Posted by: Dirk | May 21, 2009

Out of the dark age – enlightening macroeconomics

Paul Krugman, who has recently criticized that macroeconomics is in a dark age, has now stated that he is

gravitating toward a Keynes-Fisher-Minsky view of macro, although of the three I’d much rather read Keynes.

For the non-economist: what is that supposed to say? Since – surprise, surprise! – I am not Paul Krugman, I cannot tell. But – I can make an informed guess since I have been studying Keynes, Fisher and Minsky in the last 2 years. I have not come up with any paper yet, since it is difficult to add to any of the three genius (is there a plural?), but I can summarize their findings and contrast them with the mainstream, which currently goes by the name of new neo-classical synthesis.

I will keep things simple so that non-economists can understand what macroeconomists are discussing. Also, I will take on the three one by one in chronological order, based on their main contributions: Fisher (1933) on debt deflation, Keynes’ (1936) General Theory on what to do when monetary policy fails, and Minsky (1986) on financial instability.

Fisher (1933) on debt deflation (pdf)

Fisher argues that a fall in asset prices can trigger deflation if financial firms are indebted. It works like this. A fall in stock prices causes pain for financial firms, since the value of their assets is affected. Their debt does not change in size though. If credit lines are then cancelled or not renewed, financial firms are forced to sell some of their assets to adjust. This causes stock prices to fall even further, triggering a new round of adjustment.

The neo-classicals have been arguing that money would be neutral (with respect to GDP). A rise in the monetary supply would result in a proportional rise in prices. Hence, a change in the total amount of money in the economy would not have any influence on GDP (given that the velocity of money does not change). An example would be Milton Friedman’s idea that monetary growth should equal the growth rate of the real economy, since all growth of monetary supply above this rate would result in inflation.

Keynes (1936) on what to do when monetary policy fails (html)

John Maynard Keynes argued that if and only if monetary policy fails, fiscal policy should be used to bring up effective demand to guarantee positive profits for firms. This would defeat deflationary tendencies in the economy. Since hoarded money would be transferred from banks to government, there is an increase in government debt. However, since corporate debt is not essentially different from government debt, this does not pose any problem. The benefits from stabilizing the economy are bigger than the loss from a decline in efficiency.

Keynes thereby could explain what the neo-classicals could not – persistent unemployment and a low GDP. This was the situation during the Great Depression. Neo-classical theory started with the labor market. Unemployment would arise if people wanted higher wages than those offered by firms. However, in the Great Depression it became clear that workers were not demanding wages that were too high. They would work for whatever wage would be offered to them, but there were no jobs.

Policy-wise, the neo-classical only believed in monetary policy. However, since changes in the monetary supply would only change the price level, it was not clear how monetary policy could be used to fight the Great Depression. As Keynes analyzed, monetary policy was useless anyway. The neo-classicals hence had nothing to offer.

The General Theory is a model of an economy in times of financial crisis. It is driven by investment, which depends on the interest rate. Since investment drives the economy, it is the financial market which causes business cycles, and not external shocks (both real and monetary, as proclaimed by the new neo-classical synthesis). The last recessions in the US are connected to the savings&loans crisis in the early 1990s, the dot-com crash in 2000/01, and now the financial crisis.

Minsky (1986) on financial instability

Hyman Minksy reinterpreted Keynes. He focused on monetary flows that are needed to cover debt payments. To finance a company, debt will be used. In good times, the acceptable level of debt is higher than in bad times. In consequence, firms borrow heavily in good times when many assets are considered liquid. In bad times, debt deflation (see above) is a threat to the economy and might result in a Minsky moment. Minsky argues that institutions change the behavior of the financial market and are therefore relevant. While financial instability can be forecasted, it is impossible to predict a Minsky moment since it depends very much on (changes in) expectations.


Misinterpretations of the General Theory and the reliance on mathematical models that have to be microfunded has led macroeconomics astray. The central piece of a modern economy is a financial economy. Money is not used only for transactions, but also to regulate debt. It is not neutral. On financial markets, savings are turned into investments. This does not always work properly, causing saving-investment imbalances to rise. These imbalances have been assumed away in most modern models.

Two people I would add to Krugman’s list of macro-economists. Axel Leijonhufvud has done work on a two sector economy where prices of investment goods and prices of consumption goods can move in different speeds, causing over-investment (and underinvestment). Also, Knut Wicksell has done research on saving-investment imbalances which is very insightful. I think the concept of a natural rate of interest should be part of any meaningful macro model.


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