Hicks abandoned IS-LM 35 years ago. Now it’s time for Krugman!

3 April, 2015 at 18:35 | Posted in Economics | 3 Comments

As we all know Paul Krugman is very fond of referring to and defending the old and dear IS-LM model.

John Hicks, the man who invented it in his 1937 Econometrica review of Keynes’ General TheoryMr. 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conclude that the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better – is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of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.

Back in 1937 John Hicks said that he was building a model of John Maynard Keynes’ General Theory. 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?

In a recent op-ed dated March 14, “John and Maynard’s Excellent Adventure”, Paul Krugman defends John Hicks’ original 1937 interpretation of Keynes’s General Theory that cast macroeconomics within a general equilibrium framework, but without the current insistence on the micro foundations that so concerns today’s general equilibrium macro theorists …

hicksbbc But while we agree with Krugman’s criticism of the hordes of “micro-foundation” revisionists that now dominate economics, we are curious why he did not mention Sir John Hicks recantation of IS-LM analysis (see “IS-LM: An Explanation”, Journal of Post Keynesian Economics, 3 (2) (Winter 1980-81)). Many of us remain deeply sceptical about the usefulness of the IS-LM framework for interpreting a real world characterized by uncertainty, crises, and institutional transformations that hardly bring the economy towards any equilibrium, never mind “general” equilibrium. But even if we abstract from these complications with the usual excuse of rendering the analysis simple for pedagogic purposes, the original Hicksian IS-LM model and its various textbook extensions (usually constructed with some sort of Phillips curve add-on) are extremely problematic. The difficulties have really little to do with the view that it’s too aggregative by representing only three markets: product, money, and bond markets – which is the criticism to which Krugman seems to be pre-emptively alluding in his article.

The first and obvious problem is that, even in the three-market aggregative model, there can never be such a thing, even at the conceptual level, called general equilibrium. To get that we must presume that there are independent functions of investment and saving and, at the same time, independent demand and supply functions for money. But one of the most basic criticisms that Keynes himself had come to recognize immediately after writing the General Theory is that the supply of money is not some exogenous variable that can be independently pitted against a distinct demand for money function. In a sophisticated monetary economy, the supply of money must be treated as a purely endogenous variable as many modern post-Keynesians and also neo-Wicksellians have come to recognize. Hence, the idea of money market equilibrium is meaningless, since one cannot conceptually ever be out of equilibrium when the two cannot be defined independently of one another …

Heterodox economists have traditionally rejected the IS-LM approach for many such reasons; but, even if one were to hold one’s nose, in an uncertain world in which investment is governed by animal spirits (and therefore I being interest inelastic unless inclusive of household spending) and in a world of endogenous money, at best, the IS curve can be represented by a vertical line (or a more elastic relation when including household spending, an IS’ curve). In much the same way, the LM curve can be represented by a horizontal line at any level of interest rates set by the central bank (as shown in the figure below). What insights can such a tool of analysis really offer economists? It suggests that an increase in autonomous spending will generate increases in output without any “crowding out” effect arising through higher interest rates. But one hardly needs an IS-LM framework whose truly central feature is the role played by interest rates to infer that! In our humble opinion, Hicksian IS-LM analysis cannot offer us very much and this is why even Sir John Hicks himself eventually abandoned it almost 35 years ago. And so should Paul Krugman!

Mario Seccareccia & Marc Lavoie

3 Comments »

RSS feed for comments on this post. TrackBack URI

  1. Lars, you might be interested in what Stiglitz & Weiss had to say about Hick’s IS-LM model. From their 1988 paper:

    Perhaps no thinker has contributed as much to the understanding of monetary economics during the past half century as Sir John Hicks. His formulation of the IS-LM curves (Hicks, 1937), translating the Keynesian model into a simple and manipulable form in which changes in the money supply could be easily and directly related to changes in the level of economic activity, provided not only a textbook paradigm, but a tool of analysis employed by policy makers. Moreover, it has served as a framework in which those who disagreed with Keynesian prescriptions could recast their arguments. The monetarist debate became a controversy over the shape of the relevant curves’-an empirical debate about the magnitude of the relevant elasticities and the Cambridge-Fisher identity was at last raised to the level of a “theory.”

    But Hicks went further, and was an important contributor to the general equilibrium approach to the analysis of money (Hicks, 1933, 1935, 1938). Money became an object, like peanuts, corn, and tobacco, for which there was a demand and supply; the money rate of interest was the “price of money,” the opportunity cost of holding money as opposed to other short term assets. The ability to analyze monetary phenomenon within the same general framework used to analyze other market phenomena not only lent stature to the general theory, showing the power of these tools and concepts, but also gave to monetary economics a sense of analytic rigor, precision, and which previously had been missing. There were, to be sure, “problems” remaining to be resolved, but these gave to the subject a scientific aura: significant progress had been made, and there remained but few unresolved, yet precisely stated, issues to which ongoing research was directed.

    Hicks was perfectly aware of the limitations of his approach (some of which were discussed at great length by Leijonhuvud), and his later writings have provided a much richer picture of monetary economics (Hicks, 1967, 1979, 1980, 1982, 1986). Unfortunately, the forcefulness of his earlier writings, and the ease with which those ideas could be cast in the formal models which were to become so much the fashion in the half century following, seemed (at least until recently) to have inhibited deeper research by others in the profession into the mechanisms by which money and monetary policy affect the economy, an enquiry which Hicks has continued to pursue.

    Banks as Social Accountants and Screening Devices for the Allocation of Credit
    Joseph E. Stiglitz, Andrew Weiss

    September 1988

    http://www.nber.org/papers/w2710
    http://www.nber.org/papers/w2710.pdf

    https://www.facebook.com/notes/joseph-e-stiglitz/joseph-stiglitz-on-john-hicks-is-lm-model/691598444187194

  2. Steve Keen remarked somewhere that the title Hicks used for his 1980 paper “IS-LM: An Explanation” is more properly understood as, “IS-LM: An Apology.”

  3. I think I can take credit for convincing Hicks that his ISLM model did not have anything to do with Keynes’s General Theory. That is why he published his ISLM: An explanation” paper in the JPKE where I was the editor at the time..

    On pages185-186 of my2007 book JOHN MAYNARD KEYNES [in the “Great Thinkers in Economics” series of Palgrave/Macmillan] I give the story of how and when I convinced Hicks about the errors of his ISLM analysis. Finally I note that Hicks wrote to me , after reading my article on the fallacy of the rational expectations hypothesis ” I have just been reading your RE [rational expectations] paper….I do like it very much…You have now rationalized my suspicions and shown me that I missed a chance of labelling my own point of view as nonergodic. One needs a name like that to arm a point home.”

    Unfortunately some heterodox economists such as Rod O’Donnell are trying to tear down this clear ergodic- nonergodic dichotomy between calculating the actuarial certainty of the future via probability analysis (ie an ergodic system) and not having any scientific method of forecasting the future (a nonergodic world). When heterodox economists fight amongst themselves it just lets the mainstream divide and conquer.
    [


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Blog at WordPress.com.
Entries and comments feeds.