contributions to the discipline. It was Muth’s former colleague, Robert Lucas, who won the Nobel Prize for rational expectations, with Muth’s contribution scarcely mentioned in the awards announcement. His work merits at least a perfunctory account.

The idea of rational expectations is deceivingly simple: Buyers and sellers who need to forecast future prices do not merely assume that they will be the same as current prices. Instead, they use all available information to make an educated guess as to what prices will be — at least when it is worth their while to do so.

What’s more, their educated guess will, on average, be correct — people will make mistakes, but they will not be consistently wrong. Muth demonstrated that in a market for hogs, which had been thought to exhibit wide, predictable price swings, rational expectations explains prices quite well.

Muth’s paper was published at the very time that Keynesian economics had become ascendant in the policy world — the Phillips Curve had recently been unveiled and was ripe to be exploited. Behind it lay the notion that policymakers can permanently reduce unemployment by inflating the money supply and increasing inflation.

The rationale underlying the Phillips Curve says that higher inflation fools workers, who mistake a rising dollar wage for a real rise in their buying power. As a result, people take jobs they might not otherwise take and work more hours than they would otherwise work, increasing employment and output.

Given the exceptional performance of the economy in the 1960s, few had any reason to question the economic orthodoxy of the time. Muth’s rational expectations model languished before Lucas thought to use Muth’s concept to explain why the Phillips Curve stopped working during the “stagflation” era of the 1970s. Rational expectations said that the Phillips Curve was nonsense — people may not make the economically optimal decisions all of the time, but they can’t be consistently fooled by government policies.

The idea utterly transformed the discipline. In short order it changed the conversation amongst macroeconomists and policymakers from managing aggregate demand — that is, steering the economic ship — to talk of providing a stable, healthy economic environment that would serve to increase the supply side of the economy. It’s no coincidence that supply-side economics developed in the wake of rational expectations.

Today, the impact of rational expectations remains enormous. For instance, Federal Reserve Board chairman-elect Ben Bernanke’s stated desire to target inflation to between one and two percent, a policy praised by many today, would have been seen as foolhardy before the ascension of rational expectations.

Muth went on to have a long and productive career at Indiana University, where he made important contributions to operations management and was also one of the first to study artificial intelligence. While he would have appreciated the recognition of a Nobel Prize, Muth was a shy gentleman who would have been uncomfortable with the notoriety that comes with the prize. He was much more at home at the various pubs in downtown Bloomington, where he was not averse to holding his office hours.

The world of economics owes him a debt of gratitude for his work, and his passing shouldn’t come without at least a nod in his direction for putting in motion a seismic change in how economists view the world. President Richard Nixon famously said in 1971 that we are all Keynesians now. Because of John Muth, virtually none of us are today.

Ike Brannon is an economist in Washington, D.C. His lengthy tribute to John Muth will appear in the Spring issue of Regulation magazine.