Paul Krugman – the IS-LM-organ-grinder

27 Oct, 2012 at 19:06 | Posted in Economics | 3 Comments

Howard Davies has an interesting article on Project Syndicate about  the shortcomings of modern mainstream economics:

But what of the core disciplines of economics and finance themselves? Can nothing be done to make them more useful in explaining the world as it is, rather than as it is assumed to be in their stylized models?

George Soros has put generous funding behind the Institute for New Economic Thinking (INET). The Bank of England has also tried to stimulate fresh ideas. The proceedings of a conference that it organized earlier this year have now been edited under the provocative title What’s the Use of Economics?

Some of the recommendations that emerged from that conference are straightforward and concrete. For example, there should be more teaching of economic history … Many conference participants agreed that the study of economics should be set in a broader political context, with greater emphasis on the role of institutions … But it is not clear that a majority of the profession yet accepts even these modest proposals. The so-called “Chicago School” has mounted a robust defense of its rational expectations-based approach, rejecting the notion that a rethink is required. The Nobel laureate economist Robert Lucas has argued that the crisis was not predicted because economic theory predicts that such events cannot be predicted. So all is well.

And there is disturbing evidence that news of the crisis has not yet reached some economics departments … The University of Chicago’s Eugene Fama has described the notion that finance theory was at fault as “a fantasy,” and argues that “financial markets and financial institutions were casualties rather than causes of the recession.” And the efficient-market hypothesis that he championed cannot be blamed, because “most investing is done by active managers who don’t believe that markets are efficient.”

This amounts to what we might call an “irrelevance” defense: Finance theorists cannot be held responsible, since no one in the real world pays attention to them!

Great critique, and you would of course expect even IS-LM-organ-grinder Paul Krugman to concur. But no – instead Krugman complains that

The truth is that basic macroeconomics, the stuff that is still taught in textbooks, has been very, very useful in this crisis. The problem is that half the profession and most policy makers turned their back on this kind of economics.

What is the magic silver bullet that Davies missed? Good old IS-LM of course!

I’m starting to get rather tired of  PK:s endless tirades about the splendour of the Hicksian invention. Why? Well, read this for a starter: 

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.

John Hicks: “IS-LM: an explanation” Journal of Post Keynesian Economics (1980)