Home > Uncategorized > Hyman Minsky and the IS-LM obfuscation

Hyman Minsky and the IS-LM obfuscation

from Lars Syll

As a young research stipendiate in the U.S. yours truly had the pleasure and privilege of having Hyman Minsky as a teacher. He was a great inspiration at the time. He still is.

The concepts which it is usual to ignore or deemphasize in interpreting Keynes — the cyclical perspective, the relations between investment and finance, and uncertainty, are the keys to an understanding of the full significance of his contribution …

miThe glib assumption made by Professor Hicks in his exposition of Keynes’s contribution that there is a simple, negatively sloped function, reflecting the productivity of increments to the stock of capital, that relates investment to the interest rate is a caricature of Keynes’s theory of investment … which relates the pace of investment not only to prospective yields but also to ongoing financial behavior …

The conclusion to our argument is that the missing step in the standard Keynesian theory was the explicit consideration of capitalist finance within a cyclical and speculative context. Once capitalist​ finance is introduced and the development of cash flows … during the various states of the economy is explicitly examined, then the full power of the revolutionary insights and the alternative frame of analysis that Keynes developed becomes evident …

The greatness of The General Theory was that Keynes visualized [the imperfections of the monetary-financial system] as systematic rather than accidental or perhaps incidental attributes of capitalism … Only a theory that was explicitly cyclical and overtly financial was capable of being useful …

If we are to believe Minsky — and I certainly think we should — then when people like Paul Krugman and other ‘New Keynesian’ critics of MMT and Post-Keynesian economics think of themselves as defending “the whole enterprise of Keynes/Hicks macroeconomic theory,” they are simply wrong since there is no such thing as a Keynes-Hicks macroeconomic theory!

There is nothing in the post-General Theory writings of Keynes that suggests that he considered Hicks’s IS-LM anywhere near a faithful rendering of his thoughts. In Keynes’s canonical statement of the essence of his theory in the 1937 QJE 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. So, of course,​ there can’t be any “vindication for the whole enterprise of Keynes/Hicks macroeconomic theory” — simply because “Keynes/Hicks” never existed.

To be fair to Hicks, we  shouldn’t forget that he returned to his IS-LM analysis in an article in 1980 — in Journal of Post Keynesian Economics — and self-critically wrote:

sir_john_hicksThe 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 …

When one turns to questions of policy, looking toward the future instead of the past, the use of equilibrium methods is still more suspect … 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 …

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.

In his 1937 paper, Hicks actually elaborates on four different models (where Hicks uses I to denote Total Income and Ix to denote Investment):

1) “Classical”: M = kI   Ix = C(i)   Ix = S(i,I)

2) Keynes’ “special” theory: M = L(i)   Ix = C(i)    I = S(I)

3) Keynes’ “general” theory: M = L(I, i)   Ix = C(i)   I = S(I)

4) The “generalized general” theory: M = L(I, i)   Ix =C(I, i)  Ix = S(I, i)

It is obvious from the way Krugman and other ‘New Keynesians’ draw their IS-LM curves that they are thinking in terms of model number 4 — and that is not even by Hicks considered a Keynes model! It is basically a loanable funds model, that belongs in the neoclassical camp and which you find reproduced in most mainstream textbooks.

Hicksian IS-LM? Maybe. Keynes? No way!

  1. January 28, 2023 at 10:48 pm

    All of Keynes, Minsky etc. have insight. Their only problem is they are reforms when what is required is a paradigm change in finance and the economy. The evolving work of the new applied operant concept has been done here: https://www.amazon.com/dp/B07PLNJLRN/ref=sr_1_1?keywords=wisdomics-Gracenomics&qid=1552358772&s=books&sr=1-1-catcorr

  2. rsm
    January 29, 2023 at 12:11 am

    Gerald Holtham said, after mentioning Minsky, on Lars’s last post here:

    《I don’t think people speculate in the expectation they will get bailed out.》

    Even today after the Fed has demonstrated it will pull out all the stops, twice, in 2007 and 2019?

    《Derivatives that fell out of favour after the GFC are creeping back into use but most institutions are now required to have bigger capital reserves or buffers than they did.》

    Can we put numbers to that intuition?

    Is an increase from $3.3 trillion daily average turnover of OTC foreign exchange instruments in 2007 to $7.5 trillion in 2022 “creeping back into use”, or vaulting up 150%? (See Table D5.2 in the BIS statistics explorer at https://stats.bis.org/statx/toc/DER.html )

    Interest rate derivatives totaled $432 trillion in 2007, thus does the current 2022 value of $505 trillion indicate derivatives are a much bigger part of the picture than things either mainstream or heterodox economists talk about? (See table D7)

    As for bigger capital reserves, did those not come from the Fed’s Quantitative Easing programs?

    《Banks’ margins do rise as interest rates go up but credit growth tends to fall because demand for credit falls. Borrowers also become less credit-worthy so banks hesitate and spreads widen.》

    Are you disputing fedguy’s data? From https://fedguy.com/credit-boom/

    《A tremendous credit boom took place in 2022 and it may not even be over. The combination of healthy banks, financially strong households, and attractive rates appears to have to led to a surge in bank lending. Banks and credit unions together created $1.5t in cash last year that likely has not yet fully filtered into economic activity. Recall, bank lending creates money out of thin air. Interestingly, higher interest rates have so far only shown very tentative signs of moderating the boom. This post reviews the credit boom of 2022, suggests it was due to the strong financial position of banks and households, and notes that it will be supportive of demand throughout the year.》

  3. yoshinorishiozawa
    January 29, 2023 at 1:44 pm

    Who among Post Keynesian economists want or try to defend IS-LM now?

    Lars Syll seems to believe that all Keynes wrote or said is right. Is it? For example, I = S was an identity for Keynes, by definition. Logically, it is true (many Post Keynesians believe so except a few), but is it meaningful? Hicks changed this equation into an equilibrium condition. I believe both Keynes and Hicks were wrong. But, Keynes had a deep core of truth among his confused thinking. It was the principle of effective demand. See my paper: The principle of effective demand: a new formulation.  

  4. Gerald Holtham
    January 31, 2023 at 4:40 am

    The specific instruments that caused most problems in 2008 were bundled mortgages, CBOs etc. These are what are coming back after a gap.
    Interest rates may not be very effective in limiting credit demand but I thought you were suggesting that higher rates would increase credit because banks would be keener to lend. My point was that may be so but they find fewer suitable customers. Eventually higher rates tend to reduce credit as Volker demonstrated.

    • rsm
      February 1, 2023 at 5:38 am

      “Eventually higher rates tend to reduce credit as Volker demonstrated.”

      Is this a nice story, but I can weave a tale where Reagan’s tougher stance towards OPEC was more effective than Volcker in bringing down inflation? In other words was Volcker proven wrong because credit supply exploded even as inflation dropped? How do you know high interest rates were not just coincidental, or a purely psychological (and thus arbitrary and fickle), cause of disinflation?

  5. Gerald Holtham
    January 31, 2023 at 4:54 am

    “The” interest rate in IS-LM is in fact the bond yield as bonds are the only financial asset in the model apart from “money”. In that system the authorities alter bond yields by altering the quantity of money, which is assumed to be under their control.
    That, of course, is quite unrealistic in itself. Broad money is endogenous, created by commercial banks in response to credit demand. The government has only remote and ineffective control over it by raising interest rates to restrict credit demand.
    Quantitative easing did enormously swell banks’ reserves but the truth which text books have yet to recognise is that banks don’t need reserves to create credit. The problem with the swollen reserves is that they make it either harder or more expensive for the central bank to control interest rates. The Fed is doing it now by paying the commercial banks interest on those reserves, costing the public an enormous fortune. It’s a scandal – but a other story.

    • yoshinorishiozawa
      January 31, 2023 at 7:25 am

      A short comment on interest rate and investment.

      Interest rate(s) is a very weak factor that may influence investment (to increase the production capacity, not that “investment” on stocks or other financial assets). A clear exception may be the housing investment.

      The irrelevance or weakness of interest rate on investment was known since the time of Oxford Economists’ Research Group (see Mead and Andrews 1938, Henderson 1938). Keynes gave a very misleading account on this point. See four models that Lars cites above. In all four models, investment (Ix) is a function of interest rate (i). This was not an idea particular to Keynes. It was rather a common idea of those economists in Keynes’s time. Hicks only inherited this confusion. To defend Keynes by rejecting Hicks or IS-LM is a quite strange idea. Before we study methodology of economics, it would be necessary and better to study the history of economics.

  6. Gerald Holtham
    February 7, 2023 at 12:04 pm

    Being tough with OPEC did not and could not have caused a double-dip recession in the US in the early 1980s. History gives Volker’s interest rate policy the “credit” for that and history is right. No-one should doubt that if you ramp up interest rates enough you will eventually choke off demand. Housing investment and consumer credit particularly. But it is a rough and ready mechanism with loose linkages and long lags. It should not be used for trying to fine-tune routine economic fluctuations. Monetary policy works like a cosh. If the economy gets too excited you hit it over the head; it’ll probably get more excited so you hit it again. Eventually it falls over. If it doesn’t break any bones you call it a soft landing.

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