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.
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.