IS-LM: “A classroom gadget” (Wonkish)

July 6th, 2011

I’ve long felt inadequate when reading Very Serious People discussing economics, especially monetary economics (really: what other kind is there?), when they drop into discussions of the IS-LM model — standard fare that is proposed as gospel in economics textbooks and is widely used by Very Serious Economists making Very Serious Points. I feel inadequate because no matter how hard I try, I can’t seem to make sense of it. Yes, its basic mechanics are clear, but it seems to be reliant on assumptions that make no sense to me, at least in relation to how real economies appear to work.

But I lacked the knowledge and understanding to enunciate clearly (to myself, much less others) my intuitions about why it seemed so wrong. So I was quite relieved a year or so back to be directed to the work of the man himself, John Hicks, who first bruited the IS-LM model in his 1937 Econometrica review of Keynes’ General Theory. (“Mr. Keynes and the ‘Classics’; A Suggested Interpretation.” More on that review below.)

Hicks returned to the subject in a 1980 article in the Journal of Post Keynesian Economics, “IS-LM: an explanation,” in which he unabashedly ridicules the value of his own model (emphasis mine):

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conclude that the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better — is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of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. There must always be a problem of traverse. For the study of a traverse, one has to have recourse to sequential methods of one kind or another. 11

11 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 The 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.

What Hicks generously acknowledges here, with his footnoted mention of “security,” is that his original review was not actually addressing Keynes’ central concept: uncertainty. In fact it ignored the concept. It was, rather, seeking to reformulate Keynesian thinking by misrepresenting and denuding it, and bolting the remainder onto a set of neoclassical concepts which the uncertainty concept had itself upended. (As if the many other upendings by the discipline’s own leading practitioners, before and since, were not sufficient to cast that thinking into the realm of religion and self-justifying fantasy.)

Brad DeLong:

In his “Mr. Keynes and the ‘Classics’: A Suggested Interpretation,” John Hicks says that he is building a model of John Maynard Keynes’s General Theory of Employment, Interest and Money. He is not. What he is actually doing is creating a framework that combines the monetarist theories of Irving Fisher, the financial-market insights of Knut Wicksell, and the multiplier insights of Richard Kahn into one package.

Even so-called “Keynesians” who write textbooks and Very Serious Economics Papers (across the political spectrum, from Krugman to Mankiw) have continued this duplicitous charade for seventy years — thirty years after Hicks himself fully pulled the rug out from under their simplistic and wooly-headed notions. And innumerable gullible undergrads have gobbled up this nonsense from those textbook writers over the decades. I can only attribute this to a self-perpetuating cycle of desperate psychological need — the need to cling to a seemingly coherent complex of interlocking (and, together, hermeneutically sealed) concepts that they Worked Very Hard to internalize in kindergarten, and hence are loathe to let go of — or go beyond. (It doesn’t hurt that this crystalline construct maintains the economic system that maintains and promotes the the wealth of the wealthy, a group which they are part of.)

There’s much more to say, but I’ll simply conclude by thanking Steve Keen, whose name should perhaps have started this blog post, for first pointing/bringing me to this understanding in Debunking Economics (new version coming out this fall) — a book that should be required reading for every student and practitioner of the “discipline,” at every level. (For a longer and undeniably more erudite explanation of Hicks and IS-LM, see pages 202-211.) His cogent understanding and lucid explanation of the historical schools of economics that have brought us to our present “understandings” are, within the scope of my amateurishly limited reading, unsurpassed.

Hat tip for reminding me how much I’d been wanting to write this post, and for telling this important story himself (briefly, in the course of debunking the well-intentioned but ultimately misconceived notion of the liquidity trap): Bill Mitchell.

 

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