Home > Uncategorized > Kelton and Krugman — MMT vs IS-LM

Kelton and Krugman — MMT vs IS-LM

from Lars Syll

UnknownIs there some reason the straightforward framework Krugman laid out is wrong? Yes, as even its creator went on to acknowledge. MMT rejects the IS-LM framework that Krugman uses to demonstrate the conclusion that widening budget deficits put upward pressure on interest rates and crowd out private investment.

The model remains the workhorse for many mainstream Keynesians. MMT considers it fundamentally flawed …

Keep this in mind: Higher deficits give rise to higher interest rates, which give rise to lower investment. The last bit is referred to as “crowding out.” This is the inherent tradeoff that MMT denies and Krugman defends.

And it’s easy for him to defend it because his model assumes a fixed money supply, which paves the way for the crowding-out effect!

Krugman’s framework treats investment as a simple function of the interest rate. Higher rates mean lower investment, and vice versa. Central banks can juice (or slow) the economy simply by lowering (or raising) interest rates. It’s Pavlovian in its simplicity: stimulus-response.

Keynes’s analysis was more nuanced. Investment decisions were forward-looking, heavily influenced by “animal spirits,” and overwhelmingly dependent on the state of profit expectations. When the profit outlook is sufficiently grim, no amount of rate cutting will entice businesses to borrow and invest in new plant and equipment (think Great Recession).

Stephanie Kelton

Again — as so often — it turns out that when we economists disagree it ultimately boils down to methodology .  And here — again — we are back to the question if Krugman’s and other ‘New Keynesians’ hobbyhorse IS-LM interpretation of Keynes is fruitful and relevant for understanding monetary economies.

My own view is that IS-LM is not fruitful and relevant and that it does not adequately reflect the width and depth of Keynes’s insights on the workings of monetary economies:

 Almost nothing in the post-General Theory writings of Keynes 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 famous 1937 Quarterly Journal of Economics 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. John Hicks, the man who invented IS-LM in his 1937 Econometrica review of Keynes’ General Theory — “Mr. Keynes and the ‘Classics’. A Suggested Interpretation” — returned to it in an article in 1980 — “IS-LM: an explanation” — in Journal of Post Keynesian Economics. Self-critically he wrote 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.” What Hicks acknowledges in 1980 is basically that his original IS-LM model ignored significant parts of Keynes’ theory. IS-LM is inherently a temporary general equilibrium model. However — much of the discussions we have in macroeconomics is about timing and the speed of relative adjustments of quantities, commodity prices and wages — on which IS-LM doesn’t have much to say.

 IS-LM forces to a large extent the analysis into a static comparative equilibrium setting that doesn’t in any substantial way reflect the processual nature of what takes place in historical time. To me, Keynes’s analysis is in fact inherently dynamic — at least in the sense that it was based on real historical time and not the logical-ergodic-non-entropic time concept used in most neoclassical model building. And as Niels Bohr used to say — thinking is not the same as just being logical …

 IS-LM reduces interaction between real and nominal entities to a rather constrained interest mechanism which is far too simplistic for analyzing complex financialised modern market economies.

 IS-LM gives no place for real money, but rather trivializes the role that money and finance play in modern market economies. As Hicks, commenting on his IS-LM construct, had it in 1980 — “one did not have to bother about the market for loanable funds.” From the perspective of modern monetary theory, it’s obvious that IS-LM to a large extent ignores the fact that money in modern market economies is created in the process of financing — and not as IS-LM depicts it, something that central banks determine.

 IS-LM is typically set in a current values numéraire framework that definitely downgrades the importance of expectations and uncertainty — and a fortiori gives too large a role for interests as ruling the roost when it comes to investments and liquidity preferences. In this regard, it is actually as bad as all the modern microfounded Neo-Walrasian-New-Keynesian models where Keynesian genuine uncertainty and expectations aren’t really modelled. Especially the two-dimensionality of Keynesian uncertainty — both a question of probability and “confidence” — has been impossible to incorporate into this framework, which basically presupposes people following the dictates of expected utility theory (high probability may mean nothing if the agent has low “confidence” in it). Reducing uncertainty to risk — implicit in most analyses building on IS-LM models — is nothing but hand waving. According to Keynes we live in a world permeated by unmeasurable uncertainty — not quantifiable stochastic risk — which often forces us to make decisions based on anything but “rational expectations.” Keynes rather thinks that we base our expectations on the “confidence” or “weight” we put on different events and alternatives. To Keynes, expectations are a question of weighing probabilities by “degrees of belief,” beliefs that often have preciously little to do with the kind of stochastic probabilistic calculations made by the rational agents as modeled by “modern” social sciences. And often we “simply do not know.”

6  IS-LM not only ignores genuine uncertainty, but also the essentially complex and cyclical character of economies and investment activities, speculation, endogenous money, labour market conditions, and the importance of income distribution. And as Axel Leijonhufvud so eloquently notes on IS-LM economics — “one doesn’t find many inklings of the adaptive dynamics behind the explicit statics.” Most of the insights on dynamic coordination problems that made Keynes write General Theory are lost in the translation into the IS-LM framework.

Given this, it’s difficult not to side with Stephanie Kelton. The IS/LM approach is not fruitful or relevant for understanding modern monetary economies. And it does not capture Keynes’ approach to the economy other than in name.

  1. March 3, 2019 at 3:06 am

    Ok, very readable Lars, for such difficult terrain. I’ll share my reaction to Krugman’s postings: will he ever sit down and have a face-to-face debate, maybe with a moderator, with enough time so that both sides can clarify their terms so that we can get to the heart of the disputes, as Lars has done here? It seems to me Krugman is avoiding that, and maybe what we need is a tag team event, three each side, but the K would probably never accept the terms where he wouldn’t be in control. That’s why I’ve referred to him as the “Pope.”


    And here’s a question for the MMTers, esp. L. Wrandall Wray: in the new world of flows and incomes and debts balancing out in the great accounting equations, has the FED assumed a more neutral technocratic role, or does it still have the bankers biases that William Greider ascribed to it in “Secrets of the Temple.” Yes they acted to save Wall Street in the operations of 2008-2016, but could they do the same in a Green New Deal? Would they, the Board accept the tools of MMT – and this is what is actually triggering this debate – to favor more egalitarian outcomes in investment priorities, and in funding programs…? Or is one of the Secrets of the Temple that the tools only work in one grand direction…the status quo?

  2. Craig
    March 3, 2019 at 7:32 am

    I’m in agreement with the policy thrust of every heterodox economic theorist from Keen, to Hudson to MMT etc. about there being a need to inject more money into the economy. I’ve been on here for several years advocating a 50% discount at retail sale which is entirely rebated back to the retailer by the monetary authority. What I want to know is who here sees the paradigm changing effect of this single policy? Anyone want to critique it, let me hear from you, but you have to consider a couple of things. #1 retail sale is the terminal ending point for every consumer item or service thus #2 it is also by definition of #1 the terminal summing and expression point for all forms of inflation #3 Lets assume you have 3% garden variety inflation, so if you tacked that on and made the discount 53% it would automatically make everyone’s purchasing power double and not only completely eliminate any inflation, but would integrate price deflation painlessly and beneficially into profit making systems. #4 It simultaneously doubles the actually available business revenue in the economy which is a tremendous incentive for the business community to stand up and salute such a policy. #5 There are many other benefits that would consequently be possible and also further regulations and requirements, none of which would be onerous, to keep normal inflation before retail sale from increasing.

    So who sees it? Yes the economic system is complex, but the actual operations and concepts behind all historical paradigm changes are always simple, elegant and powerful. Critique away…..

  3. Mike Ryan
    March 3, 2019 at 4:18 pm

    Why is it economists hang in the clouds yet fail to luck down and see what is going on.

    “When the profit outlook is sufficiently grim, no amount of rate cutting will entice businesses to borrow and invest in new plant and equipment ”

    What? during the great recession plants were not running anywhere near capacity. There was no need to invest in new plant and equipment.

    “Higher deficits give rise to higher interest rates, which give rise to lower investment.”

    What? All because you say something doesn’t make it true. The fed controls interest rates, the congress/president determine deficits. You would think the Obama deficits would have resulted in astronomical rates – but nope. You would think the recession associated with Opec’s price spikes would have driven rates down – but nope – the fed raised rates to combat the inflation side of stagflation.

    “IS-LM forces to a large extent the analysis into a static comparative equilibrium setting that doesn’t in any substantial way reflect the processual nature of what takes place in historical time”

    What? My third grade student writes clearer than this. Just say “IS-LM theories rely upon ceteris/paribus and equilibrium, two critical assumptions that do not exist in real life. We all should know by now that assumptions make an ASS out of U and Me.”

    The problem that all economists have is they don’t understand there are two types of investment, capital and financial. A financial investment does not result in capital investment. Most of all wall street transactions are financial investment. But wall street doesn’t want the public to understand this distinction. If the public understood, they would regulate the hell out of leveraged buyouts – a form of financial investment that leads to three things – layoffs, higher prices and bankruptcy.

    Throw out any ill conceived ideas from your basic economics class. Start all over.

    • anobserver
      March 3, 2019 at 6:33 pm

      The problem that all economists have is they don’t understand there are two types of investment, capital and financial […] But wall street doesn’t want the public to understand this distinction.

      Interestingly enough, the distinction exists in some languages other than English.

      In German, there are “Investition” and “Anlage” (verbs: “investieren” and “anlegen”), in French “investissement” and “placement” (verbs: “investir” and “effectuer un placement”) to denote the two meanings you discuss.

  4. March 3, 2019 at 5:37 pm

    Great everyone. But we must find ways to get the debates into public forums. In considerable ways, the fate of a Green New Deal depends upon our ability to persuade enough of the public that the programs can be paid for or not without catastrophic consequences – and that many of the Neoliberal assumptions being dissected here no longer hold…but there is a huge gap between the ideas in this exchange and the “kitchen table family budget model” in most citizens’ heads. FDR himself never quite escaped the gravitational field of balanced budget traditions, despite ditching the gold standard from the late 19th century.

    • Craig
      March 3, 2019 at 9:41 pm

      Yes, that’s necessary, but iconoclasm and debate will only get you so far. You have to 1) incorporate philosophy/wisdom into the debate so that 2) the single concept that illustrates, defines and resolves the problems of economics becomes clear. Then you have to 3) discover the best way to integrate that concept into the economy in the form of policy.

      1) wisdom is the integrative process itself and the natural philosophical concept of grace is its pinnacle concept

      2) Monetary grace as in gifting is the applicable concept that strategically and insightfully resolves continual debt build up and price and asset inflation via

      3) a 50% discount/rebate policy at the terminal ending point for all consumer items and services at the point of final retail sale.

      Just look at it. Keep looking at it until you see the applicability of the idea, its workability and the problem resolving effects of the policy.

  5. Helen Sakho
    March 5, 2019 at 1:46 am

    We are fixated on particular explanations that are outdated and devoid of even acknowledging what is going on in ALL economies around the world, let alone capable of posing valid questions for deliberation. In Germany under Hitler, the price of a cup of coffee went up beyond the financial ability of the consumer to pay for it by the time the coffee was drunk. Right now, in Venezuela, a country rich in oil and Gas resources, a loaf of bread is costing so much because of hyperinflation that it has become unaffordable for the vast majority of people.
    Economics really needs to repent! It does keep missing the main issues that one has repeatedly pleaded here need urgent attention: the arms race, climatic catastrophes, abject poverty, collapse of all systems of credible governance and associated outcomes.

    • Craig
      March 5, 2019 at 4:38 am

      Correct Helen. Everyone touts their particular tweak of theory and policy, but none of them have any real idea how to create an entirely new pattern in economics….except me. Here’s a list of beneficial effects of my two primary policies a $1000/mo. universal dividend available to everyone 18 and older and a 50% discount/rebate policy at retail sale.

      1) Immediately more than doubles everyone’s purchasing power. Does that sound like a policy most people could get behind even if they are die hard libertarians and conservatives?
      2) Because individual income is basically the same as business revenue the potential business revenue is also more than doubled. Does that sound like a policy the business community could get behind?
      3) With everyone getting $2000/mo. worth of purchasing power when they hit 18 students could pay for their tuition at a university that charged $10k/yr (reduced 50% by the discount/rebate policy to $5k/yr divided by 12 = $416.67/mo and still have $583.33/mo. which would purchase $1166.66/mo of goods and services….and never have to borrow a cent to get their degree
      4) Few or no one gets $2000/mo worth of welfare and few people get $2000/mo of social security so the transfer taxes for welfare, unemployment insurance and social security that both individuals and businesses pay could be eliminated. Nice little addition to individual paychecks and business profit margins there, eh?
      5) Retail sale being the terminal end of the entire economic/actually productive process it by definition is also then the terminal expression point for any and all forms of inflation. No one has ever gotten a call from the grocer they just bought $100 worth of groceries from where the grocer then demanded another $30-40…..because when you buy it its now consumption. If possession is 90% of the law possession as in consumption is 99.99% of economics. Hence a 50% discount/rebate policy at the point of retail sale amazingly and miraculously from an orthodox economic perspective…integrates price DEFLATION painlessly and beneficially into profit making systems.
      6) It inverts present individual and systemic monetary realities and destroys orthodoxies on both the left and right. Those are classical, historical signatures of paradigm changes.

      The benefits go on and on and on and not only in economics. My book Wisdomics-Gracenomics: The Theory of the New Monetary and Economic Paradigm will be on Amazon in about 2-3 days. Probably be a free kindle rental. That will give you the full program. No one here even comes close to offering a better and more inclusively heterodox theory and program.

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