×

Fill out the brief form below for access to the free report.

  • George W. Bush Institute

    Our Ideas

  • Through our three Impact Centers — Domestic Excellence, Global Leadership, and our Engagement Agenda — we focus on developing leaders, advancing policy, and taking action to solve today’s most pressing challenges.

I'm interested in dates between:
--

Issues

I have minutes to read today:

Programs & Issues

Issues

Publication Type
Date
I'm interested in dates between:
--
Reading Time

I have minutes to read today:

Why Keynesian Economics Died

February 1, 2013 7 minute Read by Ike Brannon
The internet has been atwitter the last couple of weeks regarding the forecast of higher pork prices. Can a bunch of commentators accurately predict what will happen to pork prices in the future? It is a question that has been asked — and answered — before, with profound results that are relevant not just to the price of bacon next year (don’t bet on it going up), but also to the pressing macroeconomic questions of the day, such as whether more government spending or another round of quantitative easing can be expected to stimulate the economy. (Probably not). Fifty years ago an obscure economist named John Muth published a paper titled “Rational Expectations and the Theory of Price Movements” in which he argued that economic agents acting in their own self-interest make it impossible for pork prices — or any prices, for that matter — to behave in a predictable way. Muth was taking direct aim at a dubious maxim called the cobweb model, which said that the price of various commodities often follows a boom and bust cycle. For example, if a drought causes corn prices to rise in year one, farmers will anticipate higher prices and react by planting a lot of corn the next spring. Because of so much planting, corn prices actually fall, and farmers react in year three by planting fewer acres of corn. Of course, this reduces the supply of corn and thus sends the price upward again.  This pattern continues until there’s another shock to the system. Muth said this theory was garbage: Farmers know better than to simply assume that next year’s prices will be the same as this year’s prices, and they use all available information to make a rational prediction as to future prices and then act accordingly. By doing so, they render it impossible for anyone to accurately forecast prices in the future. Farmers cannot afford to be consistently wrong on prices; the ones who do go out of business. Muth used historical data on pork prices to demonstrate that his story fit the actual data much better than did the cobweb model. Muth’s paper languished for a few years until some of his colleagues picked it up and asked whether his model would apply to the entire macroeconomy. Keynesian economics, which was then in its ascendancy, stipulated that the government could stimulate the economy through expansionary fiscal or monetary policy. It worked by creating unanticipated inflation, which increases demand for labor, and the economy creates more jobs. The rationale for this in the Keynesian world was that people are fooled by the unanticipated inflation and that it takes time for their expectations to catch up to inflation. So in this story people think that a nominal wage increase is a real increase so they work more hours, some people give up being students or homemakers to take a job, and the economy is goosed a bit. The Keynesian model seemed to work marvelously in the 1950s and 1960s, and economists at the time believed that judicious use of fiscal and monetary policy would put an end to the business cycle. Muth and his colleagues at Carnegie Tech didn’t put much stock into such hubris, and by the 1970s the Keynesian model ceased being able to explain the macro economy. One of Muth’s colleagues, Robert Lucas, took Muth’s ideas and tried to come up with a better model of how the macro economy worked. Rational expectations rejected the idea that the government could fool people by injecting inflation into the economy. The average Joe may not have a Ph.D. in economics, but he knows enough to avoid being consistently fooled by the government into working more when wages go up simply because of inflation. Rather than trying to stimulate aggregate demand to smooth out the business cycle — a focus of macroeconomists since the great depression — economists started thinking about what the government can do to stimulate aggregate supply and encourage long-term economic growth. This development paved the way for supply-side economics. While Art Laffer was doodling on napkins to demonstrate the revenue-maximizing tax rate, people like the economist Steve Entin and Orrin Hatch — newly elected into the U.S. Senate — were pondering the optimal structure of the tax code and how we should tax work, savings, and investment. Even the deregulatory agenda that began during the Carter administration owes its impetus at least in some degree to the turn away from managing the demand side of the economy. Robert Lucas won the Nobel Prize in economics for his research, and the proof of the importance of his work lies in the fact that it is nearly impossible to find an academic macroeconomist who hews to the Keynesian perspective. Paul Krugman, the Linus Pauling of the profession, did his seminal work on trade theory. By the time rational expectations had elevated Lucas to the ranks of elite economists, Muth had moved on, to some degree frustrated by the indifference the economic profession had given his paper. As Lucas himself remarked, “It must be quite an experience to write papers that radical and…nothing happens.” But if the profession refused to give him the recognition he deserved, John Muth was at least able to look around at the economy and take some solace in the fact that very few scribblers had as much of an impact as he did on the world. And while politicians will always look for the academic who tells them that more spending is the answer to an ailing economy, Muth’s work laid waste to that notion and ultimately helped set us on a path to renewed prosperity.

Author

Ike Brannon
Ike Brannon

Ike Brannon served as an Economic Growth Fellow of the George W. Bush Institute from 2012 to 2015. He has a Ph.D. in economics from Indiana University and a B.A. in math, Spanish, and economics from Augustana College. View his full bio

Full Bio