Raising Keynes

7 Oct, 2021 at 11:24 | Posted in Economics | 3 Comments

The defeat and suppression of the classical perspective — with its evolutionary, institutionalist, and developmental descendants — cleared the way for a dogmatic economics that exalted self-regulating competitive markets …

As we have seen, this perspective soon ran into serious — but temporary — difficulties with the Great Depression, mass unemployment, and the rise of Keynes, whose theory is revived in Harvard University economist Stephen A. Marglin’s Raising Keynes …

Raising Keynes: A Twenty-First-Century General Theory (9780674971028):  Stephen A. Marglin - BiblioVaultMarglin’s basic argument is stated in two parts. First, he focuses on the “Keynesian first-pass model” in the context of the static, general equilibrium framework favored by John Hicks (this is known in textbooks as the IS-LM model). He concludes that within that framework, Keynes’s theory is reduced to dealing with “frictions and rigidities,” implying that “if only” markets were competitive in the neoclassical mode, mass unemployment could not exist …

In his “second-pass model,” Marglin resets Keynes in a dynamic frame, dealing with events and changes that occur through time … Like Keynes, Marglin argues, correctly, that in this world, persistent involuntary unemployment cannot be resolved by cutting wages and breaking unions, even if you can get away with doing these things. Here, Marglin is, in effect, restating what Keynes’s closest collaborators always argued. My first encounter with Robinson came in a University of Cambridge lecture hall in 1974. She had been sitting in to heckle Frank Hahn, one of the leading neoclassicists there at the time. As undergraduates fled the scene, I introduced myself and she invited me to lunch. Once seated in the buttery of the University Library, she started in: “You can’t put time on the IS-LM diagram. Time comes out of the blackboard.” I had no idea what she was talking about, but she certainly did (and now so do I) …

Marglin has taken 80 years of neoclassical distortions of Keynes, presented them with great clarity in their own language, and then pounded them into dust, pushing the detritus back into the faces of the high priests of the neoclassical synthesis, the New Keynesians, and the New Classical Economists. Raising Keynes issues a challenge that they would be cowardly to refuse – which is not to suggest that they won’t do their best to ignore it.

James K. Galbraith

Again — as so often — it turns out that when we economists disagree it ultimately boils down to methodology . And here — again — we are back to the question if ‘bastard Keynesians’ hobbyhorse IS-LM interpretation of Keynes is fruitful and relevant for understanding monetary economies.

Here yours truly’s view is basically the same as Marglin’s — IS-LM is not fruitful and relevant and it does not adequately reflect the width and depth of Keynes’s insights on the workings of monetary economies:

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 historical 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.”

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 not to side with Marglin. The IS/LM approach is not fruitful or relevant for understanding modern monetary economies. And it does not capture Keynes’ approach to the economy other than in name.


  1. Lars writes:
    “IS-LM is typically set in a current values numéraire framework that definitely downgrades the importance of expectations and uncertainty…”
    It is possible to accommodate changes in expectations by shifting the IS and the LM curves. The problem is quantifying expectational shifts.
    “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.”
    This is a very tricky area. In pure neoclassical/Walrasian general equilibrium theory, the process of attaining equilibrium is atemporal. In neoclassical theory it is spontaneous. In Walrasian theory it is given by a process of tatonnement, outside of time.
    But to describe Keynes’s exposition as dynamic leads to all sorts of problems. What is the order of causality? Keynes more or less explained this. But it seems inane to suggest that during the time investment is being determined there is no consumption going on. In a real economy, all things are happening contemporaneously.
    The Australian economist, J. Nevile, wrote an interesting and sophisticated paper, “What Keynes Would Have Thought of the Development of ISLM”, included in a volume of papers edited by Young and Zilberfarb, “IS-LM and Modern Macroeconomics”.
    Nevile concluded that Keynes would have welcomed the recognition that effective demand determines the level of employment (and not the equation of the marginal utility of wages with the marginal disutility of work) and that changes in the quantity of money had real effects.
    However, he concluded that Keynes would have been critical of:
    – the use of ISLM analysis to support the notion, promoted by modern mainstream economics, that the macroeconomy tends to full employment.
    – the neglect of aggregate supply which Keynes said was important (even though Keynes neglected this in the GT himself).
    – the neglect of time. ISLM is based on an atemporal simultaneous equation system whereas Keynes’ analysis is sequential (a reflection of his Marshallian roots, it is said).
    – the neglect of long term expectations. Expectations determine the marginal efficiency of capital and liquidity preference. (I can’t see why this is a problem given that changes in expectations can be accounted for by shifts in the IS and LM curves.)
    There is a good deal more to Nevile’s paper and is worth a close read.

  2. ISLM is really a bit of a red-herring. Although Krugman likes it, the economics profession has long disregarded it. They like things even worse – sticky price rational expectations optimisation models.

    The fundamental methodological problem, however, is the same – basically a reliance on manipulated quantitative methods and/or axiomatic deductivism and an absence of any interest in pursuing widely and deeply informed research. The work of historians and other social scientists, if it is considered at all, is relegated to casual remarks, even if they get much closer to the heart of the matter.

    • What is the heart of the matter? That prices are administered, inflation is a power play by price makers, but the Fed has proven the most credible price maker and can thus insure us all against unwanted inflation?

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