Krugman on Unreal Keynesians (IS/LM again)

Paul Krugman exchanges views with Lars Syll (from Malmö University, Sweden) over what makes a Keynesian. The former summarizes the exchange like this:

Brad DeLong points me to Lars Syll declaring that I am not a “real Keynesian”, because I use equilibrium models and don’t emphasize the instability of expectations.

One way to answer this is to point out that Keynes said a lot of things, not all consistent with each other. (The same is true for all of us.) Right at the beginning of the General Theory, Keynes explains the “principle of effective demand” with a little model of temporary equilibrium that takes expectations as given.

The is a lot that could be said. For instance, fundamental uncertainty is not the same as instability of expectations. However, it should be granted to Paul Krugman that he is a at least a Keynesian in the old policy-making sense: an economist who is not against an increase in government spending per se. And this, to me, seems to be the fundamental issue of macroeconomics. Keynes in his General Theory (1936) makes the point that neoclassical economics is a special case of his general theory: the one in which demand equals supply at full employment.

Keynes sets out to show that there are possible equilibria in which goods, money and bonds markets are in equilibrium while there is unemployment. Equilibrium means that supply equals demand, which means that every buyer finds a seller at the going rate, and every seller finds a buyer at that very same rate. At the end of the day, everybody is happy and the plan tomorrow of what to buy and what to sell stay the same. Hence in equilibrium we have stability in the sense that tomorrow is like today (or yesterday).

What’s wrong with IS/LM then? Lars Syll attacked the model for many flaws (see his original post). My own point of view is that IS/LM is mistaken in assuming that the central bank controls the money supply and that the sectoral balances (private and public) are not made explicit. You actually can get a lot of mileage out of the good old IS/LM model if you let the central bank set the interest rate on the short-term money market (horizontal LM curve) and – because of general depression – determine some level of expenditure (or demand) that does not react to changes in the interest rate (vertical IS curve). The resulting cross is so trivial that I tend to agree with Syll: maybe it is not the best idea to use a macroeconomic model to show that:

1. Demand is exogenous and smaller than potential output
2. The central bank creates the interest rate, but that doesn’t matter because of 1.
3. Demand is exogenous, but government spending can add to that

Using a mathematical model with all eyes crossed and all teas dotted to then arrive at this conclusion really is a waste of time. How do we fix this?

I have published the so-called IS/MY model to show what could be done to improve on the shortcomings of the IS/LM model (working paper version here). First of all, the main idea is that expenditure equals spending in equilibrium. Then, net deposits (money) are created through three mechanisms that rely on the same balance sheet trick. A rise in net debt leads to a rise in deposits for each of the three sectors: private, public and external. The monetary circuit works well as long as the amount of deposits is increasing (given velocity, and ignoring complications of what is money).

The economy has two modes: thinking fast and thinking slow, if I may borrow from Kahneman. In the fast mode, firms maximize profits and they act on animal spirits. Investments is strong, debt levels increase and Hyman Minsky would start to look scared. When the Minsky moment is reached and suddenly the actors realize that the boom is over, prices adjust (both relative and absolute) and the economy turns into a social system ruled by people concerned about the liability side and, ultimately, insolvency. We have what Richard Koo termed a balance sheet recession as firms and/or households start paying off debt and stop taking out more loans.

This is when the public sector can stabilize incomes by creating and spending deposits, usually by issuing bonds and deficit spending. This creates more deposits in the economy which helps the private sector to deleverage. This, in a nutshell, is/my model. It is not perfect, but it might be better than the IS/LM model because its features are more realistic and it shows the external sector as well. That would then not only reveal the paradox of thrift, but also the paradox of net exports. As all countries try to get into a net exporting position by cutting imports, they all fail miserably.

The IS/LM model was not perfect, and never will be. Any alternative will face the same fate. However, it would be nice for the macroeconomist to have something small and “unbreakable” that works on the back of an envelope. The IS/MY model is based on (BoP) accounting relations and assume only that consumption and imports depend on income. Most economists should be able to live with these assumptions. What is left to the economist is to speculate about the quantity of investment, government spending and exports. These will, using the vocabulary of Wynne Godley, determine the fiscal and trade stance and allow discussions of sustainability of macroeconomic regimes.