IS-LM vs. Minsky

25 Mar, 2014 at 13:56 | Posted in Economics | 18 Comments

As we all know, Paul Krugman and some other more or less unorthodox mainstream economists keeps on arguing that IS-LM is a valid model for analyzing modern economies.

Yours truly disagrees. In this article I want to focus on why IS-LM doesn’t adequately reflect the width and depth of Keynes’s insights on the workings of modern market economies and why we have so much more to learn from Hyman Minsky than a “brilliantly silly” gadget like the IS-LM model.

• Almost nothing in the post-General Theory writings of Keynes 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 famous 1937 Quarterly Journal of Economics 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. 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he wrote that ”the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better — is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of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.” What Hicks acknowledges in 1980 is basically that his original IS-LM model ignored significant parts of Keynes’ theory. IS-LM is inherently a temporary general equilibrium model. However — much of the discussions we have in macroeconomics is about timing and the speed of relative adjustments of quantities, commodity prices and wages — on which IS-LM doesn’t have much to say.

• IS-LM forces to a large extent the analysis into a static comparative equilibrium setting that doesn’t in any substantial way reflect the processual nature of what takes place in historical time. To me Keynes’s analysis is in fact inherently dynamic — at least in the sense that it was based on real historic time and not the logical-ergodic-non-entropic time concept used in most neoclassical model building. And as Niels Bohr used to say — thinking is not the same as just being logical …

• IS-LM reduces interaction between real and nominal entities to a rather constrained interest mechanism which is far too simplistic for analyzing complex financialised modern market economies.

• IS-LM gives no place for real money, but rather trivializes the role that money and finance play in modern market economies. As Hicks, commenting on his IS-LM construct, had it in 1980 — “one did not have to bother about the market for loanable funds.” From the perspective of modern monetary theory, it’s obvious that IS-LM to a large extent ignores the fact that money in modern market economies is created in the process of financing — and not as IS-LM depicts it, something that central banks determine.

• IS-LM is typically set in a current values numéraire framework that definitely downgrades the importance of expectations and uncertainty — and a fortiori gives too large a role for interests as ruling the roost when it comes to investments and liquidity preferences. In this regard it is actually as bad as all the modern microfounded Neo-Walrasian-New-Keynesian models where Keynesian genuine uncertainty and expectations aren’t really modelled. Especially the two-dimensionality of Keynesian uncertainty — both a question of probability and “confidence” — has been impossible to incorporate into this framework, which basically presupposes people following the dictates of expected utility theory (high probability may mean nothing if the agent has low “confidence” in it). Reducing uncertainty to risk — implicit in most analyses building on IS-LM models — is nothing but hand waving. According to Keynes we live in a world permeated by unmeasurable uncertainty — not quantifiable stochastic risk — which often forces us to make decisions based on anything but “rational expectations.” Keynes rather thinks that we base our expectations on the “confidence” or “weight” we put on different events and alternatives. To Keynes expectations are a question of weighing probabilities by “degrees of belief,” beliefs that often have preciously little to do with the kind of stochastic probabilistic calculations made by the rational agents as modeled by “modern” social sciences. And often we “simply do not know.” As Keynes writes in A Treatise on Probability:

The kind of fundamental assumption about the character of material laws, on which scientists appear commonly to act, seems to me to be [that] the system of the material universe must consist of bodies … such that each of them exercises its own separate, independent, and invariable effect, a change of the total state being compounded of a number of separate changes each of which is solely due to a separate portion of the preceding state … Yet there might well be quite different laws for wholes of different degrees of complexity, and laws of connection between complexes which could not be stated in terms of laws connecting individual parts … If different wholes were subject to different laws qua wholes and not simply on account of and in proportion to the differences of their parts, knowledge of a part could not lead, it would seem, even to presumptive or probable knowledge as to its association with other parts … In my judgment, the practical usefulness of those modes of inference … on which the boasted knowledge of modern science depends, can only exist … if the universe of phenomena does in fact present those peculiar characteristics of atomism and limited variety which appears more and more clearly as the ultimate result to which material science is tending.

Models can never be more than a starting point in the endeavour of finding causal mechanisms. Consequently we cannot — from a relevant and realistic point of view — simpliciter presuppose that what has worked before, will continue to do so in the future. How strange then that macroeconomic models — IS-LM included — as a rule do not even touch upon these aspects of scientific methodology that seems to be so fundamental and important for anyone trying to understand how we learn and orient ourselves in an uncertain world. An educated guess on why this is a fact would be that Keynes’s concepts are not possible to squeeze into a single calculable numerical “probability.” In the quest for quantities one – IS-LM models included — puts a blind eye to qualities and looks the other way.

Why is this important? Because the kind of involuntary unemployment and low investment activity that intermittently characterizes modern market economies is basically impossible to understand without weighing in the kind of uncertainties and expectations that was at the forefront of Keynes’s analysis.

• IS-LM not only ignores genuine uncertainty, but also the essentially complex and cyclical character of economies and investment activities, speculation, endogenous money, labour market conditions, and the importance of income distribution. And as Axel Leijonhufvud so eloquently notes on IS-LM economics — “one doesn’t find many inklings of the adaptive dynamics behind the explicit statics.” Most of the insights on dynamic coordination problems that made Keynes write General Theory are lost in the translation into the IS-LM framework.

Thirty years ago — as a young research stipendiate in the U.S. — yours truly had the great pleasure and privelege of having Hyman Minsky as teacher. He was a great inspiration at the time. He still is — and the points I have made here are some of the main reasons why I still think Hyman was right when maintaining that “Keynes without uncertainty is rather like Hamlet without the Prince,” and characterizing IS-LM as an “unfair and naive representation of Keynes’s subtle and sophisticated views”:

The glib assumption made by Professor Hicks in his exposition of Keynes’s contribution that there is a simple, negatively sloped function, reflecting the productivity of increments to the stock of capital, that relates investment to the interest rate is a caricature of Keynes’s theory of investment … which relates the pace of investment not only to prospective yields but also to ongoing financial behavior …

The conclusion to our argument is that the missing step in the standard Keynesian theory was the explicit consideration of capitalist finance within a cyclical and speculative context. Once capitalist finance is introduced and the development of cash flows … during the various states of the economy is explicitly examined, then the full power of the revolutionary insights and the alternative frame of analysis that Keynes developed becomes evident …

The greatness of The General Theory was that Keynes visualized [the imperfections of the monetary-financial system] as systematic rather than accidental or perhaps incidental attributes of capitalism … Only a theory that was explicitly cyclical and overtly financial was capable of being useful …

As all students of economics know, time is limited. Given that, there has to be better ways to optimize its utilization than spending hours and hours working through or constructing irrelevant economic models. I rather recommend my students to allocate some time to study great forerunners like Keynes and Minsky, helping them to construct better, real and relevant economic models – models that really help us to explain and understand reality.