Krugman on Minsky, IS-LM and Temporary Equilibrium

Catching up on my blog reading, I found this one from Paul Krugman from almost two weeks ago defending the IS-LM model against Hyman Minsky’s criticism (channeled by his student Lars Syll) that IS-LM misrepresented the message of Keynes’s General Theory. That is an old debate, and it’s a debate that will never be resolved because IS-LM is a nice way of incorporating monetary effects into the pure income-expenditure model that was the basis of Keynes’s multiplier analysis and his policy prescriptions. On the other hand, the model leaves out much of what most interesting and insightful in the General Theory — precisely the stuff that could not easily be distilled into a simple analytic model.

Here’s Krugman:

Lars Syll approvingly quotes Hyman Minsky denouncing IS-LM analysis as an “obfuscation” of Keynes; Brad DeLong disagrees. As you might guess, so do I.

There are really two questions here. The less important is whether something like IS-LM — a static, equilibrium analysis of output and employment that takes expectations and financial conditions as given — does violence to the spirit of Keynes. Why isn’t this all that important? Because Keynes was a smart guy, not a prophet. The General Theory is interesting and inspiring, but not holy writ.

It’s also a protean work that contains a lot of different ideas, not necessarily consistent with each other. Still, when I read Minsky putting into Keynes’s mouth the claim that

Only a theory that was explicitly cyclical and overtly financial was capable of being useful

I have to wonder whether he really read the book! As I read the General Theory — and I’ve read it carefully — one of Keynes’s central insights was precisely that you wanted to step back from thinking about the business cycle. Previous thinkers had focused all their energy on trying to explain booms and busts; Keynes argued that the real thing that needed explanation was the way the economy seemed to spend prolonged periods in a state of underemployment:

[I]t is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed it seems capable of remaining in a chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.

So Keynes started with a, yes, equilibrium model of a depressed economy. He then went on to offer thoughts about how changes in animal spirits could alter this equilibrium; but he waited until Chapter 22 (!) to sketch out a story about the business cycle, and made it clear that this was not the centerpiece of his theory. Yes, I know that he later wrote an article claiming that it was all about the instability of expectations, but the book is what changed economics, and that’s not what it says.

This all seems pretty sensible to me. Nevertheless, there is so much in the General Theory — both good and bad – that isn’t reflected in IS-LM, that to reduce the General Theory to IS-LM is a kind of misrepresentation. And to be fair, Hicks himself acknowledged that IS-LM was merely a way of representing one critical difference in the assumptions underlying the Keynesian and the “Classical” analyses of macroeconomic equilibrium.

But I would take issue with the following assertion by Krugman.

The point is that Keynes very much made use of the method of temporary equilibrium — interpreting the state of the economy in the short run as if it were a static equilibrium with a lot of stuff taken provisionally as given — as a way to clarify thought. And the larger point is that he was right to do this.

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. Assuming short-run equilibrium in some things — in this case interest rates and output — doesn’t mean that you’ve forgotten that things change, it’s just a way to clarify your thought. And the truth is that people who try to think in terms of everything being dynamic all at once almost always end up either confused or engaging in a lot of implicit theorizing they don’t even realize they’re doing.

When I think of a temporary equilibrium, the most important – indeed the defining — characteristic of that temporary equilibrium is that expectations of at least some agents have been disappointed. The disappointment of expectations is likely to, but does not strictly require, a revision of disappointed expectations and of the plans conditioned on those expectations. The revision of expectations and plans as a result of expectations being disappointed is what gives rise to a dynamic adjustment process. But that is precisely what is excluded from – or at least not explicitly taken into account by – the IS-LM model. There is nothing in the IS-LM model that provides any direct insight into the process by which expectations are revised as a result of being disappointed. That Keynes could so easily think in terms of a depressed economy being in equilibrium suggests to me that he was missing what I regard as the key insight of the temporary-equilibrium method.

Of course, there are those who argue, perhaps most notably Roger Farmer, that economies have multiple equilibria, each with different levels of output and employment corresponding to different expectational parameters. That seems to me a more Keynesian approach, an approach recognizing that expectations can be self-fulfilling, than the temporary-equilibrium approach in which the focus is on mistaken and conflicting expectations, not their self-fulfillment.

Now to be fair, I have to admit that Hicks, himself, who introduced the temporary-equilibrium approach in Value and Capital (1939) later (1965) suggested in Capital and Growth (p. 65) that both the Keynes in the General Theory and the temporary-equilibrium approach of Value and Capital were “quasi-static.” The analysis of the General Theory “is not the analysis of a process; no means has been provided by which we can pass from one Keynesian period to the next. . . . The Temporary Equilibrium model of Value and Capital, also, is quasi-static in just the same sense. The reason why I was contented with such a model was because I had my eyes fixed on Keynes.

Despite Hicks’s identification of the temporary-equilibrium method with Keynes’s method in the General Theory, I think that Hicks was overly modest in assessing his own contribution in Value and Capital, failing to appreciate the full significance of the method he had introduced. Which, I suppose, just goes to show that you can’t assume that the person who invents a concept or an idea is necessarily the one who has the best, or most comprehensive, understanding of what the concept means of what its significance is.


13 Responses to “Krugman on Minsky, IS-LM and Temporary Equilibrium”

  1. 1 Rajiv Sethi September 22, 2014 at 5:06 am

    Another great post David… this has become by far my favorite blog.

    Perhaps Hicks described his approach as quasi-static because he didn’t close the loop by developing a theory of expectation revision. But he was well aware that the revision of expectations could lead to cumulative divergence away from steady growth. This was a feature of his trade cycle model, and it was also a key element of the approach to business fluctuations taken by Kaldor, Samuelson, and especially Goodwin.

    But it was Minsky who really paid serious attention to expectation revision. He did so from an evolutionary perspective, explaining precisely why steady growth was likely to be locally unstable:

    “The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well. The inherited debt reflects the history of the economy, which includes a period in the not too distant past in which the economy did not do well. Acceptable liability structures are based upon some margin of safety, so that expected cash flows, even in periods when the economy is not doing well, will cover contractual debt payments. As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event it becomes apparent that the margins of safety built into debt structures were too great. As a result, over a period in which the economy does well, views about acceptable debt structure change. In the deal making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases. This increase in the weight of debt financing raises the market price for capital assets and increases investment. As this continues, the economy is transformed into a boom economy.” (Minsky, 1982, pp. 65 f.)

    And from the very modestly named book John Maynard Keynes:

    “Financing is often based on an assumption ‘that the existing state of affairs will continue indefinitely’ (GT, p. 152), but of course this assumption proves false. During a boom the existing state is the boom with its accompanying capital gains and asset revaluations. During both a debt-deflation and a stagnant recession the same conventional assumption of the present always ruling is made; the guiding wisdom is that debts are to be avoided, for debts lead to disaster.” (Minsky, 1975, p. 128)

    “A recovery starts with strong memories of the penalty extracted because of exposed liability positions during the debt-deflation and with liability structures that have been purged of debt. However, success breeds daring, and over time the memory of the past disaster is eroded. Stability — even of an expansion — is destabilizing in that more adventuresome financing of investment pays off to the leaders, and others follow.” (Minsky, 1975, p. 126)

    Linking this with some of your earlier posts, perhaps Minsky was closer to the Stockholm School than to Keynes in his approach.

    More on Minsky here:


  2. 2 Blue Aurora September 22, 2014 at 8:35 pm

    Well, it’s been a while, Dr. Glasner! I apologise for my absence…real world commitments have divided my attention. But I have a question that does pertain to monetary economics, even if it isn’t about Paul Krugman or Hyman Minsky: have you seen Aldo Barba’s book review of the David Ricardo anthology which you contributed to? It was published in the 2014 annual edition of Contributions to Political Economy:


  3. 3 David Glasner September 23, 2014 at 9:36 am

    Rajiv, Thanks so much. Your conjecture about Hicks sounds right to me. Another puzzle about his discussion of temporary equilibrium is his failure to mention Hayek, while acknowledging his indebtedness to Lindahl. Perhaps it was not politically correct for Hicks to mention Hayek in 1939, or even in 1965. But it’s Hayek’s 1937 paper “Economics and Knowledge” where the connection between equilibrium and expectations is analyzed at a very profound level, an analysis that makes clear that a theory of dynamic equilibrium must be a theory of expectation formation. Of course, the flip side is that a theory of expectation formation is also a theory of fluctuations.

    Minsky certainly identified an aspect of expectation formation that can, and often does, lead to cyclical fluctuations. And I think that you are right to draw attention to the connection to the Stockholm School. Do you think that he was aware of the connection?

    Blue Aurora, No apologies, please. But you are always welcome around here. Thanks very much for the link to the book review, which I had not seen.


  4. 4 rajivsethi September 23, 2014 at 10:52 am

    David I completely agree that Hayek’s analysis of equilibrium as the mutual consistency of individual plans in his 1937 paper was very deep, and his general approach to markets, based on disequilibrium adjustments in the face of local information, was profound. He deserves a lot of credit for this. It’s very much in the spirit of today’s agent-based computational models.

    But I don’t think that he explored the consequences of this dynamic process with an open mind, allowing for the possibility of market-driven pathologies. The attachment to laissez-faire was too great. This had the unfortunate effect of limiting his audience largely to those who shared his political philosophy. Methodologically I see a lot of similarities between Minsky and Hayek, but as far as policy is concerned they were worlds apart.


  5. 5 Barkley Rosser September 23, 2014 at 2:10 pm

    For what it is worth, I agree with Rajiv and will add nothing furher.


  6. 6 David Glasner September 23, 2014 at 2:30 pm

    Rajiv, Thanks, I certainly agree that Hayek was an unreliable guide on monetary policy, especially in the 1930s, when his policy advice was horrible, e.g., his disgraceful defense of the Bank of France in 1932. But he did get better, terminating his defense of the gold standard, and he was generally more sensible than Friedman, effectively criticizing the absurd 3% money supply growth rule. In his old age he became enamored of currency competition, and here too there was a combination of a profound insight, but also a certain blindness to complicating factors. But if we look at his 1937 paper in isolation, I think that he was very careful simply to analyze the problem of intertemporal equilibrium without pursuing any policy agenda. He may not have realized that his formulation of the problem left open the possibility of serious coordination failures that would not spontaneously remedy themselves, but his student Ludwig Lachmann, who was politically at least as conservative as Hayek, recognized the potentially interventionist policy implications without flinching.

    Barkley, IMHO, a lot! Thanks for chiming in.


  7. 7 Blue Aurora September 24, 2014 at 1:28 am

    You’re welcome, Dr. Glasner. Speaking of the history of economic thought and Friedrich von Hayek, though…were you aware that the Italian journal History of Economic Ideas is now available on JSTOR? If not, please see the following link:

    Also, here’s a selection of articles that I thought you might be interested in (I thought you would be especially interested in the last link), Dr. Glasner:


  8. 8 djb October 7, 2014 at 8:41 am

    i dont think there is as much contradiction in the general theory as people allege,

    for example how does the investment equals saving concept

    compare to

    the marginal efficiency of capital on one side (basically investment) versus savings (with a given interest rate) on the other side,

    does this investment equal that savings??


    the investment equals savings only applies to the investment side, that is what ever money is invested will continue to exist, in someones pocket, as savings at the end of the process

    the other savings in the interest bearing accounts, since it was not invested, is not counted as part of that investment equals savings identity


  9. 9 Jan October 13, 2014 at 4:00 pm

    John Hicks- IS-LM: An Explanation – Journal of Post Keynesian Economic 1980 : – ”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.”


  1. 1 Krugman’s blog, 9/22/14 | Marion in Savannah Trackback on September 23, 2014 at 4:37 am
  2. 2 Temporary Equilibrium One More Time | Uneasy Money Trackback on September 23, 2014 at 8:13 pm
  3. 3 La méthode temporaire-équilibre par Paul Krugman traduction française par Nathalie Lacladère | Vénus-étoile du berger Trackback on September 23, 2014 at 10:27 pm
  4. 4 Hicks on IS-LM and Temporary Equilibrium | Uneasy Money Trackback on October 14, 2014 at 8:37 pm

Leave a Reply

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

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

Facebook photo

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

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


Enter your email address to follow this blog and receive notifications of new posts by email.

Join 3,263 other subscribers
Follow Uneasy Money on

%d bloggers like this: