IS-LM is bad economics no matter what Krugman says

20 Mar, 2013 at 14:26 | Posted in Economics | 13 Comments

Paul Krugman has a post up on his blog once again defending “the whole enterprise of Keynes/Hicks macroeconomic theory” and especially his own somewhat idiosyncratic version of IS-LM.

The main problem is simpliciter that there is no such thing as a Keynes-Hicks macroeconomic theory!

So, let us get some things straight.

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conclude that the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better – is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of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.

 
The editor of JPKE, Paul Davidson, gives the background to Hicks’s article:

I originally published an article about Keynes’s finance motive — which in 1937 Keynes added to his other liquidity preference motives (transactions, precautionary, speculative motives) , I showed that adding this finance motive required that Hicks’s IS curve and LM curves to be interdependent — and thus when the IS curve shifted so would the LM curve.
Hicks and I then discussed this when we met several times.
When I first started to think about the ergodic vs. nonergodic dischotomy, I sent to Hicks some preliminary drafts of articles I would be writing about nonergodic processes. Then John and I met several times to discuss this matter further and I finally convinced him to write the article — which I published in the Journal of Post Keynesian Economics– in which he renounces the IS-LM apparatus. Hicks then wrote me a letter in which he thought the word nonergodic was wonderful and said he wanted to lable his approach to macroeconomics as nonergodic!

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?

Paul Krugman 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.