Keynes-Hicks macrotheory — a ‘New Keynesian’ unicorn fantasy

22 August, 2016 at 17:08 | Posted in Economics | 20 Comments

Paul Krugman has in numerous posts on his blog tried to defend “the whole enterprise of Keynes/Hicks macroeconomic theory” and especially his own somewhat idiosyncratic version of IS-LM.

Unicorn-s-fantasy-227928_300_312The 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conclude that the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better – is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of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.

In his 1937 paper Hicks actually elaborates four different models (where Hicks uses I to denote Total Income and Ix to denote Investment):

1) “Classical”: M = kI   Ix = C(i)   Ix = S(i,I)

2) Keynes’ “special” theory: M = L(i)   Ix = C(i)    I = S(I)

3) Keynes’ “general” theory: M = L(I, i)   Ix = C(i)   I = S(I)

4) The “generalized general” theory: M = L(I, i)   Ix =C(I, i)  Ix = S(I, i)

It is obvious from the way Krugman draws his IS-LM curves that he is thinking in terms of model number 4 – and that is not even by Hicks considered a Keynes model (modells 2 and 3)! It’s basically a loanable funds model, that belongs in the “classical” camp and which you find reproduced in most mainstream textbooks. Hicksian IS-LM? Maybe. Keynes? No way!

20 Comments »

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  1. There are two minor slips In the equations given above:
    1) “Classical”: M = k*I should be M = k*Y
    4) The “generalized general” theory: I =C(i) should be I =C(i,Y)

    More substantive points are:
    (i) Prof Syll claims that the inclusion of i in S =C(i,Y) makes the IS-LM “basically a loanable funds model”. However, this generalisation does not imply that i is the major determinant of S. It merely “allows for any effect of the rate of interest upon saving”. This is likely to be of only minor importance and in no way upsets the main thrust of Keynes’ arguments.

    (ii) According to Prof.Syll: “Hicks acknowledges in 1980 basically that his original review totally ignored the very core of Keynes’ theory – uncertainty.”
    However, there is no mention of “uncertainty” in Hicks 1980 article.
    Moreover, Hicks’ 1937 article very clearly recognised uncertainties regarding the IS curve:
    “Surely there is every reason to suppose that an increase in the demand for consumers’ goods, … will often directly stimulate an increase in investment, at least as soon as an expectation develops that the increased demand will continue. If this is so, we ought to include Y in the second equation, though it must be confessed that the effect of Y on the marginal efficiency of capital will be fitful and irregular.”

    (iii) In his 1980 article Hicks did NOT say that the use of IS-LM is always invalid. To the contrary, as quoted above, Hicks wrote:
    – “IS-LM analysis usefully survives… 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 am quite prepared to believe that there are cases where he [the applied economist] is entitled to overlook them [divergences between reality and the theoretical model].”

    (iv) Keynes and Hicks 1937, like most other economists, employed ergodic “equilibrium methods” methods. Rejection of these methods would imply rejection of most of the General Theory. In 1980 Hicks noted some of the limitations of these methods, but he did not totally reject them.

    (v) Arguably, IS-LM is of very little use because the LM curve is horizontal if the main focus of monetary policy is stable or “target” interest rates. This matter was recognised in Hicks 1937 (page 157). However, this is a completely different issue to the matters raised by Prof. Syll and Davidson.

    • Thanks for pointing out the slips. I’ve now put the equations in Hicks’ original form.

  2. Is there a short reference to what all the symbols are? not easy to follow unless you eat IS-LM models as cereal for breakfast.

  3. ” Keynes and Hicks 1937, like most other economists, employed ergodic “equilibrium methods” methods.”

    Kingsley,

    Where exactly does Keynes do this?

  4. M = quantity of money
    Ix = output of investment goods = “investment”
    C(..) = function determining investment = “marginal efficiency of capital schedule”
    [NB confusingly C is NOT consumption]
    I = total income = output of investment goods + consumption goods
    S = savings, S(..) = supply function for savings
    i = rate of interest
    L(..) = liquidity preference function = demand function for money

    http://public.econ.duke.edu/~kdh9/Courses/Graduate%20Macro%20History/Readings-1/Hicks_Mr.%20Keynes%20and%20the%20Classics.pdf

  5. Kingsley,

    Firstly, I didn’t ask about Hicks – I’ve read his paper. Thanks.

    What’s ergodic about the functions mentioned?

  6. @ Henry
    See Keynes – General Theory, chapter 3:
    Regarding ergodicity:
    “given the propensity to consume and the rate of new investment, there will be only one level of employment consistent with equilibrium; since any other level will lead to inequality between the aggregate supply price of output as a whole and its aggregate demand price.”
    Regarding equilibrium:
    “the volume of employment in equilibrium depends on (i) the aggregate supply function, (ii) the propensity to consume, and (iii) the volume of investment. This is the essence of the General Theory of Employment.”

  7. Kingsley,

    Thanks. I’ve read those passages many times.

    However, I don’t get where ergodicity is involved.

    I’m sorry, I’m just hooked on your use of the term “ergodicity”.

  8. Henry,
    This is my best understanding of “ergodic”. Please elucidate if there are any errors here.
    The term “ergodic” seems to have been borrowed into economics from statistics.
    The clearest concise definition that I have found is in TheSage English Dictionary and Thesaurus:
    “Ergodic (adjective) = Positive recurrent aperiodic state of stochastic systems; tending in probability to a limiting form that is independent of the initial conditions.”
    Similarly, from the Oxford Dictionary of Statistics, an ergodic state of a Markov process is: “A recurrent state with finite expected time until return”.

    Keynes model as described in chapter 3 of the General Theory is not a stochastic Markov process. There is no mention of randomness or variables depending on their values in earlier periods.
    Thus strictly speaking use of the term “ergodic” is illegitimate in this context.

    However, Keynes’ equilibrium levels of income, employment etc. are levels towards which the the economy would tend to return within a single time period following small temporary disturbances. Thus Keynes’ equilibrium is a state which would recur (or at least be approached) analogous to an ergodic state in statistical theory.

    Of course it is possible to construct all sorts of models where investment etc. depends on past levels of income. Such models are likely to be “non-ergodic” in the sense that the economy in unlikely to return to any particular equilibrium.
    However, this was not Keynes purpose in the General Theory. Instead he emphasised that propensities to consume and invest may persist for many periods at levels which result in static “ergodic” equilibrium with high unemployment.

  9. Kingsley,

    Firstly, it seems to me the two definitions you have provided seem contradictory.

    Secondly, you of course seemingly contradict yourself also admitting on the one hand “Thus strictly speaking use of the term “ergodic” is illegitimate in this context.” and then “Instead he emphasised that propensities to consume and invest may persist for many periods at levels which result in static “ergodic” equilibrium with high unemployment.”

    Thirdly I disagree with the assertion in this last quote. I would argue that Keynes did anything but this in the GT. Keynes was at pains to say how unpredictable economic outcomes are, mainly because expectations, confidence and animal spirits are extremely fickle. I would argue that is why he did not layout a comprehensive model with equations. I think he would argue that to lay out such a model and the attendant equations would require the placing of expectational operators in all of them and also equations relating the expectational operators to each other. The feedback loops between macroeconomic variables are such that they are far too complex to model reliably.

  10. Henry,

    I have given my best understanding of the term “ergodic”, so you being a bit unfair in pressing me further on this. It would be helpful if you could give your own preferred definition.
    I used the word and tried to give it some meaning because Davidson and Prof.Syll use the word. However, basically I find its use in economics to be inappropriate, unnecessary, ambiguous and confusing..

    Regarding your third point, my comments concerned only Part 1 of the GT. Krugman describes Part 1 as being “essentially about the refutation of Say’s Law, about the possibility of a general shortfall in demand”.
    (Krugman – “Mr. Keynes and the Moderns”, 2011)
    The IS-LM apparatus is just a generalisation of what Keynes says in Part 1. So it is misleading for Prof.Syll to claim “there is no such thing as a Keynes-Hicks macroeconomic theory!”

    However, as you emphasise, many further complex factors are mentioned in the GT, especially in Chapter 12. Moreover, Keynes in his 1937 QJE article “in effect declared himself a Chapter12er” rather than just a “Part 1er” (Krugman’s words).

    Does the IS-LM apparatus allow for Chapter 12 considerations?
    Arguably IS-LM equilibrium concepts remain valid even in a moving dynamic economy.
    And, Hicks 1937 mentions some factors which are related to Chapter 12, as in the quote in point (ii) of my original comment.
    Even so, perhaps we almost agree the IS and LM curves may often be so volatile, inter-related and unpredictable that the apparatus has little practical use.

  11. Kingsley,

    IS-LM is all very controversial. It’s not clear what Keynes actually thought of Hick’s portrayal of the GT. Anyway, from memory, I believe that Hick’s has written that he had already formulated his model a year or two prior to the release of the GT. If I recall correctly he said that it was based on classical principles. If “Keynes-Hicks macroeconomic theory” ever existed it was so probably only in the minds of people like Hansen, who had a great deal of ambivalence to the GT anyway from what I can see. (Perhaps all the confusion is over here with me!)

    • ‘ . . . in his letter of 31 March 1937, commenting on a draft of Hicks’ 1937 paper, Keynes wrote: “I found it very interesting and really have next to nothing to say by way of criticism.”’

      http://www.econ.ucla.edu/workingpapers/wp537.pdf

      • I think you have to consider Keynes’s state of mind at the time. He probably was very unwell having a serious heart condition. Also, other people (Neville, Hancock) have argued that his comments in the letter were faint praise compared to praise of others who had expounded on the GT.

  12. The ideas behind “ergodic” seemed to get lost in the exchange between Kingsley Lewis and Henry. That’s unfortunate.
    .
    I thought Kingsley Lewis was basically correct.
    .
    It is certainly easier, as a first cut, to propose a theory in which the next state of the world is a function of the current state of the world. Not an accurate representation of the economy and how it works, though.

  13. ” Not an accurate representation of the economy and how it works, though.”

    Precisely. That’s why the term does not fit comfortably next to Keynes perspective on macroeconomics.

  14. There’s several papers which recently dealt with ergodicity and uncertainty:

    O’Donnell R., A critique of the ergodic/nonergodic approach to uncertainty. Journal of Post Keynesian Economics, Winter 2014-15, Vol. 37, no.2, p. 187-209.

    Davidson, P., A rejoinder to O’Donnell’s critique of the ergodic/nonergodic explanation of Keynes concept of uncertainty. Journal of Post Keynesian Economics, 2015, Vol 38, p.1 -18.

    Rosser, J.Barkley, Jnr. reconsidering ergodicity and fundamental uncertainty. Journal of Post Keyesian Economics, 2015, Vol 38, p. 331-354.

    Ergodicity is related to stochastic/probalistic processes. Davidson would argue that probalistic processes entail a form of knowledge and therefore are incompatible with the notion of uncertainty of the Keynesian variety. Keynesian uncertainty is the inverse of knowledge, he would say.

  15. Henry,
    Thanks for the references.
    According to Davidson, classical writers assumed what he calls “the ergodic hypothesis”, namely that “actuarially certain knowledge regarding the future is available to decision makers”.
    In contrast, Keynes emphasised that “some economic decisions (e.g., “animal spirits” investment spending) are made under uncertainty, i.e., without actuarial knowledge of the future payout of such spending decisions.”
    My main objection to this is concerns Davidson’s idiosyncratic use of the word “ergodic”. His usage is sloppy and very confusing because it is quite different to the meaning more commonly used in statistics and other sciences.
    If investment decisions are subject to Keynesian uncertainty then yes, the economy is not a stochastic process, and therefore, yes, the economy cannot be described as “ergodic”.
    But that does not make the economy “non-ergodic”. Both adjectives, “ergodic” and “non-ergodic” are similarly inappropriate if the economy is not a stochastic process due to Keynesian uncertainty.

  16. Kingsley

    “His usage is sloppy and very confusing…”

    Maybe. It may not be mathematically rigorous as the term stochastic might suggest it should be, but I think it is a useful use of the terms. Davidson would have otherwise had to invent two new terms to cover the distinction. Have you read Rosser’s paper? He deals with the etymology of the word “ergodic” along with technical issues around the use of the terms.

  17. Barkley Rosser’s paper makes some useful points about the distinction between probability as a measure of the frequency of events produced by stochastic processes and probability as a problem of epistemology. “Ergodic” makes sense in the framework of statistical mechanics, which is preoccupied with the former use of probability concepts. There are problems of epistemology in measurement, but they concern approximation and not the kind of subjective assessment that Keynes was anxious to characterize.
    .
    It wouldn’t make much sense to introduce the term, ergodic, into economics at all except for the widespread use of pseudo-physics analytic techniques, in which presumptions of maximization and equilibrium are used to motivate mathematical models in which optimizing behavior under “uncertainty” corresponds to agents acting on mathematical expectation and variation as sufficient statistics. The argument would seem to be that these analytic techniques require an implicit assumption of ergodicity, but the actual economy does not qualify as ergodic. Modeling the economy as ergodic is likely to be a category error — which is, I think, what Kingsley Lewis just said above, 8 Sept.
    .
    If “uncertainty” is a problem of epistemology in the subjective experience of knowledge, then the behavioral economy consists of rule-bound, strategic agents, who must coordinate their actions. It is hard to see how “ergodic” or “non-ergodic” applies.


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