Krugman doesn’t understand IS-LM (Part 1)

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This is a post in at least 4 parts; for part 1, click this link to the Business Spectator article.

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Krugman doesn't understand IS-LM--Part 1

Krugman describes himself as a “sorta-kinda New Keynesian”, and explains in his book End This Depression NOW! that New Keynesian macroeconomics evolved in reaction to the failure of the new classical approach to “explain the basic facts of recessions”.

His “sorta-kinda” qualification is because both New Keynesian and new classical models are derived from applying assumptions about the behaviour of individuals and markets at the level of the macroeconomy, and he has a healthy scepticism about these assumptions:

 "I don’t really buy the assumptions about rationality and markets that are embedded in many modern theoretical models, my own included, and I often turn to Old Keynesian ideas, but I see the usefulness of such models as a way to think through some issues carefully – an attitude that is actually widely shared on the saltwater side of the great divide."

This is one aspect of Krugman that I genuinely applaud: the awareness that models aren’t reality. At best they are representations of reality, but some neoclassicals show an amazing capacity to believe that their models are reality – as in this piece by French economist Gilles Saint-Paul which the blog Unlearning Economics deservedly flogged recently – in a way that leads to truly delusional thinking about the real world.

Of course, we need models to think about the economy in the first instance, because it is such a complex entity. Even those who deride modelling in economics are using a model when they talk about the economy – it’s just a verbal (or even unarticulated) one, as opposed to an academic construct.

One might hope that experience and experimentation over time would weed out unrealistic models in economics, but that hasn’t happened. In many ways, the models that dominate economics today are less realistic than those which prevailed as much as seventy years ago.

Krugman alludes to this by his reference to “Old Keynesian ideas” above. In particular, he champions John Hicks’ IS-LM model as an explanation of our economic crisis today.

This model, first published in 1937, seeks to explain the relationship between interest rates on one hand and real output in goods and services and money markets, on the other.

Click here to read the rest of this article

About Steve Keen

I am a professional economist and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous debts accumulated in Australia, and our very low rate of inflation.
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One Response to Krugman doesn’t understand IS-LM (Part 1)

  1. Steve Hummel says:

    bit.ly/108FzQ9

    Ann Pettifor’s link to this video is utterly apropo.…..except for one thing.

    Pre-Keynesian eco­nom­ics does not have to be under­stood as a regres­sion. Why? Because C. H. Dou­glas was one of the first indi­vid­u­als to under­stand the “loans cre­ate deposits” real­ity. That plus his ground­ing in engi­neer­ing, and his knowl­edge of dou­ble entry book­keep­ing as well as its sub­set cost account­ing gave him an excel­lent under­stand­ing of both micro and macro eco­nom­ics. Dou­glas wasn’t nearly as bur­dened by the ortho­dox myth that mar­kets are sta­ble and equi­li­brat­ing or that cap­i­tal­ism was sacro-sanct in and of itself con­ceived of by most in Amer­ica and else­where. His ground­ing in cost account­ing enabled him to see the micro-economic prob­lem lack of money for the indi­vid­ual and his under­stand­ing of the ex nihilo/creditary nature of money enabled him to envi­sion a macro-economic solu­tion like the retail discount.

    Key­ne­sian­ism was utterly supe­rior to its neo-classical dece­dent, but Dou­glas (whom Keynes prob­a­bly only uncon­sciously pla­gia­rized) was in fact both eco­nom­i­cally and eth­i­cally supe­rior to Keynesianism.

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