LARS P SYLL

Paul Krugman’s pathetic IS-LM obsession

Paul Krugman has a post up on his blog commenting on the latest IMF WEO report. Unfortunately the basically sound argumentation about IMF’s concession on the adverse effect of austerity actually being much worse than expected, gets drowned in Krugman’s endless harping on the same old IS-LM string:

[B]ack in 2010, as advanced economies “pivoted” to austerity despite protests from yours truly and others … who argued that historical experience from countries that were not up against the zero lower bound, had flexible exchange rates, and were pursuing austerity amidst a strong global economy was likely to greatly understate the effects of austerity in the current environment. Our position was, if you like, that times like this are different …

[T]he theoretical framework we used to make this dire prediction — basically some form of IS-LM or successor model (which includes New Keynesian approaches) — was consistent with the evidence. I don’t think any of us would have gone with the theory if budget deficits had in fact caused interest rates to soar in 2009-2010, or if expansion of the monetary base had caused an inflationary explosion. But the analytical framework was essential to the conclusion that the experience of countries not in a liquidity trap was a poor guide to what would happen under current conditions.

At some level, then, the vindication of this position is also a vindication for the whole enterprise of Keynes/Hicks macroeconomic theory, which does indeed, done right, turn out to yield crucial insights that naive empiricism would miss.

“Keynes/Hicks macroeconomic theory”? What an unbelievable oxymoron! Let us get some things straight right away.

There is nothing in the post-General Theory writings of Keynes that suggests him considering Hicks’s IS-LM anywhere near a faithful rendering of his thought. In Keynes’s canonical statement of the essence of his theory in the 1937 QJE-article there is nothing to even suggest that Keynes would have thought the existence of a Keynes-Hicks-IS-LM-theory anything but pure nonsense. So of course there can’t be any “vindication for the whole enterprise of Keynes/Hicks macroeconomic theory” – simply because “Keynes/Hicks” never existed.

And it gets even worse!

John Hicks, the man who invented IS-LM in his 1937 Econometrica review of Keynes’ General Theory – Mr. Keynes and the ‘Classics’. A Suggested Interpretation – returned to it in an article in 1980 – IS-LM: an explanation - in Journal of Post Keynesian Economics. Self-critically he wrote:

I accordingly conclude that the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better – is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate. I have deliberately interpreted the equilibrium concept, to be used in such analysis, in a very stringent manner (some would say a pedantic manner) not because I want to tell the applied economist, who uses such methods, that he is in fact committing himself to anything which must appear to him to be so ridiculous, but because I want to ask him to try to assure himself that the divergences between reality and the theoretical model, which he is using to explain it, are no more than divergences which he is entitled to overlook. I am quite prepared to believe that there are cases where he is entitled to overlook them. But the issue is one which needs to be faced in each case.

When one turns to questions of policy, looking toward the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected-if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium. It may be hoped that, after the change in policy, the economy will somehow, at some time in the future, settle into what may be regarded, in the same sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is reached …

I have paid no attention, in this article, to another weakness of IS-LM analysis, of which I am fully aware; for it is a weakness which it shares with General Theory itself. It is well known that in later developments of Keynesian theory, the long-term rate of interest (which does figure, excessively, in Keynes’ own presentation and is presumably represented by the r of the diagram) has been taken down a peg from the position it appeared to occupy in Keynes. We now know that it is not enough to think of the rate of interest as the single link between the financial and industrial sectors of the economy; for that really implies that a borrower can borrow as much as he likes at the rate of interest charged, no attention being paid to the security offered. As soon as one attends to questions of security, and to the financial intermediation that arises out of them, it becomes apparent that the dichotomy between the two curves of the IS-LM diagram must not be pressed too hard.

So – back in 1937 John Hicks said that he was building a model of John Maynard Keynes’ General Theory. In 1980 he openly admits he wasn’t.

What Hicks acknowledges in 1980 is basically that his original review totally ignored the very core of Keynes’ theory – uncertainty. In doing this he actually turned the train of macroeconomics on the wrong tracks for decades. It’s about time that neoclassical economists – as Krugman, Mankiw, or what have you – set the record straight and stop promoting something that the creator himself admits was a total failure. Why not study the real thing itself – General Theory – in full and without looking the other way when it comes to non-ergodicity and uncertainty?

For the nth time organ-grinder Paul Krugman pretends it’s raining and persists in talking about a Keynes-Hicks-IS-LM-model that really never existed. It’s deeply disappointing. You would expect more from a Nobel prize winner.