FEW IDEAS HAVE HAD AS MUCH OF AN effect on the science of economics as the concept of rational expectations. The idea is deceivingly simple: Buyers and sellers who need to guess future prices do not merely assume that they will be the same as previous 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 is more, the educated guess will, on average, be correct. People will not consistently make mistakes when it comes to prognosticating future prices.
This elementary notion, first formulated by the economist John Muth, ultimately upended four decades of economic research on macroeconomics and monetary policy, utterly discrediting the notion that governments can simply fiddle with the money supply and inflation rate to achieve the desired rate of unemployment. New Fed chairman Ben Bernanke's stated desire to target inflation to between one and two percent, a policy that seems quite sensible today, would have sounded foolish only 30 years ago.
Eventually, the bulk of what came to be considered as mainstream "Keynesian" economics, with its emphasis on the need for governments to play an active role in the economy, was jettisoned. Robert Lucas, the economist who popularized the idea of rational expectations, received the Nobel Prize for his efforts.
Despite the impact of Muth's idea, the honor and glory ultimately accorded by the profession for this titanic idea skipped by him with nary a nod in his direction. John Muth passed away last October 25th at the age of 75, and if the lack of honor and glory bothered him, he never let on. Muth, a shy and socially awkward man, would have found the attention and fuss that goes with a Nobel Prize pure torture.
THE LIFE OF JOHN MUTH
Muth grew up in the Midwest, with his family eventually settling in St. Louis. He attended Washington University in St. Louis, where he studied industrial engineering, and in 1952 he went to Carnegie Tech in Pittsburgh to study mathematical economics. At the time, Carnegie Tech was the place to be for young academics studying quantitative economics. Future Nobel laureates Herb Simon, Merton Miller, and Franco Modigliani were on the faculty, and John Nash, the game theorist who won the prize in 1984 and whose life story was the subject of the movie A Beautiful Mind, had finished his undergraduate degree a couple years earlier. Future Nobel winners Ed Prescott and Robert Lucas arrived later in Muth's tenure there.
Muth excelled at Carnegie; Modigliani, his adviser, called him "a very original and talented man." Modigliani, with whom Muth did a good bit of his research, also commented upon Muth's eccentricity, remarking that "he seemed to take pains to appear as an oddball." Muth quickly went from graduate student to professor before taking the Ph.D., and it was there that he conceived of and published his research on rational expectations.
The first paper he published in this area, entitled "Rational Expectations and the Theory of Price Movements," appeared in Econometrica in 1961. The paper was little noted at the time of its release, and one of the referees fought against its publication, claiming it was of little consequence. A companion piece appeared in The Journal of the American Statistical Association around the same time
It was not until a decade after publication that other economists began to recognize the importance of Muth's idea, after it was incorporated into a paper by Bob Lucas and Leonard Rapping. By that time, Muth had left Carnegie, first to Michigan State and then to Indiana University.
Much like Nash, who abandoned his work on game theory shortly after graduation after its lack of acclaim forced him to "settle" for a job at MIT, Muth soon abandoned work on rational expectations. He once confided that after his Econometrica article came out, he had assumed that he would be able to go anywhere he wanted, but no one paid it much attention. …