Keynes vs. Wicksell on loanable funds theory

22 Sep, 2014 at 13:41 | Posted in Economics | 8 Comments

WicksellThe fundamental difference between Keynes and Wicksell and in general the
supporters of the LFT [Loanable Funds Theory] lies in the specification of the consequences of the presence of bank money. Introducing the distinction between the natural rate of interest and interest rate on money, Wicksell and the LFT supporters state that an economy that uses bank money converges towards the equilibrium position that characterises an economy without banks, in which there is no credit market, but just a capital market where the resources not consumed by savers are exchanged. The presence of bank money does not alter the structure of the economic system; the only element that distinguishes a pure credit economy is the presence of an adjustment mechanism that drives the rate of interest on money, determined within the credit market, towards the natural rate of interest. The working of a pure credit economy can therefore be described using a theory that applies to a world without banks.

In contrast, Keynes states that the spread of a fiat money such as bank money changes the structure of the economic system. He underscores this point by introducing the distinction between a real exchange economy and a monetary economy. As is well known, Keynes uses the former term to refer to an economy in which money is merely a tool to reduce the cost of exchange and whose presence does not alter the structure of the economic system, which remains substantially a barter economy. Keynes notes that the classical economists formulated an explanation of how the real-exchange economy works, convinced that this explanation could be easily applied to a monetary economy. He believed that this conviction was unfounded …

Giancarlo Bertocco

Skola och samhälle

22 Sep, 2014 at 09:32 | Posted in Education & School | Comments Off on Skola och samhälle

lipsillYours truly har i senaste upplagan av nättidningen Skola och samhälle en artikel om vinster i skatte-finansierade friskolor. Grundfrågan är inte om dessa ska få göra vinstuttag eller om det krävs hårdare tag i form av kontroll och inspektion. Ytterst handlar det om huruvida marknadens eller demokratins logik ska få styra våra välfärdsinrättningar.

The loanable funds fallacy

21 Sep, 2014 at 18:51 | Posted in Economics | 16 Comments

The loanable funds theory is in many regards nothing but an approach where the ruling rate of interest in society is — pure and simple — conceived as nothing else than the price of loans or credit, determined by supply and demand — as Bertil Ohlin put it — “in the same way as the price of eggs and strawberries on a village market.”

loanIn the traditional loanable funds theory — as presented in maistream macroeconomics textbooks like e. g. Greg Mankiw’s — the amount of loans and credit available for financing investment is constrained by how much saving is available. Saving is the supply of loanable funds, investment is the demand for loanable funds and assumed to be negatively related to the interest rate. Lowering households’ consumption means increasing savings that via a lower interest increase investment.

Nick Rowe has presented a formalization of New Keynesian loanable funds reasoning on his blog that goes like this:

Let output demanded (call it Yd) be a negative function of the rate of interest r, a positive function of actual income Y, and a function of other stuff X.

Yd = D(r,Y,X)

And the ONKM [orthodox New Keynesian macroeconomist] central bank wants to set r such that output demanded equals potential output Y*, so that:

D(r,Y*,X) = Y*

Assume a closed economy for simplicity, subtract Cd (consumption demand) plus Gd (government demand) from both sides, remember the accounting identities C+I+G=Y and S=Y-C-G, where I is investment and S is national saving, and we get:

Id(r,Y*,X) = Sd(r,Y*,X)

The central bank sets a rate of interest such that desired investment at potential output equals desired national saving at potential output. Which is precisely the loanable funds theory of the rate of interest.

From a more Post-Keynesian-Minskyite point of view the problem with this formalization is quite obvious:

1 As already noticed by James Meade decades ago, the causal story told to explicate these accounting identities gives the picture of “a dog called saving wagged its tail labelled investment.” In Keynes’s view — and later over and over again confirmed by empirical research — it’s not so much the interest rate at which firms can borrow that causally determines the amount of investment undertaken, but rather their internal funds, profit expectations and capacity utilization.

2 As is typical of most mainstream macroeconomic formalizations and models, there is pretty little mention of real world phenomena, like e. g. real money, credit rationing and the existence of multiple interest rates, in the loanable funds theory. Loanable funds theory essentially reduces modern monetary economies to something akin to barter systems — something it definitely is not. As emphasized especially by Minsky, to understand and explain how much investment/loaning/crediting is going on in an economy, it’s much more important to focus on the working of financial markets than staring at accounting identities like S = Y-C-G. The problems we meet on modern markets today have more to do with inadequate financial institutions than with the size of loanable-funds-savings.

3 As clearly noticed by Rowe — “it would be more correct to say that the central bank sets the rate of interest where it thinks the loanable funds theory says it will be” — the loanable funds theory in the ONKM approach means that the interest rate is endogenized by assuming that Central Banks can (try to) adjust it in response to an eventual output gap. This, of course, is essentially nothing but an assumption of Walras’ law being valid and applicable, and that a fortiori the attainment of equilibrium is secured by the Central Banks’ interest rate adjustments. From a realist Keynes-Minsky point of view this can’t be considered anything else than a belief resting on nothing but sheer hope. [Not to mention that more ad more Central Banks actually choose not to follow Taylor-like policy rules.] The age-old belief that Central Banks control the money supply has more an more come to be questioned and replaced by an “endogenous” money view, and I think the same will happen to the view that Central Banks determine “the” rate of interest.

4 A further problem in the traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities. To Keynes this was seriously wrong:

gtThe classical theory of the rate of interest [the loanable funds theory] seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the assumption that income is constant is inconsistent with the assumption that these two curves can shift independently of one another. If either of them shift, then, in general, income will change; with the result that the whole schematism based on the assumption of a given income breaks down … In truth, the classical theory has not been alive to the relevance of changes in the level of income or to the possibility of the level of income being actually a function of the rate of the investment.

There are always (at least) two parts in an economic transaction. Savers and investors have different liquidity preferences and face different choices — and their interactions usually only take place intermediated by financial institutions. This, importantly, also means that there is no “direct and immediate” automatic interest mechanism at work in modern monetary economies. What this ultimately boils done to is — iter — that what happens at the microeconomic level — both in and out of equilibrium —  is not always compatible with the macroeconomic outcome. The fallacy of composition (the “atomistic fallacy” of Keynes) has many faces — loanable funds is one of them.

5 Contrary to the loanable funds theory, finance in the world of Keynes and Minsky precedes investment and saving. Highlighting the loanable funds fallacy, Keynes wrote in “The Process of Capital Formation” (1939):

Increased investment will always be accompanied by increased saving, but it can never be preceded by it. Dishoarding and credit expansion provides not an alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of increased saving.

So, in way of conclusion, what I think New Keynesians — like Paul Krugman and Greg Mankiw — “forget” when they hold to the loanable funds theory, is the Keynes-Minsky wisdom of truly acknowledging that finance — in all its different shapes — has its own dimension, and if taken seriously, its effect on an analysis must modify the whole theoretical system and not just be added as an unsystematic appendage. Finance is fundamental to our understanding of modern economies, and acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, simply isn’t enough.

All real economic activities nowadays depend on a functioning financial machinery. But institutional arrangements, states of confidence, fundamental uncertainties, asymmetric expectations, the banking system, financial intermediation, loan granting processes, default risks, liquidity constraints, aggregate debt, cash flow fluctuations, etc., etc. — things that play decisive roles in channeling money/savings/credit — are more or less left in the dark in New Keynesian formalizations of the loanable funds theory to the real world target system.

 

Added 19:30 GMT: Nick Rowe has responded to this post here.

Added 20:00 GMT: Naked Keynesianism has an interesting post and link on the issue here.

Added September 30: Victoria Chick and Geoff Tily has a  good piece in CJE (March 2014) on the loanable funds theory (LPT) and the liquidity preference theory (LP) of interest, and why Keynes considered the two theories “radically opposed.” Since IS-LM can be shown to be essentially  equivalent to LPT, this is also a further argument to be sceptical of those who maintain that the Hicksian construct should be a good representation of Keynes’s thoughts.

Courage

19 Sep, 2014 at 14:14 | Posted in Politics & Society | Comments Off on Courage

John F. Kennedy once wrote:

To be courageous requires no exceptional qualifications, no magic formula, no special combination of time, place, and circumstance. It is an opportunity that sooner or later is presented to us all.

In spite of this, many would probably still maintain that courage is not anything very common, and that the value we put on it is a witness to its rarity.

Courage is a capability to confront fear, as when in front of the powerful and mighty, not to step back, but stand up for one’s rights not to be humiliated or abused in any ways by the rich and powerful.

Courage is to do the right thing in spite of danger and fear. To keep on even if opportunities to turn back are given. Like in the great stories. The ones where people have lots of chances of turning back — but don’t.

Dignity, a better life, or justice and rule of law, are things worth fighting for. Not to step back – in spite of confronting the mighty and powerful – creates courageous acts that stay in our memories and means something – as when Rosa Parks on December 1, 1955, in Montgomery, Alabama, refused to give up her seat to make room for a white passenger.

Uncertainty and reflexivity — two things missing from Krugman’s economics

18 Sep, 2014 at 09:36 | Posted in Theory of Science & Methodology | 7 Comments

One thing that’s missing from Krugman’s treatment of useful economics is the explicit recognition of what Keynes and before him Frank Knight, emphasized: the persistent presence of enormous uncertainty in the economy. Most people most of the time don’t just face quantifiable risks, to be tamed by statistics and probabilistic reasoning. We have to take decisions in the prospect of events–big and small–we can’t predict even with probabilities.uncertainty Keynes famously argued that classical economics had no role for money just because it didn’t allow for uncertainty. Knight similarly noted that it made no room for the entrepreneur owing to the same reason. That to this day standard economic theory continues to rules out money and excludes entrepreneurs may strike the noneconomist as odd to say the least. But there it is. Why is uncertainty so important? Because the more of it there is in the economy the less scope for successful maximizing and the more unstable are the equilibria the economy exhibits, if it exhibits any at all. Uncertainty is just what the New Classical neglected when they endorsed the efficient market hypothesis and the Black-Scholes formulae for pumping returns out of well-behaved risks.

If uncertainty is an ever present, pervasive feature of the economy, then we can be confident, along with Krugman, that New Classical models wont be useful over the long haul. Even if people are perfectly rational too many uncertain, “exogenous” events will divert each new equilibrium path before it can even get started.

There is a second feature of the economy that Krugman’s useful economics needs to reckon with, one that Keynes and after him George Soros, emphasized. Along with uncertainty, the economy exhibits pervasive reflexivity: expectations about the economic future tend to actually shift that future. This will be true whether those expectations are those of speculators, regulators, even garden-variety consumers and producers. Reflexiveness is everywhere in the economy, though it is only easily detectable when it goes to extremes, as in bubbles and busts, or regulatory capture …

When combined uncertainty and reflexivity greatly limit the power of maximizing and equilibrium to do useful economics … Between them, they make the economy a moving target for the economist. Models get into people’s heads and change their behavior, usually in ways that undermine the model’s usefulness to predict.

Which models do this and how they work is not a matter of quantifiable risk, but radical uncertainty …

Between them reflexivity and uncertainty make economics into a retrospective, historical science, one whose models—simple or complex—are continually made obsolete by events, and so cannot be improved in the direction of greater predictive power, even by more complication. The way expectations reflexively drive future economic events, and are driven by past ones, is constantly being changed by the intervention of unexpected, uncertain, exogenous ones.

Alex Rosenberg

[h/t Jan Milch]

Krugman and Mankiw on loanable funds — so wrong, so wrong

16 Sep, 2014 at 09:50 | Posted in Economics | 19 Comments

Earlier this autumn yours truly was invited to participate in the New York Rethinking Economics conference. A busy schedule didn’t allow me to “go over there.” Fortunately some of the debates and presentations have been made available on the web, as for example here. Listening a couple of minutes into that video one can hear Paul Krugman strongly defending the loanable funds theory.

Unfortunately this is not an exception among “New Keynesian” economists.

Neglecting anything resembling a real-world finance system, Greg Mankiw — in the 8th edition of his intermediate textbook Macroeconomics — has appended a new chapter to the other nineteen chapters where finance more or less is equated to the neoclassical thought-construction of a “market for loanable funds.”

On the subject of financial crises he admits that

perhaps we should view speculative excess and its ramifications as an inherent feature of market economies … but preventing them entirely may be too much to ask given our current knowledge.

This is of course self-evident for all of us who understand that both ontologically and epistemologically founded uncertainty makes any such hopes totally unfounded. But it’s rather odd to read this in a book that bases its models on assumptions of rational expectations, representative actors and dynamically stochastic general equilibrium – assumptions that convey the view that markets – give or take a few rigidities and menu costs – are efficient! For being one of many neoclassical economists so proud of their (unreal, yes, but) consistent models, Mankiw here certainly is flagrantly inconsistent!

And as if being afraid that all the talk of financial crises might weaken the student’s faith in the financial system, Mankiw, in his concluding remarks, has to add a more Panglossian warning that we

should not lose sight of the great benefits that the system brings … By bringing together those who want to save and those who want to invest, the financial system promotes economic growth and overall prosperity

Really?

Finance has its own dimension, and if taken seriously, its effect on an analysis must modify the whole theoretical system and not just be added as an unsystematic appendage. Finance is fundamental to our understanding of modern economies, and acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, simply isn’t enough.

I may be too bold, but I’m willing to take the risk, and so recommend Krugman and Mankiw to make the following addition to their reading lists …

Fallacy 2

Urging or providing incentives for individuals to try to save more is said to stimulate investment and economic growth.

This seems to derive from an assumption of an unchanged aggregate output so that what is not used for consumption will necessarily and automatically be devoted to capital formation.

Again, actually the exact reverse is true. In a money economy, for most individuals a decision to try to save more means a decision to spend less; less spending by a saver means less income and less saving for the vendors and producers, and aggregate saving is not increased, but diminished as vendors in turn reduce their purchases, national income is reduced and with it national saving. A given individual may indeed succeed in increasing his own saving, but only at the expense of reducing the income and saving of others by even more.

Where the saving consists of reduced spending on nonstorable services, such as a haircut, the effect on the vendor’s income and saving is immediate and obvious. Where a storable commodity is involved, there may be an immediate temporary investment in inventory, but this will soon disappear as the vendor cuts back on orders from his suppliers to return the inventory to a normal level, eventually leading to a cutback of production, employment, and income.

Saving does not create “loanable funds” out of thin air. There is no presumption that the additional bank balance of the saver will increase the ability of his bank to extend credit by more than the credit supplying ability of the vendor’s bank will be reduced. If anything, the vendor is more likely to be active in equities markets or to use credit enhanced by the sale to invest in his business, than a saver responding to inducements such as IRA’s, exemption or deferral of taxes on pension fund accruals, and the like, so that the net effect of the saving inducement is to reduce the overall extension of bank loans. Attempted saving, with corresponding reduction in spending, does nothing to enhance the willingness of banks and other lenders to finance adequately promising investment projects. With unemployed resources available, saving is neither a prerequisite nor a stimulus to, but a consequence of capital formation, as the income generated by capital formation provides a source of additional savings.

Fallacy 3

Government borrowing is supposed to “crowd out” private investment.

The current reality is that on the contrary, the expenditure of the borrowed funds (unlike the expenditure of tax revenues) will generate added disposable income, enhance the demand for the products of private industry, and make private investment more profitable. As long as there are plenty of idle resources lying around, and monetary authorities behave sensibly, (instead of trying to counter the supposedly inflationary effect of the deficit) those with a prospect for profitable investment can be enabled to obtain financing. Under these circumstances, each additional dollar of deficit will in the medium long run induce two or more additional dollars of private investment. The capital created is an increment to someone’s wealth and ipso facto someone’s saving. “Supply creates its own demand” fails as soon as some of the income generated by the supply is saved, but investment does create its own saving, and more. Any crowding out that may occur is the result, not of underlying economic reality, but of inappropriate restrictive reactions on the part of a monetary authority in response to the deficit.

William Vickrey Fifteen Fatal Fallacies of Financial Fundamentalism

Rethinking methodology and theory in economics

16 Sep, 2014 at 07:59 | Posted in Theory of Science & Methodology | Comments Off on Rethinking methodology and theory in economics

 

Socialdemokratins historiska svek — en dag efter valet!

15 Sep, 2014 at 21:28 | Posted in Politics & Society | 3 Comments

Wikip-facepalmMindre än ett dygn efter att riksdagsvalet 2014 är klart meddelar Stefan Löfven kategoriskt att han inte kan tänka sig att ingå ett regeringssamarbete med Jonas Sjöstedt och vänsterpartiet. Däremot håller han dörren öppen för ett eventuellt samarbete med Annie Lööf och hennes högerextrema centerparti.

Man tror knappt det är sant. Ska detta kallas ett arbetarparti? Har man sovit det senaste decenniet och inte noterat att en nyliberal Stureplansmaffia tagit över det en gång så stolta parti som leddes av Gunnar Hedlund och Torbjörn Fälldin? Man tar sig för pannan!

IS-LMism and unlimited ‘ceteris paribus’ alibi

15 Sep, 2014 at 15:10 | Posted in Economics | 5 Comments

When applying deductivist thinking to economics, neoclassical economists usually set up “as if” models based on a set of tight axiomatic assumptions from which consistent and precise inferences are made. The beauty of this procedure is of course that if the axiomatic premises are true, the conclusions necessarily follow. The snag is that if the models are to be relevant, we also have to argue that their precision and rigour still holds when they are applied to real-world situations. They often don’t. When addressing real economies, the idealizations necessary for the deductivist machinery to work — as e. g. IS-LM and DSGE models — simply don’t hold.

If the real world is fuzzy, vague and indeterminate, then why should our models build upon a desire to describe it as precise and predictable? The logic of idealization is a marvellous tool in mathematics and axiomatic-deductivist systems, but a poor guide for action in real-world systems, in which concepts and entities are without clear boundaries and continually interact and overlap.

Or as Hans Albert has it on the neoclassical style of thought:

In everyday situations, if, in answer to an inquiry about the weather forecast, one is told that the weather will remain the same as long as it does not change, then one does not normally go away with the impression of having been particularly well informed, although it cannot be denied that the answer refers to an interesting aspect of reality, and, beyond that, it is undoubtedly true …

hansalbertWe are not normally interested merely in the truth of a statement, nor merely in its relation to reality; we are fundamentally interested in what it says, that is, in the information that it contains …

The neoclassical style of thought – with its emphasis on thought experiments, reflection on the basis of illustrative examples and logically possible extreme cases, its use of model construction as the basis of plausible assumptions, as well as its tendency to decrease the level of abstraction, and similar procedures – appears to have had such a strong influence on economic methodology that even theoreticians who strongly value experience can only free themselves from this methodology with difficulty …

Clearly, it is possible to interpret the ‘presuppositions’ of a theoretical system … not as hypotheses, but simply as limitations to the area of application of the system in question. Since a relationship to reality is usually ensured by the language used in economic statements, in this case the impression is generated that a content-laden statement about reality is being made, although the system is fully immunized and thus without content. In my view that is often a source of self-deception in pure economic thought …

Defending his IS-LMism from the critique put forward by e. g. Hyman Minsky and yours truly, Paul Krugman writes:

When people like me use something like IS-LM, we’re not imagining that the IS curve is fixed in position for ever after. It’s a ceteris paribus thing, just like supply and demand.

But that is actually just another major problem — in addition to the six mentioned in my post — with the Hicksian construction! As Hans Albert so perspicaciously writes:

The law of demand is an essential component of the theory of consumer market behavior. With this law, a specific procedural pattern of price-dependent demand is not postulated, that is, a certain demand function, but only the general form that such a function ought to have. The quantity of the good demanded by the consumers is namely characterized as a monotone-decreasing function of its price.

The law appears prima facie to predicate a relatively simple and easily testable relationship and thus to have a fair amount of content. However, upon closer examination, this impression fades. As is well known, the law is usually tagged with a clause that entails numerous interpretation problems: the ceteris paribus clause … The ceteris paribus clause is not a relatively insignificant addition, which might be ignored. Rather, it can be viewed as an integral element of the law of demand itself. However, that would entail that theoreticians who interpret the clause differently de facto have different laws of demand in mind, maybe even laws that are incompatible with each other …

Bringing this to bear on our law of demand, the consequence is that … if the factors that are to be left constant remain undetermined, as not so rarely happens, then the law of demand under question is fully immunized to facts, because every case which initially appears contrary must, in the final analysis, be shown to be compatible with this law. The clause here produces something of an absolute alibi, since, for every apparently deviating behavior, some altered factors can be made responsible. This makes the statement untestable, and its informational content decreases to zero.

Jimmie “jag vet inte” Åkesson

15 Sep, 2014 at 11:23 | Posted in Politics & Society | 3 Comments

 

13 % av de som röstade i det svenska riksdagsvalet tycker tydligen att vi behöver mer av “jag vet inte” inkompetens i landets styrande organ.

Samtidigt — valresultatet speglar i betydande grad de etablerade partiernas undfallenhet att ta diskussionen om hur vårt samhälle ska hantera invandrings- och integrationsfrågorna. Att bara ställa sig vid sidan om och peka finger och låtsas som om allt är frid och fröjd är att bjuda rasister och andra mörkermän på en räkmacka.

Jag hoppas att valresultatet denna en av den svenska parlamentarismens mest nattsvarta dagar kan bli en väckarklocka.

The power from within

14 Sep, 2014 at 14:01 | Posted in Varia | 1 Comment

 

Boosting IQs and improving the future

14 Sep, 2014 at 10:53 | Posted in Education & School | Comments Off on Boosting IQs and improving the future

 

9780226100098The General Educational Development test is a seven-hour exam that allows high school dropouts to show they are equivalent to high school graduates … In a 2011 study, the GED Testing Service found that within six years of earning a GED, about 40 percent of GED recipients enroll in college — but most drop out within a year. Only about 1 percent earns a bachelor’s degree.

So this year they are launching a new, more difficult test …

The GED is a good measure of scholastic ability, but it misses a completely different set of skills that matter in high school and in life. As measured by scores on other achievement tests, GED recipients are just as smart as those who graduate but do not go on to college. But why do GED recipients drop out of high school? The GED test — and achievement tests in general — miss skills like motivation, persistence, self-esteem, time management and self-control. A growing body of evidence has shown that these types of skills can be measured and that they rival raw intelligence in determining success in the labor market and school …

Making the GED harder will not address the real problem — it still will not capture many of the skills that matter in high school and in life. Most GED preparation programs focus on test preparation, with the average student studying only 30 hours before taking the exam. It is life skills that matter, not certificates.

John Tavener

13 Sep, 2014 at 17:24 | Posted in Varia | Comments Off on John Tavener

 

If a picture is worth a thousand words, music like this is worth a thousand pictures
 

tavenerIf thou hast shown mercy
unto man, o man,
that same mercy
shall be shown thee there;
and if on an orphan
thou hast shown compassion,
that same shall there
deliver thee from want.
If in this life
the naked thou hast clothed,
the same shall give thee
shelter there,
and sing the psalm:
Alleluia.
 
 
 
 
 

The Improbability Principle

13 Sep, 2014 at 16:59 | Posted in Statistics & Econometrics | Comments Off on The Improbability Principle

 

Krugman & DeLong are still wrong on Minsky and IS-LM

12 Sep, 2014 at 13:47 | Posted in Economics | 8 Comments

hicksbbc

Esteemed colleagues Paul Krugman and Brad DeLong were not exactly überjoyed over my post Minsky on the IS-LM obfuscation, where I was quoting Hyman Minsky’s critique of the Hicksian IS-LM interpretation of Keynes.

I have to confess that I’m equally unimpressed by the Krugman-DeLong retort. I still share Minsky’s doubts on IS-LM being an adequate reflection of the width and depth of Keynes’s insights on the workings of modern market economies:

1 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.

2 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 …

3 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.

4 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.

5 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.”

6 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.

Given this, it’s difficult to see how and why Keynes in earnest should have “accepted” Hicks’s construct.

In an earlier post on his blog, self-proclaimed “proud neoclassicist” Paul Krugman has argued that “Keynesian” macroeconomics more than anything else “made economics the model-oriented field it has become.” In Krugman’s eyes, Keynes was a “pretty klutzy modeler,” and it was only thanks to Samuelson’s famous 45-degree diagram and Hicks’s IS-LM that things got into place. Although admitting that economists have a tendency to use ”excessive math” and “equate hard math with quality” he still vehemently defends — and always have — the mathematization of economics:

I’ve seen quite a lot of what economics without math and models looks like — and it’s not good.

Sure, “New Keynesian” economists like Krugman — and their forerunners, “Keynesian” economists like Paul Samuelson and (young) John Hicks — certainly have contributed to making economics more mathematical and “model-oriented.”

wrong-tool-by-jerome-awBut if these math-is-the-message-modelers aren’t able to show that the mechanisms or causes that they isolate and handle in their mathematically formalized macromodels are stable in the sense that they do not change when we “export” them to our “target systems,” these mathematical models do only hold under ceteris paribus conditions and are consequently of limited value to our understandings, explanations or predictions of real economic systems.

Science should help us disclose the causal forces at work behind the apparent facts. But models — mathematical, econometric, or what have you — can never be more than a starting point in that endeavour. There is always the possibility that there are other (non-quantifiable) variables – of vital importance, and although perhaps unobservable and non-additive, not necessarily epistemologically inaccessible – that were not considered for the formalized mathematical model.

The kinds of laws and relations that “modern” economics has established, are laws and relations about mathematically formalized entities in models that presuppose causal mechanisms being atomistic and additive. When causal mechanisms operate in real world social target systems they only do it in ever-changing and unstable combinations where the whole is more than a mechanical sum of parts. If economic regularities obtain they do it (as a rule) only because we engineered them for that purpose. Outside man-made mathematical-statistical “nomological machines” they are rare, or even non-existant. Unfortunately that also makes most of contemporary mainstream neoclassical endeavours of mathematical economic modeling rather useless. And that also goes for Krugman and the rest of the “New Keynesian” family.

When it comes to modeling philosophy, Paul Krugman has in an earlier piece defended his position in the following words (my italics):

I don’t mean that setting up and working out microfounded models is a waste of time. On the contrary, trying to embed your ideas in a microfounded model can be a very useful exercise — not because the microfounded model is right, or even better than an ad hoc model, but because it forces you to think harder about your assumptions, and sometimes leads to clearer thinking. In fact, I’ve had that experience several times.

The argument is hardly convincing. If people put that enormous amount of time and energy that they do into constructing macroeconomic models, then they really have to be substantially contributing to our understanding and ability to explain and grasp real macroeconomic processes. If not, they should – after somehow perhaps being able to sharpen our thoughts – be thrown into the waste-paper-basket (something the father of macroeconomics, Keynes, used to do), and not as today, being allowed to overrun our economics journals and giving their authors celestial academic prestige.

The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic model building is little more than “hand waving” that give us rather little warrant for making inductive inferences from models to real world target systems. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around. As Keynes has it:

Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world. It is compelled to be this, because, unlike the natural science, the material to which it is applied is, in too many respects, not homogeneous through time.

If macroeconomic models – no matter of what ilk – make assumptions, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypotheses of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. Macroeconomic theorists – regardless of being New Monetarist, New Classical or ”New Keynesian” – ought to do some ontological reflection and heed Keynes’ warnings on using thought-models in economics:

The object of our analysis is, not to provide a machine, or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organized and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves. This is the nature of economic thinking. Any other way of applying our formal principles of thought (without which, however, we shall be lost in the wood) will lead us into error.

A gadget is just a gadget — and brilliantly silly simple models — IS-LM included — do not help us working with the fundamental issues of modern economies any more than brilliantly silly complicated models — calibrated DSGE and RBC models included.

Added 17:00 GMT: Matias Vernengo’s comment on this debate is well worth reading.

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