Tuesday, November 6, 2012

Despite Hicks' Denouncing His IS-LM Creation, The Classroom Gadget Lives On

Within my PhD program, the first unit/half of the Macroeconomics course was devoted to growth theory. Although the different models within this category (Solow, Ramsey-Cass-Koopmans, Diamond, etc.) are still widely used today, with various modifications, I think it’s fair to say that the empirical results of forecasts stemming from these models leave much to be desired. That view, however, is not one I wish to delve further into today.

The second half of the course has begun and will revolve largely around variations of the Keynesian IS-LM model. The Keynesian title associated with IS-LM models is a bit of a misnomer since the original model was expounded by John Hicks in a paper, “Mr. Keynes and the Classics” (1937). Considering the title of Hicks’ paper, it should come as no surprise that many (most) economists over the years have assumed the IS-LM framework was an interpretation of John Maynard Keynes’ The General Theory of Employment, Interest and Money.

Should we accept the mainstream view? Well, according to Hicks himself, the answer is no. More than 40 years after bringing the IS-LM model to economics, Hicks returned to the topic in a paper within the Journal of Post-Keynesian Economics titled “ “IS-LM”: An Explanation” (1980). He wrote (my emphasis):

“Mr. Keynes and the Classics” was actually the fourth of the relevant papers which I wrote during those years. The third was the review of The General Theory that I wrote for the Economic Journal, a first impression which had to be written under the pressure of time, almost at once on first reading of the book. But there were two others that I had written before I saw The General Theory. One is well known, my “Suggestion for Simplifying the Theory of Money” (1935a), which was written before the end of 1934. The other, much less well known, is even more relevant. “Wages and Interest: the Dynamic Problem” was a first sketch of what was to become the “dynamic” model of Value and Capital (1939). It is important here, because it shows (I think quite conclusively) that that model was already in my mind before I wrote even the first of my papers on Keynes.
The notion that IS-LM was a Hicksian, not Keynesian, construction should not dampen its value in any meaningful way. However, one may be interested to learn that Hicks later admitted to the broad uselessness of IS-LM analysis in the same paper quoted above (my emphasis):

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 …
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 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.

Unfortunately IS-LM analysis still dominates the policy field today, which is why it remains a core component of introductory Macroeconomics courses at the graduate level. As Lars P Syll points out:

Back in 1937 John Hicks said that he was building a model of John Maynard Keynes’ General Theory. He wasn’t.
What Hicks acknowledges in 1980 is basically that his original review totally ignored the very core of Keynes’ theory – uncertainty. In doing this he actually turned the train of macroeconomics on the wrong tracks for decades. It’s about time that neoclassical economists – as Krugman, Mankiw, or what have you – set the record straight and stop promoting something that the creator himself admits was a total failure. Why not study the real thing itself – General Theory – in full and without looking the other way when it comes to non-ergodicity and uncertainty?
Why not study models that incorporate endogenous money and heterogeneous capital? I recognize that time is limited, but if not now, when? Most of my fellow classmates will likely only take one more semester of Macroeconomics before earning their PhD. If historical awareness and other models are not presented now, the task of changing the mainstream approach going forward becomes that much harder. Hopefully I can play a role in changing that trend going forward.

1 comment:

  1. Excellent point. "If not now, when?" is a question every economist needs to be asking themselves every time they play with a model and say "Well, difficult to deal with variable/behavior X is probably important, but I will ignore it for now to make the math easier." In the IS/LM case the effectiveness of short term money injections almost certainly have some sort of quadratic function, becoming less beneficial and then negative as the level gets higher, but as you pointed out after class, that's annoying and difficult to show. So they ignore it. But at some point economists need to stop avoiding the difficulties and actually work to improve their models, or at least accept that they are hopelessly complicated messes of arbitrary definitions and impossible to measure data.

    I suspect they will keep on rolling with poor models and simply maintain the profession's assertion that they are good enough, however. Who needs truth or science when you have a nice job in the government dictating policy?

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