Summers on secular stagnation, the ISLM, and the liquidity trap

Two short clips from Lawrence Summers talk at the ASSA meeting in San Diego. So he first says that secular stagnation is more plausible now than before. He sees that it can be explained as a shift of the IS curve backwards. His IS has a somewhat marginalist foundation, with a natural rate, and a fairly conventional story for investment. Of course, the negative shift has bee compensated by some sort of stimulus, that is now weaker. I would say a smaller multiplier that affects the slope of the IS would make more sense.

And he does say in the next clip that the IS is steeper, and the LM is flat, or that we are in a liquidity trap. Again, I think it's not really that, and simply a policy decision of the Fed, inevitable given the circumstances, perhaps.

He also, is not optimistic on monetary policy, and is pushing for expansionary fiscal policy. And certainly, even if there are many differences in the way I would portray the current macroeconomic situation, in particular the causes of the slow recovery and what he calls secular stagnation, on the policy issue we are not that far.

The theory of endogenous money and the LM schedule

By Tom Palley. From the abstract:

Money is at the center of macroeconomics, which makes understanding the money supply central for macroeconomic theory. this paper presents the Post Keynesian theory of endogenous money supply and shows how it is fundamentally different from the conventional money supply theory. the conventional approach relies on the money multiplier and bank lending is invisible. Post Keynesian theory discards the money multiplier and focuses on bank lending which drives money creation. the paper emphasizes the structuralist version of Post Keynesian theory which retains Keynes’ liquidity preference theory of long term interest rates and also recognizes banks are subject to nancial constraints that limit their lending activities. the paper then shows how to derive the Lm schedule in an endogenous money economy, which is a necessary prelude to reconstructing the IsLm model.

Read full paper here. 

Peter Temin explains the Great Recession and the slow recovery

A bit more on Peter Temin and David Vines book on Keynes. The explanation of the Great Recession is based on a traditional negative shock to the IS curve. Temin famously wrote the response Friedman and Schwartz Monetarist view of the Great Depression, his Did Monetary Forces Cause the Great Depression?, in which a contraction of consumption, and the IS, rather than the contraction of money supply and the LM was seen as the central story.*

 So the same is essentially at work now. They say:

“the IS curve in the US moved left a great distance after the Global Financial Crisis and the adjustments that followed. It moved so far that the new IS curve no longer crossed the LM curve at a positive interest rate.”

As can be seen below.

I can live with the representation of the Great Recession as a collapse of the IS (and yes the negative slope might be explained by other elements of demand, not investment, being inverse related to the rate of interest, like consumption or housing investment). I'm more troubled by the notion that the slow recovery is caused by the negative rate of interest, which in this case precludes the intersection of the IS and LM (note that, contrary to Krugman's negative rate, the equilibrium would not be the full employment one). But I do agree with the implied solution, not defended very forcefully, to my surprise, in the book, i.e. expansionary fiscal policy to bring the economy back to full employment.

In part, Temin and Vines do not defend fiscal policy strongly, because they bring the issues of an open economy to the forefront of the discussion, using James Meade's notion of internal and external balances. It's far from clear that they think this applies to the US, but in general their solution for a country with an external problem and unemployment, would be depreciation and austerity. In their words:

“The indebted country requires a combination of the two policies. Devaluation will increase exports and reduce imports. Austerity—just the right amount—will reduce home demand for goods and leave room for the production of extra exports and the home-produced goods that replace imports. The right combination of policies will move the economy to the intersection of the external balance line and the internal balance line, or even further down the internal balance line into the region of external surplus if the country is to begin repaying its debt.”

Note that without austerity the economy would overheat. That's a lot of confidence in the expansionary power of devaluation. As noted here several times, a devaluation can be contractionary, and it often 'solves' the balance of payments problem for that reason. Devaluation and austerity, by the way, were, and still are, the traditional policy measures imposed by the IMF on indebted countries. The implication seems to be that a combination of devaluation with austerity would produce, in the US too, a healthier recovery. The book is strangely positive on austerity, because of the external balance requirements, a position that, at least in this recession, other New Keynesians like Krugman and DeLong have temporarily abandoned.

And their analysis in the book about the post-war boom, the so-called Golden Age, is also not very good. Temin and Vines, even though they recognize the role of the Marshall Plan, emphasize the positive role of the IMF in promoting growth, and suggest that the IMF is an improved version of Keynes' proposal at Bretton Woods. In their words:

“The cooperation stimulated by American generosity in the Marshall Plan was a hallmark of postwar European progress... The IMF—an improved version of Keynes’ Clearing Union—eventually became a crucial policy-making institution... The IMF, which Keynes helped to design, was central to the restoration of growth.”

The Marshall Plan, which depended not just on generosity, but on fear of the Soviets, was clearly central. The role of the IMF in a global recovery of the 50s and 60s is hard to defend though. And Keynes Plan did not involve punishing indebted countries, which is what depreciation and austerity do, quite the opposite. In fact, Keynes was relegated to the debates on what became the World Bank at Bretton Woods, while Harry Dexter White was the central figure in the creation of the IMF. And the World Bank was, until the 1980s, a more benign instrument of US external economic policy, one might add.

But Temin and Vines also botch that one, and say:

“The World Bank, which was less central than the IMF, facilitated long-run growth. The World Bank was designed to help re-create the international pattern of productive trade that Keynes had described in The Economic Consequences of the Peace.”

Yes, the World Bank was created to recreate the pre-war pattern of trade, with the periphery selling commodities, and the center manufactures, and the British as the hegemonic... Oh wait. Yeah that makes no sense either.

* In later research Temin came closer to Eichengreen in putting the Gold Standard at the center of the Great Depression. For example, in his Lessons from the Great Depression. The seeds of his positive view on the role of depreciation are associated to his view that the abandonment of the Gold Standard was at the heart of the recovery. For a critique of that go here.

Teaching macroeconomics: the resilience of the ISLM model

Teaching ISLM this and next week. I have posted in the past on this, so I'll just put the links below to the relevant posts.

ISLM: What is it good for?

ISLM: a further explanation and a defense

Krugman is actually right on ISLM and Minsky

There are more posts that deal with some relevant issues that you can access if you click on the ISLM label below.

The interesting thing is that, although the ISLM is less used in theory, in particular because the multiplier story at the core of the IS has been substituted by a Ramsey intertemporal maximization story and the LM has been substituted by a Wicksellian interest rate rule, it is still the workhorse of macroeconomic teaching, and likely of simple policy thinking. In many ways the ISLM remains a much better basis for thinking about the economy than modern New Keynesian DSGE models (if nothing else because of the multiplier).

Krugman is actually right on ISLM and Minsky

I tend to disagree a lot with Krugman, at least on theoretical issues. His brand of Keynesianism supposes that the system doesn't work because of imperfections. For him, the current slow recovery is due to the fact that the natural rate of interest is basically negative and you cannot use monetary policy to stimulate the economy (see critique of this here). However, on his recent debate with Lars Syll (and here; Brad De Long also posted here), a post-Keynesian, with whom I probably share a more radical interpretation of Keynes and its relevance for economic theory, Krugman seems to get things right.

The main points in Lars initial post, based on Minsky's book John Maynard Keynes is that traditional representations of Keynes do not emphasize the cyclical component of Keynes' theory and that true or fundamental (non-probabilistic) uncertainty is often ignored. Lars adds a little bit more on his response to Krugman and De Long, but essentially is the same argument. Keynes didn't like the ISLM (which is from a historical point of view difficult to defend, after all the only stuff he wrote on this, to Hicks, was quite positive, even if it is of little relevance), that it is static (not paying attention to cyclical or dynamic phenomena), and perhaps more interestingly that the interaction of real and monetary variables in the model is simplistic.

Krugman points out that the General Theory (GT) is NOT about cyclical fluctuations per se. It is about the determination of the long run level of output and employment, around which the economy fluctuates, and he correctly notes that cycles only appear as an afterthought in chapter 22 of the GT. And that is precisely correct. The GT is revolutionary because it suggests that with price flexibility (not price rigidity as in the old Neoclassical Synthesis or the New Keynesian stories) the system gets stuck in a situation of unemployment equilibrium. Emphasis on equilibrium. Yes, unemployment at less than full employment and output below its potential level are both together in an equilibrium situation.

Patinkin suggested that Keynes meant unemployment disequilibrium, since within the neoclassical framework, unless there is a rigidity of some sort, and the system should go to its long run equilibrium position with full employment. Minsky (1975, p. 268), in the book cited above, says that Keynesian economics should be seen as the: "economics of permanent disequilibrium." That has no basis on the GT. Actually, the GT would be a less radical book if it only said that with instability the system might be always in a disequilibrium position. Keynes was very radical since he argued that the very notion of a natural rate should be abandoned (on this Paul and Brad have a lot to learn). Some Post Keynesians tend to dislike the idea of equilibrium (echoes of Joan Robinson's late critique of the idea), which ends up making them closer in many respects to the modern mainstream authors with their dislike for long term equilibrium positions.

So the GT is not about cycles (Keynes' Treatise on Money, a very conventional and Wicksellian book was about cyclical disequilibrium caused by differences between the natural and banking rates of interest, which, interestingly enough is closer to Krugman's way of thinking than the GT, or than to Lars, who is aware of the limitations of the natural rate concept). But that's not all that Krugman got right this time.

He quotes the famous passage in which Keynes says that the system is not violently unstable (GT, p. 249). And while Post Keynesians are correct to note the relevance of fundamental uncertainty, it is important also to consider the stabilizing role of conventions and institutions, to which Keynes alludes. Expectations play a role, but investment is not completely volatile, and it was a problem for Keynes only when "the capital development of a country becomes the by product of the activities of a casino" (GT, p. 159). In fact, given the relevance of the accelerator in determining investment, the central role of expectations is about the level of demand. For example, in the US investment has been subdued since demand is not growing fast and there are not reasonable expectations that it will any time soon.

Where New Keynesians go wrong, and in this case is actually Brad, not Paul (but he would certainly agree) is on the relevance of the marginal efficiency of capital, criticized by Minsky (even though it's far from clear that Minsky abandoned it). Brad thinks that Minsky critique of it is myopic and basically a PR problem. He says that it is: 

"Short-sighted, in that it is not Hicks who would be Minsky’s long-run intellectual adversary but rather Freidman [sic], Lucas, and Hayek, and so building bridges to the Hicksians ought to be a very high priority."

Probably true, but from a policy point of view. From a theoretical point of view, Hicks use of the marginalist notion of an investment function inversely related to the rate of interest (something Keynes also used) implies that there would be a rate of interest low enough that would produce full employment, that is a natural rate, which would preclude Keynes' claim about unemployment equilibrium (and the absence of a natural rate). In other words, with the marginal productivity of capital you have that unemployment must be a disequilibrium situation caused by some imperfection that inhibits the system from reaching the natural rate.

And yes the capital debates are relevant since they show that the inverse relation is only possible in a one commodity world. No natural rate, and no need to think about imperfections. And that's why the comment by Lars on the connection between real and monetary variables being simplistic within the ISLM is right on the mark. The idea that the central bank controls a monetary rate, that may get out of whack with the natural, and that by manipulating it can affect real variables is limited at best.

PS: For my previous defense of a modified ISLM go here and here. 

ISLM, ISMP, DSGE and other models

From the Google Ngram Viewer.

Note that even though the ISLM is from 1937 (and yes it is in the GT, and Keynes did endorse Hicks formalization, as discussed here, and here), it is only in the 1970s that the term takes off. The ISMP, which substitutes a monetary policy rule for the LM, and includes as a result endogenous money into mainstream models (note again endogenous money is not central for heterodox models, since orthodox ones can incorporate it, as discussed here) takes over in the 2000s, as does the Dynamic Stochastic General Equilibrium models, in which the IS with a multiplier is substituted by a Ramsey model. So, given the trends, you should miss the good old ISLM indeed.

Oskar Lange theory of interest and the ISLM

By Roberto Lampa (Guest blogger)

In two previous posts, dated 2011 and 2013, Matías Vernengo clarified that the ISLM model can accommodate changes that incorporate the criticisms of several heterodox groups. In particular, he stresses that the ISLM can accommodate an investment function in which the level of activity (rather than the rate of interest) is central, so that the accelerator can be incorporated. More importantly, he also states the ISLM does not imply a natural rate of unemployment, thus allowing for relevant discussion of policy issues.

Both these aspects can be found in Oskar Lange's 1938 contribution to the neoclassical synthesis, in which he assumes that investment (mostly) depends on consumption, which in turn is permanently distorted by the “irrational” distribution of income, typical of any capitalist economy. More precisely, Lange outlines the mutual dependence of investment and consumption as a sort of ‘indirect’ relationship.

Firstly, he states that, as in traditional theory, in his model an increase in the propensity to save induces a decrease in the rate of interest. However, his reasoning runs along more unconventional lines than the (Neo)-Classical interaction of both supply (of) and demand (for) capital curves:

"…an increase in the propensity to save [implies that] expenditure on consumption is now lower. This causes (…) a lower quantity of investment (…). Total income decreases (…). The consequence is a fall in the rate of interest." (pp. 17-18)

In other words, in Lange's view the immediate effects of an increase in the propensity to save are a decrease in consumption, investment and total income. Therefore, as recognized by Keynes himself:

"The analysis which I gave in my General Theory of Employment is the same as the ‘general theory’ explained by Dr. Lange on p.18 of his article, except that my analysis is not based (as I think his is in this passage) on the assumption that the quantity of money is constant." (Keynes J.M., 1973a, p.232n)

Following this train of thinking, we deduce that it’s only afterwards that the decreased level of the rate of interest will stimulate investment, consumption and total income. The final result of an increase in the propensity to save will then depend on the ‘specific weight’ of each of these two effects.

Not coincidentally, Lange explicitly assumes in equation (3) – by drawing on Karl Marx's realization crisis – that consumption directly affects investment, as an excessive growth in saving (i.e. an excessive contraction of consumption, investment and total income) cannot be counter-balanced by the subsequent decrease in the rate of interest, as it destroys any incentive to invest, "at least in a capitalist economy where investment is done for profit" (Lange, 1938, p.23). He thus firmly rejects the (Neo)-Classical assumption that any abstinence from consumption implies automatically an increase in investment: according to him, such a direct relationship holds only until a certain limit (i.e. the optimum propensity to consume), beyond which the collapse of the demand for investment goods will drastically diminish investment itself. Therefore, the real issue becomes if and how it is possible to determine (and to maintain) such an optimum propensity to consume, given a market economy. Lange's opinion is definitely non-optimistic:

"In a society where the propensity to save is determined by the individuals, there are no forces at work that keep it automatically at its optimum, and it is well possible, as the under-consumption theorists maintain, that there is a tendency to exceed it." ( p.32)

In other words, the result of Lange's analysis converges with (and radicalizes, as well) Keynes' pivotal idea, that is, the tendency towards a chronic under-consumption crisis.

Recently, I have published a detailed analysis of this rather obscure work in the Cambridge Journal of Economics. I explore in depth Lange's theory of interest and its tortuous relationship with both Keynes’ General Theory (1936) and Hicks' synthesis (1937), developing two graphical models that show the non-linearity of Lange's investment function as well as the consequences of his equilibrium solution. Through an unedited manuscript, I also reconstruct Lange's beliefs about the chronic sub-optimality of the capitalist economy and his scientific endorsement of the socialist economy.

Full paper is available here.

P.S. It is worth noting that Keynes himself was prompted to reflect that Lange's article "follows very closely and accurately my line of thought" (Keynes, 1973a) notwithstanding the analytical differences. Lange was, after all, standing on the same "side of the gulf," as he clearly rejected the notion that capitalism could be a "self-adjusting system" (Keynes, 1973b).

Lars P. Syll On What’s wrong with IS-LM?

By Lars. P. Syll

Yesterday, David Fields of Naked Keynesianism wondered what was my position on the fact that many heterodox economists would consider the IS-LM framework “to still be relevant if given enough flexibility without neoclassical synthesized elements.”

I will sure come back on this when time admits a more thorough analysis, but let me start by giving at least a tentative answer — focusing on where I think IS-LM doesn’t adequately reflect the width and depth of Keynes’s insights on the workings of modern market economies.

Read the rest here.

ISLM: a further explanation and a defense

I noted before  the traditional representation of the ISLM is problematic. Yet as I also noted the ISLM model can accommodate changes that incorporate the criticisms of classical-Keynesian, post-Keynesian and other heterodox groups. There is no need for an investment function based on the marginal productivity of capital and the principle of substitution. The accelerator can be incorporated, and the inverse relation with the rate of interest would result from the effects of interest rates on other components of demand. Also, endogenous money can be incorporated easily, and for the most part this has been done in New Keynesian models (the ISMP).

In the post (linked by David here) that prompted this sort of defense of a changed ISLM, Lars Syll correctly notes that New Keynesians are often right on policy, but incorrect on theory. And I for the most part agree with Lars intentions. Yet, he suggests that the problem lies in that:

"If macroeconomic models – no matter of what ilk – assume representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable."

As I noted in my debate with Noah Smith, the problem with marginalism (neoclassical economics) is NOT rationality, utility maximization or supply and demand (not quite the same list raised by Lars). Here I would add that although one can certainly add heterogenous agents, assumptions that simplify and assume representative agents maximizing profits, for example, are not really problematic at all. Classical political economists and Marx did assume something like that and still did not reach the conclusion that the system was efficient in the sense of providing full utilization of resources.

Also, the idea that agents use all information per se is not necessarily bad (Tom Palley favors some sort of rational expectations, which he refers to as model consistent; see his old manual here). The problem is that the model used, by New Classical and other mainstream authors, has logical problems. Last but not least equilibrium per se is not a bad concept (on this there is the whole thing that Post Keynesians have inherited from Joan Robinson that makes things confusing for many heterodox economists). Equilibrium is actually quite essential for long-term analysis. And I would actually argue that it is relevant since it DOES have real world applications. In other words, real economies do fluctuate around long-term equilibrium positions that are sub-optimal.

The problem with mainstream theory is the notion of a natural rate, which is based on the principle of substitution which allows for 'factors of production' to be fully utilized. These are the problems that Keynes, by negating the idea of a natural rate, and Sraffa, by showing the logical problems of the principle of substitution, undermined. An ISLM without the natural rate is not only possible, but actually reasonably good as a tool for analyzing real economies.

PS: Note that Keynes wrote to Hicks on the ISLM that: "I found it very interesting and really have next to nothing to say by way of criticism." Keynes did not criticize the investment function in Hicks model, but note that this problem also was integral to the General Theory (GT). And yes Keynes was being nice, but he was nice too about Harrod's review of the GT, but did tell him that he did not mention effective demand.

Lars P. Syll On Krugman's Fuddy Duddy Defense of Economic Orthodoxy

By Lars P. Syll

“Sorta-kinda New Keynesian” economist Paul Krugman now has learned from Francesco Saraceno — who links to yours truly — that “some people are attacking” him for “defending an economic orthodoxy that has failed.” Let me just start with an observation on Krugman’s allusion (“simple models”) to IS-LM. This, of course, comes as no surprise, since we who have followed Krugman’s writings over the years, know that he is very fond of referring to and defending the old and dear IS-LM model.

Read rest here.

Lars Syll on Krugman as An Apologetic Defender of Esoteric Mathematization

By Lars P. Syll

Paul Krugman had a post up on his blog a while ago where he argued that “Keynesian” macroeconomics more than anything else “made economics the model-oriented field it has become.” In Krugman’s eyes, Keynes was a “pretty klutzy modeler,” and it was only thanks to Samuelson’s famous 45-degree diagram and Hicks’s IS-LM that things got into place. Although admitting that economists have a tendency to use ”excessive math” and “equate hard math with quality” he still vehemently defends — and always have — the mathematization of economics.

See rest here.

IS-LM is bad economics no matter what Krugman says

"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..." (see rest here)

The IMF and stylized fiction

The IMF has posted their Top 20 list of most popular entries since the launch of the blog. At #3 they have the Ten Commandments of Fiscal Adjustement in Advanced Economies, which is from 2010, but still worth reading, since their views have hardly changed. I am not going to go through the whole list, even though it does merit careful analysis. I want just to point out a few problems with three of the commandments (do they really need the religious analogy?). This 10 Commandments are based on the IMF's views on the stylized facts of fiscal consolidations.

Note that the IMF wants a reduction in debt-to-GDP ratios in the long run (commandment #3), even if nobody knows exactly what is the difference of having a 40% ratio, which they recommend for 'emerging markets' (meaning developing economies), or a 250%, as the UK had during the Napoleonic Wars (here). My first concern is with the idea that consolidation (by which they mean austerity) should be done by cutting spending and not increasing taxes (#4), because this is more conducive to growth.

This is a proposition they repeat in their last Fiscal Monitor (2012: p. 35), where we are told that:

"a number of earlier studies have shown that expenditure-based fiscal consolidations have a more favorable effect on output than revenue-based consolidations, in spite of the standard multiplier analysis … Chapter 3 of the October 2010 World Economic Outlook reaches the same conclusion (IMF, 2010b) and notes that this result is partly because, on average, central banks lower interest rates more in the case of expenditure-based consolidations (perhaps because they regard them as more long-lasting)."

Note, however, that the reason for the superior performance for cutting spending instead of raising taxes (on the rich one would hope) is that the Central Bank does not hike rates in the former case, since it is part of a conservative plan to reduce the size of government (note that the IMF asks for consolidations to be fair, #6, but then wants to cuts social spending, #5). Worse the notion is also based on the idea that lower (higher) spending brings down (up) the rate of interest and leads to crowding in (out) of private investment. The problem is that the evidence for a positive (negative) effect of fiscal deficits (surplus), or public spending increase (reduction), on interest rates, is that it is almost non-existent (see UNCTAD, 2011, chapter 3 for a review).

The other point is related to the last commandment (#10), which says that you should coordinate your macroeconomic policies with other countries. I'm not even going to deal with the problems of coordination. My problem is that the arguments tend to be based on the Mundell-Fleming (MF) model (the ISLMBP with perfect capital mobility), which suggests that fiscal policy is less efficient in a small open economy. In this case, fiscal policy raises the rate of interest, with capital mobility, pressures for inflows lead to an appreciation of the currency, and lower trade surpluses. Instead of crowding out, meaning lower investment, one gets lower output from the external accounts. That's why they say in their last Fiscal Monitor that "in line with the theory, fiscal multipliers tend to be smaller in more open economies" (2012, p. 33).

Again this depends on a weak empirical relation. In the United States seldom is the case that expansionary fiscal policy causes higher rates of interest. In fact, the policy of the strong dollar, with the impact on manufacturing output and exports, has often been detached from fiscal expansionism or higher rates of interest (e.g. the Clinton years in which a strong dollar went hand in hand with fiscal consolidation and monetary easing to feed the dot-com bubble).

Finally, note that even small open economies in several periods were able to have very effective fiscal policies, because in spite of relatively flexible exchange rates, they used capital controls to avoid the effects of volatile capital flows on their external accounts. In this sense, the world of relatively regulated capital flows, rather than of fixed exchange rates (even if sometimes the two are confounded as a result of the Bretton Woods arrangement), seems to be more conducive to effective fiscal policy. So the lesson should not be that small open economies cannot do effective fiscal policy, but that capital controls (which they are not quite okay with contrary to what you might have heard, but I leave for another post) are necessary.

PS: For a more consistent theoretical critique of the MF model see Serrano and Summa (2012).

Has Econ 101 done just fine?

Krugman tells us that:

"huge government deficits could fail to raise interest rates in a depressed economy ... is what Econ 101 said – and it has been completely right. Basic IS-LM macro also said that under these conditions printing lots of money would not be inflationary, and that cutting government spending sharply would cause the economy to shrink. All of this has come true. So Econ 101 has done just fine ..."

Note, however, that Krugman basically believes that this is the case because the economy is in a liquidity trap, and the natural rate of interest for him is negative. That is, the rate of interest that would stimulate enough investment to bring about full employment savings is below zero. As I have argued here there are several empirical and logical reasons why one should doubt that kind of imperfectionist argument.

So, yes the Old Keynesians policy prescriptions do work, and have done quite well, even if their theories do fail miserably, as much as any other neoclassical approach that presumes that markets work by the magic of supply and demand producing optimal outcomes.

And that is also why what we need is not more monetary stimulus, or any hocus pocus to convince investors that inflation is going to be higher. We need more demand. And as Paul Davidson said in his reply to Tyler Cowen, only the government can do this now:

"if the government were to let contracts for, say, $1 trillion to private enterprise to rebuild our failing highways, bridges, and municipal water and sewage systems, and provide resources for our shrinking public and higher education systems, this would quickly restore companies’ confidence in the profit opportunities that are available if they hire workers and buy materials from other United States companies. When these newly hired workers go out and spend their wages, the confidence of United States retailers would immediately surge as these additional customers break down the doors to get at the merchandise on the shelves.  Nothing will build the confidence and trust of business and workers quicker than the continuous ringing of cash registers."

So Paul, that has complained about Econ 101 for a long time, is quite correct. We need spending and not the inflation expectations fairy.

PS: On my views on the ISLM go here.

Brad DeLong on Carmen Reinhart

Great post by Brad DeLong, about misplaced fatalism. His comments are based on a video (you can see the whole thing in his post) debate between Krugman and Reinhart. He says:

"A word about the content: I continue to find Carmen Reinhart’s fatalist view puzzling. She agrees with me that we’re facing a demand-side problem — but insists that this problem can’t be solved quickly, that we need to go through many years of painful deleveraging that leave millions of potentially productive workers idle. I agree that this is probably what will happen, given the political realities. But surely this is a huge failure of policy, not something we should accept as inevitable. It’s truly bizarre, if you ask me, to say that our economy suffers from too little spending, and that nothing can or should be done to increase that spending."

He then uses a variation of an ISLM to explain his and Reinhart's views. Translating, political fatalism seems appropriate in the US, but theoretical fatalism is out of place. Agreed!

PS: Also worth reading is Cassidy's take on Obama's speech. An antidote to the fatalism above.

Lucas in context, Keynes out of context

Krugman decided to try his hand at history of macroeconomic thought in one of his last posts. That's great, since history of thought is essential to understand how we got here. It's also bad, since Krugman is still very much a mainstream author, and misses the point of Keynes' contributions, and the limitations of neoclassical (or more properly, marginalist) approach. He suggests correctly that the New Classical (NC)/Real Business Cycle (RBC) project was a failure, but both the reasons for that and his interpretation of the Keynesian project are misguided.

The first proposition in Krugman's reassessment of the recent history of macroeconomics, is that Keynesian models were ad hoc, and assumed wage and price rigidity. The whole of chapter 19 of the General Theory (GT) is about the effects of price and wage flexibility, and how it does not produce full employment. It was with Franco Modigliani's PhD dissertation, done at the New School for Social Research under Jacob Marschak, that the sticky wage version of Keynesian theory that would dominate the neoclassical synthesis was concocted.

Keynes is actually quite explicit about the negative effects of wage reductions. He says (GT, ch.19-link above):

"A reduction of money-wages will somewhat reduce prices. It will, therefore, involve some redistribution of real income (a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms of money has been guaranteed.

What will be the effect of this redistribution on the propensity to consume for the community as a whole? The transfer from wage-earners to other factors is likely to diminish the propensity to consume. The effect of the transfer from entrepreneurs to rentiers is more open to doubt. But if rentiers represent on the whole the richer section of the community and those whose standard of life is least flexible, then the effect of this also will be unfavourable. What the net result will be on a balance of considerations, we can only guess. Probably it is more likely to be adverse than favourable."

Hence, the fix-wage version of Keynes' thought is the result of misconception, that suggests that if markets worked well, without imperfections, they would move to full employment. Unemployment is a disequilibrium, by definition a short run situation resulting from a rigidity.

The whole point of the neoclassical synthesis was to suggest that one could continue to teach that markets are efficient, and that supply determined the price and quantity of equilibrium in all markets including those of "factors of production" (i.e. the labor and capital markets), and as a result unemployment could only result  from rigidities in the labor market. Nothing revolutionary there, and in that case, as Keynes foresaw, people would think he was quite wrong or said nothing new.

By the way Krugman does not believe that rigid wages are behind our current lack of full employment (in his view it is the downward rigidity of the rate of interest; Keynes also did not believe in the liquidity trap as the cause of depressions), which makes it more difficult to understand why he defines Keynesians (Old and New) as pragmatic rigid price and wage modelers. You cannot blame then Laurence Kotlikoff for his confusion (here and Krugman's reply and here; Jamie Galbraith, also implicated, gives a better answer since he never said that Keynes is about wage rigidity; scroll down for Jamie's and Kotlikoff's back and forth).

Krugman's second point is that Friedman and Phelps in the 1960s were trying to provide microfoundations to wage and price rigidity. Actually, the microfoundations agenda had more to do with the theoretical development of theories for consumption (Modigliani, Friedman), investment (Eisner, Tobin) and money demand (Baumol, Tobin) behavior. The Phillips Curve (PC) debate and the Friedman-Phelps notion of a natural rate of unemployment is associated to the idea that there is a supply side constraint to the economy, and stimulating demand would ultimately have only effects on prices and not on quantities. The economy naturally moves to full employment, unless there are restrictions, and what is needed is to eliminate the restrictions not stimulate demand.

In other words, the monetarist approach of Friedman accepts the neoclassical synthesis notion that it is the rigidities that cause unemployment. It just proposes a different policy solution. By pointing out the existence of a natural rate of unemployment analogous to Wicksell's natural rate of interest (which Keynes' criticizes in the GT) Friedman was just emphasizing that if one believes in the neoclassical theory of value and there are no restrictions the system moves to full employment. In fact, Friedman's (1970) theoretical framework, an ISLM cum PC and natural rate model, is remarkably close to the neoclassical synthesis models.

In that sense, the Lucas Revolution and the subsequent move, after Kydland and Prescott's work, of most New Classicals , including Lucas, to the Real Business Cycles camp is a not a break with Friedman, and the New Keynesians (NK) that accept everything (including the natural rate) are part of the same tradition. The difference is that some emphasize the long run neoclassical principles and others the short run rigidities that demand policy action.

The fundamental problem of the neoclassical/marginalist approach, and the importance of Keynes analysis, can ONLY be properly understood in light of the 1960s capital debates (for a good reference go here). The point, for the purposes of our discussion here, is that if there is unemployment and real wages fall, neoclassical theory tells you that according to the principle of substitution, more labor is demanded (the cheap thing that is in excess supply) and less machines (capital) are used, since they are relatively more expensive. However, since labor (which is cheaper) is used in the machine sector too their price should fall too, and is not generally true that there is a tendency for the full utilization of "factors of production" according to their relative scarcities. Further, even if the substitution effects go in the right direction, and more labor is used, the income effect of lower real wages tends to be large and have a negative effect on demand (put simply, workers cannot buy stuff), which implies that less of all "factors of production" are used. In other words, there is no natural tendency to full utilization of labor or capital, and both the natural rate of unemployment and its evil twin the natural rate of interest do NOT exist.

So it is peculiar that Krugman thinks that "NK economics [is] useful, if only as a way to check my logic, although it’s not really clear if it’s any better than old-fashioned Keynesianism." What logic? New Keynesian models assume a natural rate, and that the economy (without rigidities) moves to full employment! The problem with the NC/RBC/Lucas' type of theory is not that it failed to predict the 1980s recession or that they think that most crises are caused by real shocks (although both propositions are obviously wrong), as Krugman seems to believe, but that they do maintain the fiction of an efficient market that clears (in their case too fast for Krugman's taste) and that produces a natural rate. If he wants to move in the right direction Krugman should follow Galbraith and announce that it is time to ditch the natural rate hypothesis.

PS: That means that progress in economics is not linear, and that one can and should learn from old and forgotten traditions (classical political economy did not assume full utilization of resources).

ISLM: what is it good for?

The ISLM model persists in most undergraduate textbooks, and even though it has vanished from graduate courses*, it remains central to the way economists think about policy issues.  The main reason it survives is not so much that it allows a relatively simple intro to policy issues to undergrads, as some argue, but the fact that it captures the interaction between real and monetary phenomena which was central for Keynes’ General Theory (still worth reading), and is flexible enough to accommodate divergent views, often reflected in different inclinations of the curves.

It is also true that the conventional interpretation of the ISLM is fraught with problems.  But the ISLM model is incredibly flexible and can accommodate most critiques.  For example, a few years back a reader asked Mankiw why he still taught that the Fed controls money supply, rather than control the rate of interest, which would be more relevant.  His reply was not particularly good (just an ad for his book), but the fact remains that it is easy to change the LM to reflect the fact that central banks control the rate of interest.  The ISLM with a horizontal LM is sometimes referred to as the ISMP, where MP stands for monetary policy rule, and for the most part this is done for the benefit of students (i.e. you can buy the new text with the updated ISMP model for $150!).

The ISLM can also accommodate an investment function in which the level of activity, rather than the rate of interest, is central, which is more empirically accurate, and different consumption functions in which other elements besides disposable income appear.  More importantly the ISLM does not imply a natural rate of unemployment, which often appears in the supply side part of the macro course.  In other words, the ISLM allows for relevant discussion of policy issues, and clarification of policy differences.  Besides, compare this model with the consumption theory you get in micro, and this is still one of the most relevant things you can learn in economics.  The other would be not to trust economists!

* David Colander suggests that it’s not taught in graduate courses because more sophisticated dynamic stochastic general equilibrium models (DSGE) are more important.  DSGE models are based on the aggregation of individual maximizing behavior, and have been less relevant for policy analysis than old fashion macroeconometric models based on the old Keynesian theory.  The whole conference on the ISLM, in which you can find Colander’s paper is available here

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